Costco: The King Of Retail

Summary

• What type of deep insight you gain by analyzing cash conversion cycles of Costco and competitors.
• How to interpret and compare the CCC ratio to uncover potential catalysts.
• The beauty of negative cash conversion cycle.

The Quick Theory

The main way a company can make more profit is to simply sell more stuff. But how do you sell more stuff?

Cash.

More cash availability equals more products you can make and sell.

Wall Street loves earnings and many people believe earnings drives cash and profitability, but this is incorrect. Cash drives earnings. The faster the cycle of cash, the quicker it can be reinvested to generate earnings.

Regardless of what the media says, cash is and always will be king. No business can start or grow without cash. That's why growth and startup companies are constantly looking to raise cash.

By looking at the cash conversion cycle and analyzing the CCC formula, a company that can shorten the cash conversion cycle is going to be ahead of its competitors.

The basic theory of the cash conversion cycle is this:

1. you start with cash
2. it becomes accounts payables as you buy inventory from a supplier
3. you receive the inventory
4. the inventory is then sold and becomes accounts receivables
5. when accounts receivables is collected, you have cash again and you restart the cycle from step 1

The entire cash conversion cycle is a measure of operating efficiency and management effectiveness. The lower the number, the quicker the cycle. The quicker the cash conversions cycle, the better the management is at operating the business.

In this way, you can use the cash conversion cycle formula to compare efficiency and management on an apples to apples basis. In other words, do not use the Cash Conversion Cycle to compare companies from different industries or different business models.

No company does this better than Costco (NASDAQ:COST).

Costco Is Unbeatable at Retail

The best way to use the Cash Conversion Cycle is to compare competitors from within the same industry with essentially the same business model.

Let's look at Costco, Walmart (WMT), Target (TGT) and Big Lots (BIG).

COST vs. WMT vs. TGT vs. BIG cash conversion cycle | Source: Old School Value Key Ratios

When looking at a company on an individual basis, it's best to look at the trend and see how it has been moving.

If the cash conversion number continues to go up, it's a sign that business is not operating well. Because the CCC looks at the entire cycle from purchasing to sales to collections, any time the final cash conversion cycle number increases, dig in to see where the real issue is coming from.

When you look at COST vs. WMT vs. TGT vs. BIG above, the clear winner is COST and the clear loser is BIG.

Costco is able to convert everything back into cash in 1.82 days. Operating magic for a retailer. A quicker cycle also means that they can operate at lower margins.

Case in point;

• Costco gross margins = 13%
• Walmart gross margins = 26%
• Target gross margins = 30%
• Big Lots gross margins = 40%

From this, you can see that assuming high margins is a good thing is a fallacy. Big Lots has the highest margin, but the worst cash conversion cycle. You can also see the strategy behind each company when you look at this.

• Costco's strategy is to focus on high volume and sacrifice margins
• Walmart also goes for high volume with low margins
• Target is looking for a mix where it doesn't want to overly sacrifice margins
• Big Lots focuses on high margins which is a surprise considering their product mix

Then you add Costco's membership fees and with a renewal rate of 90%, it's literally minting money year after year.

With an estimated average number of households in the US at 126M, every 2.5 households is a Costco member.

Source: Costco Investor Presentation

How to Interpret the Data for Costco and Competitors to Pick Stock Winners

Here are general rules of thumb on reading the trend in Cash Conversion Cycle.

• An increase in Days Sales Outstanding (DSO) means that collections are not being managed properly. Customers are not paying on time or the company is extending the payment date in order to lock in a deal. Conversely, a decrease in DSO means the company is receiving payments quicker than expected.

• An increase in Days Inventory Outstanding (DIO) means it is taking longer for the company to sell its inventory. The smaller the number, the quicker it is selling through inventory.

• An increase in Days Payable Outstanding (DPO) is actually a good thing - unless the company is taking forever to pay because it has no cash. But technically, the longer it can delay payments or get good terms, the better.

When you put the companies side by side, there's additional insight you can gather. Here's my analysis.

The Cash Conversion Cycle Analysis | source: Old School Value Key Ratios

Of the group, the company with the best Cash Conversion Cycle is Costco.

Worst is Big Lots.

Walmart and Target make up #2 and #3, but because Target does not report receivables as it is considered too short to make it material, there is no receivables data, therefore DSO is zero. If Walmart also decides to use similar accounting methods, their CCC would come down to 2.54 days.

Look closely at the blue highlight and the pattern you see across well run retailers is that DIO and DPO are in a close range. Makes sense because you want to be selling and paying for inventory as close together as possible. Not like BIG where it takes them an additional 70 days to sell inventory after they have paid their bills.

Does the CCC Affect Costco's Stock Price?

It does not directly affect the stock price. Analysts and most people do not consider this type of accounting and business analysis. I have yet to come across a stock that shot up because the cash cycle improved.

So how does this help with stock picking like for Costco?

1. you can see beyond the headlines and see for yourself how strong the fundamentals are
2. you can pick the strongest of the competitors
3. you understand the business better so you don't panic sell

The CCC ratio is mainly used by business owners and accountants to better understand the business. This is the type of hidden catalyst that can help you identify winning stocks before it gets picked up by the crowd.

Summary

• Costco's cash conversion cycles shows that it is the best at operating efficiency and management effectiveness
• Costco's margins may be lower, but that is a result of a very fast cash cycle
• Comparing with very close competitors shows that it is the king of retail
• The CCC ratio won't predict stock returns, but you get a great fundamental reading of the business

Analyst’s Disclosure: I am/we are long WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Steeler5788]

My daughter, 26, and husband just had their first child, went to Costco to get labor going and shop there all the time. They love it! Not every young family exists order drone food from Amazon

[tk11]

Whole Food is Amazing now

[joeBV]

Thanks for your article. This is the true analysis that made me invest in COST. Their model and consistency in quality/pricing are key tools to win in a changing retailers world. PS: do not read the article about Costco and Sam’s on Business Insider!!! It seems like they never visited either store prior!!

[tk11]

BI was an excellent article. Thank you sir but you don't need to advertise it here.

[joeBV]

Tk11 I was not advertising it, rather on the contrary I was praising the quality of this article vs. that one. Anyhow glad you read more about Costco. :-)

[tk11]

There is more than reading about it. There is a movie, its a comedy, about the company and its management.

[Ham Huang]

It's an important metric and key consideration why I bought COST, glad you point it out.

[Gr8Expectations]

Jae, Great article all around but one key point caught my eye which was the gross margin comparison between COST and WMT. Since we can't take % to the bank but rather dollars, I did the following exercise which I found insightful. For every $100 sale COST makes, it brings in half of what WMT does in gross profit, $13 vs $26. However, based on your CCC calculations, COST generates $7.14 of gross profit per day ($13 / 1.82) whereas WMT generates $3.79 per day ($26 / 6.86). COST spits out 88% more gross profit per day! And, here's the kicker... COST's current PE is "only" 55% higher than WMT's (31.8 vs 20.4). I know, it's not a perfect correlation, since other factors may explain the differences in PEs, but it sure makes you wonder which stock is truly more expensive! Long COST.

[tk11]

"PE is only 55% higher than WMT"? Anyone sees the absurdity of this difference on a low margin retail stock that derives 90% of its profits from full of risk membership fees?

[Briar]

Jae, you’ve written a useful article on Costco. Another metric worth looking at is Costco’s current ratio. If you take out the excess cash Costco operates with negative working capital. Some of this is accounting, conservative accounting. Costco ended last year with close to $1.5 billion in deferred membership fees, that is unearned income, because the fees are earned ratably throughout the year, so on average half the fees will be booked as deferred, but the cash is sitting in the bank. This deferral is recorded as a current liability, but because of the high renewal rate it is more like a perpetually renewing loan.

What really distinguishes Costco from the others is it’s membership franchise. This amounts to roughly 2/3rds of reported net income. Received up front, at the beginning of the year. The membership fee allows Costco to sell goods at lower prices. This enhances the member’s feeling of being treated fairly. Thus many of us end up spending more than we expected to. And we can buy an oversized hotdog after checking out for $1.50. It includes a Pepsi, too.

But here is another buffer: in a recession if we cut back shopping Costco still earns the deferred membership fee.

One has to admire how well Costco has thought through its business. Sure it is slow to figure out it’s online business, but last Sunday, around noon, all checkouts were open with lines, and the sales people were working efficiently and cheerfully.

Thanks for writing a fine article!

[tk11]

Oversized hotdog is oversized junk food waiting in the food court line for an hour. You value your time a dollar an hour. Way below minimum wage!

[Briar]

tk11, I am well aware of your useless, uninformed comments. Keep them up and I will start reporting abuse.

[tk11]

Briar, feel free to report abuse as many times you want. I am not receiving fees like you do or I am an employee of SA. Since you were unable to answer the points raised about Costco I raised some more in other comments.

Make believe stuck arrogance doesn't contribute to this discussion or safeguarding readers investments, only facts, analysis and logic do. You look immature with threatening in public other participants.

p.s. Hot dogs are junk food and waiting more than 10 minutes on a line to save a buck values your time to less than $6 an hour. Below minimum wage!

[bobzark]

Ever since I bought Costco stock for my wife's Roth IRA, the lines at Costco are much less stressful.

[EdKin]

Well played Sir!

[tk11]

Typical falling in extreme love. The falling out will be costly. Some people keep staying in the love-house even as empty nesters costs them a fortune and ties them down. Other people keep that old car they fell in love 10 years ago and keep driving it despite annual maintenance costs exceed its present value.
Oh something hsppening to the COST stock. Is it another breakdown? I am ready to sell half of my puts for at least a 300% profit. The rest keep that 1% dividend.

[davehumphrey2]

The unmeasured metric with Costco is the stress of shopping there. It is so crowded all day long.

[MSP20]

Yogi Berra - “Nobody goes there anymore. It’s too crowded.” It’s an experience thing, samples, products you don’t see everywhere, incredible value on everything in the store.

[tk11]

Nobody from the smart people goes there anymore, neither any young adults, the future of any company. The times of expansion and growth are gone with the departure of the founders.

Warehouses are too crowded with time wasters 65+ year old who are overrepresented, inadequate parking, freebie lines crowding aisles. Long checkouts during evenings and weekends when most people shop. Company is way behind in investing for future growth. Management are lifers ex-stock boys. Static "business as usual".

The corporate tax cut prolongs a painful death. Today's Blockbuster Video. Thoughtful analysts see the similarities. AMZN & WMT investing in online and corporate talent will dominate this field!

[Jae Jun]

I don't know where this sentiment is but couldn't be further from the truth looking at their numbers.

In the end, the numbers don't lie.

[davehumphrey2]

Wonder how Amazon would compare here.

[Zissou]

TGT looks interesting - lower conversion and high margins.

[smf723]

I love to shop at Costco and I'm long on them but their technology is behind the their competitors. Their website is primitive and no ability to have ship to store. I also shop at BJ's and their Express Scan is awesome. They need to fix their technology side or they will slowly wither over time.

[correct way to invest]

Yield 1 percent not getting paid enough and just hoping all the idiots keep justifying buying the stock with this high of a pe

[vooch]

whopping huge special
dividends every other year

[krispytoast]

Every now and then Costco pays a "Special Dividend" last year it was $7 a share before that I believe they paid $7 and $5. This year they didn't pay one but this does not mean they won't be paying one in 2019.

[BitterrootBrown]

They will announce the next dividend in April along with any increase. It wouldn't surprise me if they added a special dividend because of the new tax policy.

[LERF]

Nice Job, this particular analysis makes looking beyond the numbers easy to understand. The conclusions here reveal an important explanation as to why Costco's recent stock valuation (in lieu of stock markets recent volatility) has maintained its lofty status relative to its peers, despite some wall street pundits (in my estimation erroneous) efforts to downgrade. I think that unlike the author, some of those pundits focus on the wrong metrics/fail to account for how well a business recycles their cash and what effect that has on a corporations ability to generate future profits. It looks like Costco is just better at it or just figured out a more efficient use that best fits their business model (read stay ahead of their competitors).