I first discovered Costco when I realized that Charles Munger was a director after reading the proxy statement of Wesco. I immediately sent away for Costco's annual report, 10K, and proxy statement to do research on the business (I also looked around my area for a Costco to no avail). What I discovered was a fascinating business, so interesting in fact that I had to share it with anyone who would listen.

Here is a great quote from Charles Munger (from the 1999 Berkshire Hathaway Annual Meeting): "I'm such an admirer of the Costco culture and the Costco system that I'm not sure I'm totally rational. I love the place. That isn't so bad in life, to find a couple of things you love."

History

The company's current structure is a result of a 1993 merger between The Price Company and Costco Companies. Sol Price, a legendary leader in the "Warehouse" shopping concept, managed the Price Company.

The Business

Costco sells private label and branded merchandise to businesses and individual shoppers. The idea behind Costco is to sell very large volumes of merchandise and achieving high inventory turnover. Costco does this by offering a limited selection of items in a wide variety of product groups at great prices. For instance you can buy toilet paper at the store and at the same time purchase a $20,000 diamond ring. (Some shoppers feel there must be a catch to the prices, after all how can anyone sell products at these prices and stay in business!)

One of my favorite indicators of how well Costco is doing is that they have had to enlarge their shopping cart four times! Costco also has extremely loyal members; they have renewed their membership at an 86% renewal rate. What better way to tell if you are keeping your members satisfied with your performance.

How does Costco keep their prices so low? Costco is a company extremely focused on keeping their prices as low as possible while still providing the company with a decent profit. Prices are low due to several factors:

1. Distribute through own efficient depot facilities
2. Enhanced sales of higher margin ancillary departments (i.e. Optical, Pharmacy, one hour photo centers)
3. Strong Operational Controls over markdowns and inventory shrinkage
4. Expanded private label programs (Kirkland Signature)

Costco has an obsession with keeping costs under control, for instance their own home office furniture was purchased used from Boeing Corporation. Also the corporate jet isn't used unless all the seats are full. Yet another example of this focus is clearly shown by Costco having its computer system set up to advise management when the price of any particular item is above its cost by 14%. In this way they can keep the prices below their competitors.

Since Costco has such high sales volume and rapid inventory turnover it is able to receive cash from the sale of a large portion of its inventory before it has to pay back its suppliers. The use of float is a major advantage in its own right; they are essentially borrowing money from their suppliers at no cost to themselves!

Ratios

Another example of how efficiently Costco is at managing how money flows through its organization is by observing its Flow Ratio, for 1998 its Flow Ratio was .99. The lower the Flow Ratio the better and a flow ratio less than one is extraordinary (The company is managing its cash flows very well indeed. (The flow ratio number was derived from information in the 1999 Costco annual report) The Flow Ration has been improving; in 1999 the Flow Ratio was .91. Costco sales per square foot have been increasing, on average, approximately 5.5% per year. So Costco is putting the space it occupies to good use!

Another measure of how effectively Costco manages its inventory is its inventory turnover ratio (1998) of 12.47. A number between six and seven is "normal" so as you can see Costco is doing a great job of moving its inventory out the door.

Psychology

One of the most fascinating areas of interest in the Costco model is how they use psychology. When a member begins shopping at Costco they are amazed at the prices and how fast certain bargain priced merchandise sells. The member then feels compelled to take their time when shopping so they can cover the entire store, thus no bargain will be missed. From this stage the member starts going more and more often, after all why shop other places when the prices are so good at Costco (not to mention they might miss a good deal if they don't check back often). Members seem to develop an addiction to shopping at Costco.

Future Prospects

Looking at the map provided in the 1998 Costco Annual Report is striking; there are large areas of the country where Costco has not expanded. While Costco has expanded in some area around the world (Korea, United Kingdom, Canada, Taiwan, and Mexico) there is also a lot of room for expansion overseas.

Costco's main competition is Sam's Club, which is owned by Wal-Mart. How does it compare to this extremely well run company? Costco has two hundred fewer stores than Sam's and yet still has more than 1 billion more in revenues per year.

Here is a very interesting quote from the Sept. 27th issue of Warehouse Club Focus concerning future growth prospects:

"In a telephone interview with the Los Angeles Times, Costco chairman Jeff Brotman said that the company plans to double the number of location that it has in California in five to ten years. This fact alone probably scares the supermarket industry most of all. The current population in California is approximately 32.7 million people. Based on industry assumptions that a club requires a population of 275,000 people, California could currently support 119 clubs. Costco, with 88 locations, and SAM'S, with 25 locations, combine for a total of 113 locations in California. If Costco achieves its plan to double its locations in ten years, and the state population grows an average of 2% per year (based on WCF assumptions), by 2010 there will be approximately 220 clubs (including SAM'S) with an average of 200,000 people per club location. If the clubs can successfully operate in markets of 200,000 people, the industry's growth prospects, not in only in California, but nationwide, are much greater than initially thought."

CONCLUSION

Costco is a superb company with plenty of room for growth. Its business model is fantastic, all customers want to find great bargains and Costco is setup to keep the customer coming back to find them. I my opinion Costco is a great stock to consider for a focused portfolio.

What is the intrinsic value of Costco? I would recommend checking the Costco Motley Fool Message board and reading message #290 by Dale Wettlaufer. I would also strongly recommend reading Dale's articles on Costco in his Motley Fool Boring Portfolio reports.

Do your own research on Costco and tell me what you think, I can be found on my web site, FocusInvestor.com (www.focusinvestor.com), just look for the message board area from the main menu, or at the Motley Fool Costco message board.

Richard M. Rockwood
October 25, 1999
Revised: Jan 17, 2000

rich@focusinvestor.com

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