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"My 'secret' is so simple that I'm reluctant to speak openly about it for fear of appearing stupid. I sell things as cheaply as I can." Sol Price, The Intellectual Creator of The Wholesale Concept

Costco Wholesale (NASDAQ:COST) operates 602 warehouses across the world. Of revenue, 72.5% came from the United States, 15.7% from Canada, and the remaining 11% from the rest of the world. As of May 6th, it has a total fee-paying member population of 66,500,000[1]. Costco operates its wholesale operations with a faster turnover than Wal-Mart (NYSE:WMT) and its average sales per square foot have steadily increased over the past 10-year period:

Costco has successfully established its private "Kirkland Signature" brand within its stores; and while the brand makes up only 15% of items carried, it now makes up about 20% of sales. Costco is rated by Interbrand to have 15th most valuable retail brand, after Dollar General (NYSE:DG). (I've written about Dollar General here, and Wal-Mart here.)

And anecdotally, Costco has one store which did an incredible $400 million of business last year -- $0.4 billion at one location.

Capital Requirements

The founder of Wal-Mart, Sam Walton, notes in his autobiography that one of the most important features of discount retailing is to control turn:

"...or [to control] inventory turn over - the ratio of sales to inventory. That's a key. The more you turn your inventory, the less capital is required. And all this involves getting the merchandise to the store at the right time, communicated how it's being priced and how it's being market down, whatever." [2]

Inventory turnover it calculated by dividing "cost of goods sold" by average inventory. If you take the reciprocal of that, and then multiply it by 365 days, you get the average number of days which inventory is within the store before being sold, or what is called: "days inventory outstanding." Below you can compare Costco Wholesale to the discounters Wal-Mart, Target (NYSE:TGT), and Dollar General across the days inventory outstanding metric (lower is better):

COST Days Inventory Outstanding Chart

COST Days Inventory Outstanding data by YCharts

Wal-Mart and Costco both dominate across this metric, but Costco does significantly better. It is able to achieve this by combining a voluminous strategy like Wal-Mart's (and, well, discounters generally) with a low SKU count strategy like Dollar General's. Meaning that they sell fewer products at higher volume. For instance, Costco writes:

"...we carry an average of approximately 3,600 active stock keeping units (SKUs) per warehouse in our core warehouse business, as opposed to 45,000 to 140,000 SKUs or more at discount retailers, supermarkets, and supercenters." (2011 Annual Report, p. 9)

Sam Walton says that the faster one sells one's goods, the less capital that will be required within the business -- therefore one is able to achieving a better return on capital invested. Costco takes this notion one step further: why not sell the goods so fast as to make no working capital required. Or as put by Costco:

"Because of our high sales volume and rapid inventory turnover, we generally sell inventory before we are required to pay many of our merchandise vendors, even though we take advantage of early payment discounts when available. To the extent that sales increase and inventory turnover becomes more rapid, a greater percentage of inventory is financed through payment terms provided by suppliers rather than by our working capital." (Emphasis added; 2011 Annual Report, p. 9)

Given that Costco has a inventory days outstanding metric of 32.6 days, we can safely say that for the portion of its payment terms which are net 30 (or longer), it sells the goods before having to pay the vendor.

Membership

To shop at a whole-seller, one needs to pay a annual membership fee. At least, if you follow the Costco model. This is opposed to the discount model, where no fee is necessary -- and stressing the word "necessary" because in the wholesale club model, the fee is basically the profit. The collection of the fee itself requires basically no cost and the remainder of the wholesalers business is operated at almost break even -- or an operating margin (without the fee) of about 0.6% in fiscal 2011. Hence why the fee is so important.

When you look at the profit of Costco for 2011, you see that it is $1,462 million. As noted, the $1,867 million fee revenue makes up the majority of the profit. One can see this below (the percentages are the net income divided by the amount of membership fees):

The fee has to make up the profit because the merchandise is sold basically at cost plus overhead. The membership fees are what make the whole discount model work.

When it comes to membership concept, I suppose it is it better to let the founder explain the concept himself. Sol Price, who founded Price Club, which later merged with Costco in the 1993 [3], said:

"The membership concept is very important to us. First, membership provides a way for us to pre-select the demographics of our customer base without having to do all the extensive research that would otherwise be required. Business owners and managers, licensed professionals, and people who work for governments, utilities, hospitals or banks tend to be more stable than many others. We take less risk in accepting their checks. Second, dealing exclusively with selected groups makes it possible to communicate with your customers effectively. Instead of communicating with the whole world, you communicate one-on-one with the people you want to reach. Finally, someone who pays for a membership in an organization makes a form of commitment. They have a built-in reason to come back." (Emphasis added.)

Also, the membership concept helps Costco have shrinkage rates "well below those of typical discount retail operations" (2011 Annual Report, p. 9). Further, some early analysts said that Costco's membership concept forces it to serve a more affluent customer base than Sam's Club -- partially because, I suppose, Wal-Mart could not wall off Sam's Club from the influence of Wal-Mart's customer base.

Valuation

The model and its success has caught on recently on Wall Street and the shares are selling above $100 a share, putting the Price to Earnings multiple at about 28.2. See the upward trajectory of the share price below:

COST Chart

COST data by YCharts

If we look at the free-cash-flow [4] for the nine-month period ending May 6th, 2012, and then annualized it, we see that Costco is on track to achieve a FCF rate of about $1,900 million this year (which is, incidentally, identical to the amount earned in 2011).

With a market capitalization of $43.6 billion, Costco's P/FCF would be 22.9; which works out to a free-cash-flow yield of about 4.3%. Given its stable position, its membership model, and that it has been growing FCF over the years at some 15% annually [5], such valuations are not unjustified. Further, the valuation is quite comparable to discounters:

WMT Free Cash Flow Yield Chart

WMT Free Cash Flow Yield data by YCharts

Conclusion

Costco is entrenched, profitable, and growing. It is best in class when it comes to wholesale retail.

As I noted above, today's prices are basically justified -- meaning that the shares are fair valued. If an investor has a long enough time horizon, a purchase at these levels could work out in the long run. However, for the investor who wants the best return possible, an investment in Costco might want to wait for either the share price to decline or for the company to grow into its valuation.

Notes:

  1. Counting all membership types.
  2. Walton, Sam, and John Huey. "Recruiting The Team." In Sam Walton: Made In America. New York: Bantam Books, 19931992. 110.
  3. The story is slightly more interesting than that. I'll state it as briefly and simply as I can: The founder of Costco -- started 1983 -- was James Sinegal; he was the protégé of Sol Price, the founder of Price Club, started 1976. Sam Walton notes in his autobiography that he stole ideas from Sol Price. When Sam's Club -- started 1983 -- started getting larger, the master (Sol Price) and the student (James Sinegal) merged firms, creating Costco as we know it today.
  4. Free-Cash-Flow = FCF = Operating Cash Flow - Capital Expenditures
  5. Since 2006. In which I calculated FCF by using "averaging capital expenditures" from the three previous years since they were significantly higher in 2006. The growth rate would have been substantially higher had I not made the adjustment.
Source: Too Late To Buy Costco?