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Costco: Where low profit margins are a sign of strength

Not all great businesses have high profit margins. US retail giant Costco has used low profit margins to become one
Costco: Where low profit margins are a sign of strength

Investors are frequently told that high-quality businesses have high profit margins. US retailing giant Costco (US:COST) is an exception to this rule.

High profit margins are often a sign of a company’s competitive strength. In many cases, this is true. Companies with high margins often have a business that is hard to copy, which enables it to make large profits. They also tend to be safer businesses as fat margins give them a large buffer between profits and losses. Low-margin businesses can become no-margin businesses when times get tough.

However, there are often exceptions to general rules. Sometimes high margins are a sign that a company is charging its customers too much, which can create opportunities for new competitors. This has been true in the grocery sector, where incumbent operators have seen their profit margins whittled away by lean and agile hard discounters such as Aldi and Lidl.

The discounters have developed a business model that works very well. By focusing on a narrow range of products, investing in private labels and having a razor-sharp focus on business costs it is possible to offer customers goods and services at lower prices and to win a significant slice of a market. By selling lots, even at low profit margins, this type of business model can be good for shareholders, too.

You can’t buy shares in Aldi and Lidl, but you can buy shares in Costco, which has developed a very impressive way of doing business and looks set to keep on growing in the years ahead.

 

Click here to read How to invest in the US: A step-by-step guide to investing in the world's biggest market.

 

Membership warehouses

Costco is not a traditional supermarket. Its business is based around big warehouses with an average size of 146,000sq ft, which are open to members only. Membership is open to individuals and businesses. In the US, annual memberships start at $60 (£47), but for $120 a year you can sign up for an executive membership, which gives you an extra 2 per cent off your shopping and allows you to save up to $1,000 a year. Executive members tend to spend more and account for just under 39 per cent of members.

Costco is probably not a place where many people do their weekly grocery shop. This is because many of the items sold can only be bought in bulk. A typical customer may visit a warehouse a couple of times a month. 

The bulk of its revenues come from the sale of food and general household grocery items. It also sells large and small electrical appliances, health and beauty products, hardware and clothing. The company also generates a significant chunk of revenues from ancillary lines of business such as pharmacies, food courts, travel agency, opticians, hearing aids, photo processing, car tyres and fuel.

 

The business is dominated by its US and Canadian operations, which accounted for 87 per cent of revenues and 85 per cent of profits in 2019. In the US (73 per cent of total revenues), operations in California account for 30 per cent of country revenues.

Costco is an international business and has built up a reasonable presence in overseas markets including Mexico, the UK and in the Pacific region. It opened its first warehouse in China in 2019. It had a total of 785 warehouses and 593 fuel stations worldwide at the end of 2019.

The company has made a tentative entry into selling goods over the internet. It offers same-day delivery to US customers who live within a 20-minute drive of its warehouses, but internet sales still only account for around 4 per cent of annual revenues.

 

Focused and efficient business model

Costco has a very simple, but powerful business model. By operating efficiently it aims to sell great quality goods at lower prices than most of its competitors. It takes a long-term view on pricing in order to keep its customers happy. This means that it will often cut prices to gain market share or not pass on cost increases to make sure it stays price competitive. This can see reductions in short-term profit margins, but generate long-term value for the business.

It can do this because its business is focused on sales volumes rather than values and has the business economics to cope with and thrive on this.

There are many reasons for Costco's competitive strengths. One of the most significant is that it stocks a much narrower range of goods (shopkeeping units or SKUs) than most supermarkets. Whereas a large supermarket may have more than 30,000 SKUs, Costco is currently operating with just 3,700. This allows it to concentrate its buying and get better prices from suppliers, which can be passed on to customers through lower prices.

The company has also invested heavily in its own private-label brand, Kirkland Signature, from which sales have been growing rapidly in recent years. The success of private label is one of the key drivers of retailing success in the grocery market. Consumers now have a growing level of confidence in it as they can get the same quality – or better – than branded alternatives for a much lower price. Retailers are also able to earn higher gross margins than they get from selling branded goods because they are not having to pay up for a brand’s marketing costs.

Costco generated $39bn of revenues from Kirkland Signature (a reasonable chunk of this will be fuel) in 2018 and has aspirations to keep on increasing its proportion of private-label sales. According to the Private Label Manufacturers Association, the market share of private-label groceries in the US was around 25 per cent in 2018. In many parts of Europe it is over 40 per cent, which suggests that Costco has more to go for in this area in its home market.

The other benefit to Costco from its private label is that it creates competition for shelf space in its warehouses, which can give it some leverage in getting better buying prices from branded goods companies.

Costco’s private-label business has also been complemented by its significant investment in vertical integration and the cost benefits that come from it. It has invested in its own meat and poultry production and has ventured into greenhouses to produce its own salad vegetables.

As well as having a competitive source of product supply, Costco has a very efficient distribution network and in-store economics. It buys directly from manufacturers and has goods delivered directly to its warehouses and depots. It has very large freight volumes, which are kept as simple as possible with as few intermediaries as possible.

Goods are stored on racks and pallets in large quantities, which reduces the amount of labour needed. Another added labour efficiency comes from the warehouses being open only 10 hours per day. Despite this, the company prides itself on looking after its workers by paying them more than the industry average and offering them attractive employee benefits.

These significant cost advantages have given Costco a business model that is very difficult to compete with, which has served it well.

 

High volumes, low margins and membership fees stack up well for customers and investors

Costco’s business model has allowed it to keep its customers and shareholders happy. If we take a closer look at its income statement we can see how its low prices and membership fees contribute to its profits.

Costco $m

2015

2016

2017

2018

2019

TTM

Net sales

113,666

116,073

126,172

138,434

149,351

157,391

Cost of sales

-101,065

-102,901

-111,882

-123,152

-132,886

-139,848

Gross profit

12,601

13,172

14,290

15,282

16,465

17,543

SG&A

-11,445

-12,068

-12,950

-13,876

-14,994

-15,989

Profit before membership fees

1,156

1,104

1,340

1,406

1,471

1,554

Membership fees

2,533

2,646

2,853

3,142

3,352

3,485

Pre-opening costs

-65

-78

-82

-68

-86

-70

Operating profit

3,624

3,672

4,111

4,480

4,737

4,969

Source: Annual reports/Investors Chronicle

 

We can see here that Costco is selling stuff for not much more than it costs (it has a lower mark-up than many of its rivals) and this is a sign of the low prices it offers its customers. Its gross profit margin is only around 11 per cent, which is considerably lower than competitors which can operate with margins twice as big.

If membership fees are excluded then its gross profit covers its selling, general and administrative (SG&A) costs, but not by a huge amount. If we then add in the membership fees, you can see how important they are to Costco’s overall operating profits. 

The company also discloses the costs it has incurred from opening new warehouses, but to its credit does not adjust its profits to exclude them as they are a cost of doing business.

Customers are clearly getting good value through low prices. This means that many of them are happy to keep renewing their membership and Costco pockets the membership fee, which makes up the bulk of its profits. Membership growth and retention is therefore key to its future success.

By opening up more warehouses over the years and keeping renewal rates at around 90 per cent in the US and Canada, and 88 per cent elsewhere, Costco has been able to show healthy growth in its membership numbers and membership fee income.

 

The company has also been very good at growing same-store or comparable sales for the past decade, which is the hallmark of a quality retailer.

 

 

One thing to be aware of when looking at Costco’s comparable sales performance is that there seems to be a significant maturation effect from warehouses that opened in recent years.

The company presents a very useful chart in its annual report which shows the average sales per warehouse based on when they were opened. We can see how the oldest warehouses – opened in or before 2010 – have the highest sales, but that there seems to be considerable scope for sales to mature from the younger stores, depending on their location, and to continue to drive up comparable sales and average sales per warehouse.

 

 

 

This maturation effect seems to be very powerful and perhaps explains why Costco’s comparable sales track record has been so good and bodes well for future revenue growth. For example, warehouses that opened in 2015 had seen their annualised sales per warehouse increase by nearly 50 per cent by 2019 from $83m to $122m.

 

Financial performance

Costco: Key performance measures

Costco ($bn)

2014

2015

2016

2017

2018

2019

TTM

Revenue

112,640

116,199

118,719

129,025

141,576

152,703

160,876

Gross profit

11,754

12,601

13,172

14,290

15,282

16,465

17,543

Operating profit

3,220

3,624

3,672

4,111

4,480

4,737

4,969

Profit after tax

2,058

2,377

2,350

2,679

3,134

3,659

3,710

Capital employed

18,612

18,183

18,688

18,938

20,994

23,842

30,450

Capex

1,993

2,393

2,649

2,502

2,969

2,998

2,941

Free cash flow

1,991

1,892

643

4,224

2,805

3,358

4,178

Total debt

5,093

6,147

5,161

6,659

6,577

6,823

11,630

Cash

7,315

6,419

4,729

5,779

7,259

9,444

11,774

Dividend paid

584

2,865

746

3,904

689

1,038

1,110

Share buybacks

334

481

486

469

328

247

175

        

Gross margin

10.4%

10.8%

11.1%

11.1%

10.8%

10.8%

10.9%

Operating margin

2.9%

3.1%

3.1%

3.2%

3.2%

3.1%

3.1%

Capital turnover

6.1

6.4

6.4

6.8

6.7

6.4

5.3

ROCE

17.3%

19.9%

19.6%

21.7%

21.3%

19.9%

16.3%

FCF margin

1.8%

1.6%

0.5%

3.3%

2.0%

2.2%

2.6%

FCF conv

96.7%

79.6%

27.4%

157.7%

89.5%

91.8%

112.6%

Debt to FCF

2.6

3.2

8.0

1.6

2.3

2.0

2.8

Div & BB as % of FCF

46.1%

176.8%

191.6%

103.5%

36.3%

38.3%

30.8%

Capex to sales

1.77%

2.06%

2.23%

1.94%

2.10%

1.96%

1.83%

Source: Annual report/Investors Chronicle. Note: Trailing 12-mont (TTM) FCF is first two quarters with profits first three quarters of current year

 

Costco is a very low-margin business when looking at its gross, operating and free cash flow margins, but its capital turnover (sales per $1 of invested capital) is very high at 6.4 times in 2019. Its US peers Kroger and Walmart have capital turnover ratios of 4 times and 3.3 times, respectively. Tesco’s capital turnover ratio was only 1.7 times in the year to February 2020.

What this means is that Costco by selling more per $1 of invested capital can achieve returns on capital of nearly 20 per cent in a normal year (excluding capitalised rents) despite low profit margins. Given the business’s capability to generate cash flows to fund more than $3bn of capex on new warehouses going forward at similar rates of return then the investment case for Costco looks favourable.

 

How is it going to grow its future profits and cash flows?

2020 is going to be a tough year. While sales have been robust, the company has been spending lots of money on staff and health and safety to adapt to the coronavirus. It spent $239m between February and May and will spend more in its fourth quarter between May and August. It has also lost revenue due to its food courts, travel, opticians and other ancillary businesses being closed.

Despite this, the company’s profits on a rolling one-year basis have still been growing, which highlights the resilience of its business model.

When things get back to normal, a combination of comparable sales growth and openings of around 20 new warehouses a year give Costco the opportunity to grow its profits at a decent rate (high single-digit percentage is not unreasonable) for a good while yet. If new warehouses can earn similar returns on investment to existing ones then they have the potential to generate significant extra profits.

 

Costco: New warehouse openings by geography

Year

US

Canada

ROW

Total

2016

21

2

6

29

2017

13

6

7

26

2018

13

3

5

21

2019

16

0

4

20

Total

63

11

22

96

Source: Annual reports

 

Costco is still opening most of its new warehouses in the US and does not seem to be suffering from significant levels of sales cannibalisation where new warehouses take revenues from existing ones. It clearly has a business model that works and can take market share in the US.

There also remains significant potential to grow the business outside the US. Its first warehouse in China was very well received in 2019 and there is potential for more, providing political tension between the US and Chinese governments doesn’t get in the way. The rest of the Asia-Pacific region and countries such as the UK are also areas of potential expansion.

A further boost could come from the ramping up of Costco’s e-commerce business and further investment in vertical integration (food manufacturing) and logistics to drive down costs and further improve its competitive positioning.

 

The shares are not cheap but still have promising long-term potential

Excellent businesses can rarely be bought cheaply on the stock exchange and Costco is no exception. I am extremely impressed by its business model and its ability to deliver for both customers and shareholders alike. It is a model that is very much in tune with what it takes to survive and prosper in retailing.

At $307, the shares trade on a trailing 12-month (TTM) free cash flow yield of 3.1 per cent (the same as Microsoft), which is not cheap. You won’t get rich quickly owning Costco shares, however a business as well run as this still offers a great deal for patient investors with a long-term view.