Not Hating Costco
Board: Berkshire Hathaway
What is it about Costco that makes you not hate being there?
With Costco specifically, it comes down to some basics: discernible value; company values; a well-defined target customer (someone we can relate to ourselves); a refreshing ‘inverted’ perspective on markup and gross margins; limited assortment and selection but with peerless pricing ability; superb private label execution; very good return policy.
Before Costco had a presence in this area, there was BJ’s. I had a membership in BJ’s, then later at Sam’s. I hated shopping in those as much as I disliked shopping anywhere though, and pretty much limited purchases to only tires, cases of Mobil1, and things like that.
When Costco finally came to the area, Munger had been praising the company for awhile, so I rather reluctantly gave it a try. Experimenting with warehouse clubs is relatively expensive – consumers are understandably reluctant to pay an up-front annual fee to try a place they might not like after a visit or two.
[In the 1980’s a score of warehouse clubs sprang up. Each felt that it needed to be ‘first to market’ in different cities on the reasonable assumption that customers would only buy one annual warehouse membership card at a time, so rather than concentrating on single markets and expanding out, as traditional retailers might, they hop-scotched all over the map, a store or two in each metro area, hoping to score members. The fast-expanding chains of that era are mostly gone, with the category now consisting mostly of just Sam’s, BJ’s and Costco.]
For a retailer that wasn’t formally one of the Berkshire family, Costco had the right references and credentials. Charlie was on its board, and Costco had gone from a ‘no credit card’ policy to taking the card of Berkshire’s favorite issuer. In this metro area Costco was still pretty far away – well past everything else – and experimenting with warehouse clubs can be expensive and inconvenient, especially since they aren’t ‘necessary’ for anything in particular on a normal basis. Another Berkshire shareholder highly recommended trying it though, so I did.
Initially, Costco’s cash-or-Amex-only policy (most stores, including all US & Canadian stores) was a nuisance. Amex still wasn’t accepted everywhere then, so having the card didn’t seem important and I hadn’t yet switched from MC/Visa. Costco’s move to accept Amex had been intriguing, though. We could perhaps speculate – wildly or not - that Charlie had some influence in the Amex-Costco alliance, and that in return for exclusivity and perhaps other concessions it had to have been extremely close to cost-neutral for Costco to do it. There was something symbiotic in the arrangement (Amex target customers = Costco target customers).
I had long been aware that an Amex customer will spend twice what a Visa or MC customer spends, in the same store, but also restricting credit card acceptance to only Amex significantly limited the customer population. But then again, so did essentially charging people an admission fee to shop. I gave Costco membership a try, and soon after Costco became the reason for switching entirely out of MC & Visa to Amex. In my case there really was something mutually beneficial with that alliance.
Anyway, the dynamics seemed to work to the benefit of both. With the Amex card – and no more of the initial ‘carrying cash’ (or checks) inconvenience – my shopping frequency increased and the Costco retail model came into better focus. It seemed like they had a well-defined target customer, and that their core customer was someone I could definitely relate to - me. Shopping frequency increased, to the point where getting the Business/Executive membership made sense. That membership currently costs $110 – double the base membership - but with that more expensive membership there’s an annual rebate of 2% of purchases (redeemable at Costco).
[Looking at their financial statements, Costco’s total membership fees last year were about $1.9B. It looks like about $1.1B is from the premium membership group. That group ‘earned’ just under $0.9B in rebates, suggesting that premium members accounted for about half of Costco’s sales volume, or (it looks like) about $3.7K each. Costco’s overall member retention rate is just under 90%. ]
Breaking down the elements of ‘why I don’t hate Costco’ a bit more, and drawing from some additional sources (not just more of my own hyperbole) we have:
The Munger endorsement
My initial reason for giving Costco a try.
Asked about his favorite company outside of Berkshire, Munger literally interrupted the questioner and answered, "That's easy. It's Costco….It's one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet," he gushed. "I just can't say enough about my admiration for Costco. More of you should look at Costco….It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It's almost a religious duty. He's sacrificing short-term profits for long-term success…
….Generally speaking, I believe Costco does more for civilization than the Rockefeller Foundation."
"Retailing isn't rocket science. Costco has figured out the big, simple things and executed with total fanaticism," says Charles Munger, a Costco director…"Jim wouldn't let the board give him a bonus. His view was that the option glitch happened on his watch," Munger says. "How many people behave like that? No wonder everyone loves him."
Costco’s core customer:
Costco’s target customer seems to be well-defined, and those who can relate to it will probably feel right at home in the store –
Costco knew that its customer was a more sophisticated, urban creature….. "We understood that small-business owners, as a rule, are the wealthiest people in a community," says [Costco co-founder] Brotman. "So they would not only spend significant money on their businesses, they'd spend a lot on themselves if you gave them quality and value.”
Costco believes its customer is fundamentally a different shopper than a Sam’s member – with the often-used example that if a Sam’s customer saw a high-end product at an excellent price they’d pass – because it’s a high-end, expensive item, regardless of ‘value’ – while the Costco customer will stock up. Costco members spend about twice the amount each year at Costco than sam’s members spend at Sam’s – the key reason Costco does the sales-per-square-foot sales volume ($1,000+ per sf) than Sam’s. Compared to Walmart shoppers -- Costco shoppers’ family incomes are about triple that of Walmart customers’.
The small-business-owner focus - Amex-carrying clientele with certain spending propensities– the membership buy-in - all combine to create a target customer that we either relate to or we don’t. But it’s one that Costco’s corporate buyers can understand – probably even visualize - and they seem to able to anticipate and procure merchandise for that customer. They have a good sense of their target customer. Munger’s Berkshire shares aside, the Charlie’s among us are probably in Costco’s cross-hairs.
TMF has been showing that click-on ad “The Death of Wal-Mart” for awhile now, claiming that there’s another retailer out there (Costco) that’s going to do them in. Nobody has to worry much about that: Costco’s customer generally carries an American Express card and is likely either a small business owner or the corporate or professional equivalent. Walmart’s core customer is going paycheck to paycheck, and in quite a few cases may not even have a bank account. Costco’s membership fee would be an extravagance, especially since the Walmart customer is budgeting and purchasing for this week, not stocking up on three months supply of anything – even if it is a better bargain by the case.
Just perhaps, the ironic thing here might be that if Costco’s core customer is prospering (and consuming) maybe Walmart’s is as well – and it’s not necessarily ‘either/or’. The higher income levels of the pyramid have their store, and so do the vast majority. Sam’s is somewhere in the middle – as noted, its typical member spends about half of Costco’s each year -- and has its own challenges in that space between its sibling and Costco.
Inverting gross margins
As noted further up this topic’s thread: whenever we look at retailers’ gross margins, we should also take the customer’s perspective, and think of margin in terms of mark-up on the goods we are purchasing. Most retailers (and analysts) don’t usually take that customer-oriented perspective, but that is the way Costco does.
Sinegals’ former boss and mentor Sol Price: “I never allowed anybody…to use the word "discount." The whole philosophy was: How do we sell stuff at the lowest markup rather than the deepest discount?
As a matter of corporate policy, Costco refuses to mark up any product by more than 15% above its cost. When the company signed a new contract in 2005 with a supplier for Brooks Bros.-style men's cotton and button-down shirts, and got a significant price reduction for a massive two-year order, it immediately cut the price of the shirts to $12.99 from $17.99, notes Richard Galanti, Costco's chief financial officer. Other retailers might have phased in the reduction and captured added profit, but that's not the Costco way. The shirts now cost $14.99 because they are made with better-quality cotton.
”Sinegal said, “We were selling Calvin Klein jeans for $29.99, and we were selling every pair we could get our hands on … All of a sudden we got our hands on several million additional pairs of Calvin Klein jeans, and we bought them at a very good price. It meant that, within the constraints of our markup, which is limited to 14% on any item, we had to sell them for $22.99. That was $7 lower than we had been selling every single pair for. Of course, we concluded that we could have sold all of them (about four million pairs) for that higher price almost as quickly as we sold them at $22.99, but there was no question that we would mark them at $22.99 because that’s our philosophy.….….Many retailers look at an item and say, 'I'm selling this for ten bucks. How can I sell it for 11?' We look at it and say, How can we get it to nine bucks? And then, How can we get it to eight? It is contrary to the thinking of a [non-club] retailer, which is to see how much more profit you can get out of it.”
Fresh-foods buyer Jeff Lyons dreads the next session because of a problem he has created by having no problems. Lyons makes an allowance each month for produce spoilage. Because he had hardly any in October, he widened his profit margin by one-half percentage point. "Our margin goal is 10%, and there'd better be a very good reason you did better than that," Lyons explains. "Otherwise Jim will say, 'Well, why didn't you lower prices?'
[Costco CFO] Galanti: First and foremost, pricing and quality. In our brick-and-mortar operations, which is 98% of our $75 billion in annual sales, we are the low-price leader and the extreme value retailer across the various merchandise categories that we sell. Our average markup on merchandise is about 11%; this compares to 20% to 25% at supermarkets, 30% to 35% at home improvement retailers and 50% to 100% at traditional mall retailers.
Assortment, selection, and pricing
As counterintuitive – and frustrating - as this may seem to real shoppers’ shoppers (as opposed to the shopping-averse of us, like me), Costco’s approach to assortments is to keep them as narrow as possible, making the selection of the ‘best’ style, features, or even color the Costco buyers’ responsibility, and not the target customers’ (people like me).
Their objective is to pick the 20% of items that comprise what would otherwise represent retailers’ 80% of their business; keep inventory turnover high; and allow purchases of those items in huge volumes.
We can do the math off of this:
-- Costco: $77B sales, comprised of something like 4000 items (SKU’s)
-- Walmart/Sam’s: $422B sales, comprised of 100,000 items
Costco is typically purchasing higher quantities of any item than even Walmart (though its total relationship may be less critical to the supplier’s survival, because it isn’t buying the vendor’s full range). Costco can get that per-item volume reflected in price. Again the sacrifice is assortment - they might carry just one color of Jamaica Jaxx shirt, at $20, vs Nordstrom’s five colors at $70 per shirt – but the trade-off benefit for the Costco customer is price.[‘SKU quantities are for the average store. About 25% of Costco’s SKU’s regularly cycle, so the total unique items sold in a year is probably higher; Walmart sales include international and Sam’s, so the corresponding SKU total is also probably higher]
The high-volume, highly focused purchasing shows up everywhere. Last week they had an excellent Korean-made TV for $650; Best Buy had exactly the same model ‘on sale’ for $1,100. Best Buy had the manufacturer’s range of sizes in that TV; Costco just had the larger size in the line-up.
The down-side to this is limited selection, which means that for this program to work customers need to be flexible and maybe trust Costco’s judgment (and negotiating abilities). Sometimes it’s Mount Gay Rum, but one year it was LVMH’s 10-Cane. For those who can roll with it, fine, but the program requires some customer flexibility.
As noted in an earlier post, decades ago, Lands’ End founder Comer implemented that company’s successful private label credo – his golden rule that a private label knock-off had to be of better quality than the original branded product. While Costco has had a flop or two, they have nonetheless had some remarkable success following that rule.
. Private label targets
“Our goal is only about 20 percent of total sales for private label…....The first thing we work on is the quality aspect,” Rose says. “We ask suppliers for products that are quality — take out the price factor, and we’ll worry about that later. Produce the best quality product for us first, without concern for cost or sell price.
"The overall business strategy at Costco maintains a maximum markup of 14 percent – for branded and private label products. Private label items, Rose says, are to present at least a 20 percent savings vs. the leading national brand, and are not to be used as margin boosters…..
. Tuna example
“Kirkland Signature Canned Albacore Tuna is the perfect example…. Dissatisfied with the consistently declining quality of canned tuna in the national brands, Costco confronted the national brand leaders — Bumble Bee, Starkist and Chicken of the Sea.
“They all agreed that the [tuna products available] weren’t the best,” Rose says. “One of them agreed to work with us to create a better albacore tuna — it was Bumble Bee. We created a private label tuna that was more expensive than the national brands, but that was OK with us.”
“The partnership between Costco and Bumble Bee resulted in canned tuna product that had more fish, less water and better quality thanks to the focus on fillet-cut tuna. And it also resulted in Bumble Bee launching a premium-tier tuna under their own brand, using the Costco-defined specs. “…..
. Cranberry juice
“…Kirkland Signature’s Cranberry Juice also stands alone. “The single-strength cranberry juice has a little better quality than the branded product, and it actually started to outsell the branded product to the point where we took the branded one out…”
. See's knock-off
A recent example: Awhile back we were talking about See’s candies on this board. Of the See’s offerings, we might venture that their canisters of Toffee-ettes are a best-seller, if not See’s single best seller. They sell for something like $16.50 for the one-pound can. If we were selling See’s candies ourselves, we might just concentrate on that one high-volume item. This holiday season Costco offered a Toffee-ette knock-off, “Kirkland Almond Toffee’ I’m no chocolate expert but I thought Costco’s version was actually better – and that’s before considering price: $16 for a two-pound container. [If it weren’t for the several obvious problems, we might envision these being re-packaged and marked up at some retail shops.]
. Walmart's approach, in contrast
Walmart takes a different perspective with both private label and especially branded merchandise.
….Levi’s is introducing its new, less expensive Signature jeans line [for Walmart]. (The jeans, for men, women and children, sell for around $23. They have fewer detail finishes than Levi’s other lines. They don’t have the company’s trademark red tab or stitching on the pocket.)
Snapper is the sort of high-quality nameplate, like Levi Strauss, that Wal-Mart hopes can ultimately make it more Target-like. He suggested that Snapper find a lower-cost contract manufacturer. He suggested producing a separate, lesser-quality line with the Snapper nameplate just for Wal-Mart. Just like Levi did.
Likewise, anyone buying VF’s Wrangler jeans at Walmart couldn’t help but notice that they were clearly made-for-Walmart, but also priced accordingly. Walmart was selling to an entirely different customer.
Anyway, Costco goes to the other end of the spectrum. One day they suddenly featured men’s blazers in the local Costco, which I hadn’t seen before, or since. They were rather extraordinarily well-made, and at $300, appeared to be a notch higher in quality than my long-time favorite Hickey Freeman.
-> We can’t leave the subject of Costco without mentioning employee compensation. Costco has a world-wide objective of paying at least 30% above prevailing retail wages. [Some might argue that, besides forgone profits, the flip side is service. They know that. We either can adjust and ask all our questions up front, or put their local Costco’s store office phone number on speed dial (they don’t encourage that).] Costco’s employee turnover is remarkably low. Two thirds of executives came from the sales floor; they generally promote from within. Something like 80% of Costco employees – full-time and part-time - have health insurance.
-> Their return policy is very convenient.
-> Costco-sized quantities start to seem natural – eg, Costco’s cases of Coke have 32 cans. Big cuts of meat. Packs of AA batteries are big. Everything is big. For the shopping-avers, the amounts we can buy in one outing are only limited by expiration dates and deep-freezer space.
-> Serious food shoppers know that, with an eye for coupons (including things like double-coupon-day promotions), some diligence and organization, and knowing what to buy where, they can do better elsewhere on a unit basis for many food and consumable items. But it’s work, results are not necessarily consistent, quantities may be more limited, and for those who don’t perceive shopping as a series of enjoyable competitive events, it’s not particularly appealing – it can be our nightmare.
-> Their sausage sandwiches hold their own against those at minor league ball-parks, and for under $3.
-> Expensive memberships and restricted entry -- plus high employee pay and low staff turnover – result in another side benefit: very low shortage levels (virtually no shoplifting or employee pilferage), the benefits of which – you guessed it – get passed along to customers.
This is several years old now, but this 200-plus page report from a New Zealand firm entitled “Understanding Costco” is a terrific outline of Costco’s history, philosophy, operations, demographics, and culture. Some of the charts are now a decade old, but it’s also a remarkable compilation of material on the warehouse club segment of the retail industry: http://www.coriolisresearch.com/pdfs/coriolis_understanding_...
Some quotations from this report:
- “The richer people are, the more they like to save.”
Sol Price, Founder, Price Club, December 1988
– “The biggest thing with Sam's was that it didn't have a free hand to compete with Wal-Mart. There was this fundamental thing where they didn't want to kill Wal-Mart. The other problem was that Sam's didn't cater to the higher class of people that Costco did.” Sol Price, Founder, Price Club, November 2003
– “One of the best things Costco has going for it is the fact that Sam’s is affiliated with Wal-Mart where the culture says low price rules. Sam’s wants to do everything on the cheap side, and then it is reluctant to do anything that might be detrimental to Wal-Mart’s business. Those attitudes are changing at Sam’s, but until it develops its own identity, Sam’s will be chasing a moving target by copying Costco, just as other discount stores have never succeeded in copying Wal-Mart.” Maggie Gilliam, Wal-Mart newsletter publisher and former Wall Street analyst, June 1998
– “There are few more futile activities that I can think of than trying to drive sales at a club unit from $100 million to $150 million. It's much better to open new clubs and cannibalize your sales.” David Glass, Chairman, Wal-Mart, March 1993
- “Costco has enhanced its high-end merchandise by selling such brands as Prada and Gucci, as well as Baccarat and other fine crystals and giftware.” Janice Hofferber, analyst, Fulcrum, October 2002
- “Costco offers about 3,600 active items compared with a typical supermarket that might carry about 25,000 items. We have a wide range of categories - pianos to Rolex watches and 100-pound bags of rice - but they all represent quality national brands and that helps us to nearly eliminate advertising costs, which are almost nil. By offering large sizes, Costco provided substantial price savings on all merchandise… We've brought better quality, higher ticket and larger sizes to our members, as well as services.“ Richard Galanti, CFO, Costco, May 1990
- “Here's the difference between Sam's and Costco: We have a live Sam Walton who's still there, and Wal-Mart doesn't.” Charlie Munger, Berkshire Hathaway vice chairman, Costco shopper, investor, and director, November 2003
– “The biggest risk in that whole picture is Sinegal. If something happened to Jim, that would be a bad thing.” Sol Price, August 1997
Everybody – Charlie, industry analysts, Costco employee’s, industry CEO’s --everybody – has observed that Costco has one unique and over-riding competitive advantage versus Walmart and everyone else: Costco co-founder and CEO Jim Sinegal. As most are aware, Sinegal retired a couple of weeks ago. As is its practice, Costco promoted from within, and most observers are confident the Costco’s culture is solid and will continue forward.
I’m out of Costco for the moment. Not for any good reason – I am still its second-biggest fan --except that there will be a microscope on it now, and the market won’t be inclined to give it a break at the slightest blip. Not that I’d expect any reason for one, but I wouldn’t be surprised by a market over-reaction sometime in the future. The markets don’t usually give successors to iconic CEO’s a lot of performance slack, short-term, and they can be especially schizophrenic with retailers, where monthly or quarterly trends trigger all kinds of crazy headlines.
From a reluctant customer’s perspective, though, Costco is easily my favorite store. I’ll do my part to keep sales up and margin rates low.
My customer is anyone wanting to give a gift to themselves, a loved one, a hostess, etc.
At the risk of giving unwanted and un-expert advice – that may need to be developed some. Business plans seem to be out of vogue, and many people these days contend that they are a waste of time. Even so, I would really put the effort into trying to crystallize who the store selling to – who the merchandise is being purchased for. That succinct visualization often helps as the concept is developed. Merchandise doesn’t have to be restricted to what that person would buy, but the shop should look appropriate and cohesive to that core customer.
There’s a wide range of customer demographic on the island, plus some unique summer vs off-season considerations. With most of the current flower business coming in during the summer – much different than for most florists – and a shift in clientele, it may be helpful to have a much different approach to the off-season than for the summer. While there are obviously big differences here, Costco does a really good job at seasonal transitions – the one-fourth of their business that’s above their core day-in day-out categories.
After sending away for lots of catalogs and searching the internet for interesting wholesale gift products. …I seem to keep coming back to "Local" for my pottery, chocolates, soaps, candles, etc. It satisfies the whole made in the USA thing too which is appealing. Then I'll add some "Fair Trade Certified" products to go with my Fair Trade roses and try to have a theme.
This sounds like something. The challenge here is to keep the core business – florist – front and center. The flowers probably have had fast inventory sell-through and hopefully not a lot are on hand. It’s important not to alter your financial model too much so that you now tie up any significant amount of working capital (ie, inventory) in new, ancillary categories and in goods that turn much more slowly, especially if you are still feeling your way around.
If you can’t find compelling, low-risk/fast-turning items, you may want to consider selling some local goods on consignment, at least for awhile. This might be a way to get some high-end and unique merchandise on display without the risk of inventory ownership. Plus, if we remember Jim’s example of a high-ticket offering (in that case a lobster item on the menu) to reframe customer perception of a relative value, some nice consignment items might fill that bill. The other advantage to this is that you can keep things fresh by changing consignment offerings, try new artists and artisans, and keep the place interesting so customers check in. That may not be a long-term model and it can easily be abandoned if it doesn’t work, but it might be effective at least in the near term – and it doesn’t cost much or put much at risk.
In any event, I would be really careful when deploying significant assets into things outside the core floral business. You mentioned awhile back that an important objective would be capturing the business of the other larger, long-established, more expensive florist on the island. Even if that was a lengthy or even a bit of an expensive undertaking, knocking them back might be a key priority. That might be worth the real effort.
Really though, I’m no merchandiser - except maybe sometimes in liquidation situations. That’s probably why I’m very cautious, particularly when it comes to conserving cash. But I’m certainly not in the least creative or even close to competent in this.
I would like to know what every customer's reaction is to my store. I would love to ask them: What did you like? What were you looking/hoping for that I didn't have? Good informative feedback is priceless. How do the big retailers get this feedback? They are so distant from their customers?
Places like Costco test new items in small volumes. The Limited had an awesome approach – they’d carve out some store space in an existing mall store (Limited, Lane Bryant, and Victoria Secret have had the best mall locations) and wall off a temporary ‘store’ with its own entrance, and test merchandise, formats, etc until things really clicked. If nothing worked, there wasn’t much investment anyway, so they’d just convert the space back. Even with their resource and expertise, only something like one in six new-concept attempts were successful. [digressing: I’m not particularly a subscriber to the premise that good retailers are easily replaced in the market at book value, even if the barrier to entry is low – which might help rationalize why truly ‘scalable’ retail concepts are so expensive to acquirers. At the same time, I’m highly skeptical of most supposed ‘durable competitive advantages’ for established retailers.] Of course none of this helps your project.
You might put a camera in the store, mainly so you can observe at your leisure what catches their eye, and what doesn’t. If you don’t, at least have your employee take notes, including when people visit but don’t buy. I’d also spend some time visiting that chain in Boston that you wanted to emulate, and pay attention to details. If there any other best-in-class examples, I’d go look at them also.
I’ve sat on the other side of those one-way mirrors during focus groups, but those weren’t worth much for merchandising – though they did help with more basic things like service and convenience issues. Don’t get me wrong – feedback is critical, and you can get some ideas maybe, but customers aren’t usually the best merchandising inspirations. When it comes to that, the best merchants and most successful retailers lead their customers, and not vice versa. They’ll likely know what’s going on in their category in California, Europe, and Japan, places that sometimes give glimpses of where things might be headed, or where you might see some really innovative things. I’d keep up-to-date with that Boston-based florist.
You mentioned Mickey Drexler. If he ever comes to the island again, or even just visits, you might invite him over. Maybe send flowers or something, wherever he is. Same with any other merchandising executive anywhere near his caliber who might be vacationing in the area. He and those in his league are so far ahead of anyone else in retailing that just having them in the shop a few minutes could be worth diamonds. There must be other talented merchants in that area during the season.
Shifting gears, a Financial Times article on Tesco -
Bridging the pond is a stern test for retailers: http://www.ft.com/intl/cms/s/0/fae9dba2-cf45-11e0-b6d4-00144...