Episode 16 | A Dedication to Members and Employees and a Look at Global Expansion: A Deep Dive into Costco

In Episode 16 of "Market News with Rodney Lake," Rodney Lake, Director of the GW Investment Institute, delves into Costco's current valuation and growth strategy. He shines a spotlight on Costco's forward PE ratio of 48 times and a 30% return on equity. He ponders whether the company's international expansion, particularly its success in China, justifies its high valuation. Lake underlines the unique culture management fosters, prioritizing members, employees, and shareholders. Despite the high price tag, Lake gives Costco an overall score between 8 and 9, noting its continued dominance in the retail space. Tune in to discover why this business model is thriving worldwide!

Transcript

Thank you for joining Market News with Rodney Lake. This is a regular program of the GW Investment Institute where we talk about timely market topics. I'm Rodney Lake, the director of the GW Investment Institute. Let's get started. Welcome back to Market News with Rodney Lake, I'm your host Rodney Lake we are coming to you from the Duquès Family Innovation Studio, which is a fabulous place to be. Thanks again to the family. We are in Duquès Hall as well, right here at the George Washington University School of Business.

What are we going to talk about today? Another large position in our portfolio. It is Costco. Many of you, I'm sure, know Costco and possibly even shop there. Their shoppers are super loyal and we'll get into that. So we're going to use the framework business management, price valuation and balance sheet. That is the hallmark of the GW Investment Institute.

That's how we evaluate companies. And we're going to go over that framework. And we're going to be talking about Costco and each one of those elements. So let's dive right in. Many of you already know the basics of Costco and you probably have a membership. And again, they are super loyal. So what is it? Well, it's a retailer.

It's a discounter. It's a wholesaler. It's a membership club. And so what does that mean? You pay a membership for the right to go there. They just raise the prices. Doesn't seem to be an issue. And the business has been good. You know, we won't get into the history on this episode, but that's possibly another episode. We'll talk about a little bit of the history of Costco, but what we're really going to be talking about today and what do we think about tomorrow?

And as a reminder, this is not investment advice, educational and entertainment purposes only for the session and for all the work that we do. It really is for our Investment Institute students. But this is a large position for us, so we need to really think about it. So the business of Costco back to the B. It is this wholesaler.

It is the membership type of business. And so what does that mean? You pay the membership annually for the right to shop there. What is Costco trying to do then? They're trying to give you the best possible prices on what they think are the most valuable products. Who are some of their competitors and how do we distinguish it?

Well, some of the competitors would be something like Sam's Club, which is Walmart and BJ's wholesalers. And then how do they compare against let's say Walmart as an example. So you walk into Walmart, this so-called supercenter pioneered by the hyper stores in France actually care for. Shout out the super centers run something like 100,000 SKUs or something like that, meaning individual unique products.

What do you think Costco does? Well, one of the reasons they're able to keep prices lower and provide value to the customers is they run something like 4000 or just less than 4000 SKUs. That is obviously ridiculous compared to a Walmart. And so but what does that mean? It means that they can buy in bulk. And those items, they can select the things that they think are the most valuable for their clients, and try to give the best possible prices to their clients.

And it also means that inventory turnover, which is something we'll talk about, in a variety of different episodes, but including today, especially as a retailer, is probably the best in the retail business at over 12 times versus something like Walmart at eight. And if you get standard terms, which is 30 days net to pay for products that come in, you actually have what's called a negative cash conversion cycle, which means you're selling this stuff before you have to pay for it.

If you did, no, that's a great business because it means your suppliers are effectively giving you a free loan, to get the product and sell it. And, you know, the float is basically yours. So we'll talk about Berkshire Hathaway and talk about the float in the insurance business. This is an example of a little bit of a float in this business.

So really unheard of in the retail business. Again, Walmart would be a best in class retailer and they're getting something like eight times. So to get 12 times an inventory turnover is really outstanding. Best in class. But some of the other things obviously, that Costco is focused on is that in-store experience. And so the businesses, they're trying to get their customers in there, they're trying to keep them in there.

That the, you know, dollar 50 hot dog and soda, which has been around for 40 some years. They haven't raised the price on that. And they talk about never having really lost leaders. That might be one in any case, that is something that's a staple and people come in for, but really it's about, you know, the bulk.

Do I want to buy, you know, you know, a pallet of paper towels. This is an example, certainly for during the, you know, coronavirus pandemic, everybody wanted pallets of of toilet paper and paper towels. And so that was important. So what does it mean for the everyday customer? Well, it means that they're going in the shopping experiences that you're going to buy in bulk.

You're going to get the best possible prices. And what's another feature of Costco that's super important? That is the brand Kirkland Signature. If you've been in the Costco, you know what that is. If you look at the revenues associated, just with that brand, it's something like $50 billion. Well, there's another company called Nike that really it squeaks out even Nike, for everything that they do.

So that's a little surprising if you haven't really thought about it, how successful that brand is. So that's their in-house brand. That's the brand that they built because and it's become a tremendous success for Costco. And obviously if it's an in-house brand, you can have higher margins on that type of brand. So the business, for Costco is a great business, loyal customer base.

But let's really get in, to some of the some of the numbers here. Before we get into the management, let's go over the B here. So the market cap 300 and, you know, $80 billion approximately. We're in late September here, early October, you know, that that's where the you know, the market cap is. So it's a it's a very large company, you know, in comparison to other, companies, it's not the largest, you know, it's not Nvidia or Apple in the trillions, but 387 billion is an example is is quite a large business.

What do they stand on? The revenues 254 billion in revenues growing you know year over year closer to 5%. But historically they've actually grown closer to 10% compounded for 30 years, which is also unheard of, by the way. So they've had steady growth, you know, again, for three decades. That's really outstanding. So obviously people like what they're doing and people continue to shop at Costco.

So you can buy a TV, a diamond ring, get your tires changed. You know, all that stuff in one store. And people are loyal. They keep coming back. So now let's look at sort of the margins of this business. So the you know, the gross margins are at 12%. And the net margins are at 3%. So that's not a huge that's not a huge margin business.

And so really have to make you know, that in the turnover. And again, when you talk about inventory turnover at 12 a little over 12 times that, that's something fabulous. And that really helps drive your ROI. And now when we look at return on equity, now when we look at the free cash flow we're talking about a little over 6 billion.

So this is a very solid business. And so we're going to come back to the business a little bit. But I want to talk a little bit about just touch on the management. And I want to touch on all the components and kind of move around a little bit today because there is so much interplay, obviously, between all of these.

But let's think about what score we would give this business. Well, it's not a high profit margin business, but it's a steady business. It's been growing 10% compounded annually. Well, that's that's fabulous. If you use the rule 72, okay, you're going to double every, approximately 7.2 years, on the revenue. Well, that's pretty good. Next is, you know, the loyal customer base, the built in brands with Kirkland.

You know, obviously people keep coming back because they think they're getting value. And, you know, all of that membership dues, which you pay each year a really profit. Right? So that's coming down to the bottom line. And they really focus on making sure that each individual SKU or individual product is profitable, probably minus the hot dog and soda.

That's $1.50. But besides that, they're really trying to make sure that each one of those products that they're offering the 30, the for that 3800 to 4000 or by themselves have positive unit economics for them. That's really important. Again, other stores, if you compare it to a Walmart, which obviously it's not exactly comparable to Walmart, more comparable to Sam's Club.

But Walmart's going to have a lot more individual product items, so it makes it a lot more difficult to do that. So let's, that's the business. Probably we'd say that's a solid seven in the business model. Probably even better. Maybe that's an eight because you get this negative cash conversion cycle. And so that is really, really fabulous.

And so now let's talk about the management team. So the management team has a relatively new CEO. And he's only been there less than a year. So you're talking about somebody who's really taken over a fabulous business. It's been less than a year that he's been there. And so the verdict is out. His name is run backwards.

And so time will tell. But he's taking over, obviously an enterprise, that's been going gangbusters for a long time. They promote within, many times at Costco. And so the culture. So you have a lot of people that have been at Costco for years and years and really understand the culture and can really drive that forward.

And so management, I think, has been doing, you know, a fabulous job, for, for a long time. And so what do we what do we know about the culture there? Well, one of the cultures there is that surprisingly, you know, when Costco talks about its values, it doesn't automatically skip straight to shareholders, which some companies do.

They really talk about taking care of their employees. They talk about how do we make sure that we take care of the people, that take care of our customers? And then how do we take care of our customers? And then we take care of shareholders. And so that's a really important, distinctive feature in the culture that management sets.

Another part about what management sets is the compensation. And and if you look at the comp Costco versus Walmart as an example, there are some studies out there you can find that, you know, in general, the average Costco employee is going to be compensated higher than, higher than the average Walmart employee. Something like, you know, 19 for Walmart, maybe 26, for for Costco, approximately.

So a big difference, especially if you're an hourly employee. What are some other features where Costco really tries to take care of their employees to take care of their customers? Well, they have 401 K with matching. They have health benefits. For even, hourly employees. So it's a very different culture. And it's not to, to minimize the culture that Walmart has been building.

Also a fabulous retailer. So again, and we're also shareholders of that as well. So it's not to minimize Walmart, but to make a distinction around how management perceives building a specific culture at the at the store, at the company, saying that if we take care of our employees, they will take care of the customers. And in this case, it seems to be true.

It seems to be working for a long time, and it seems to be working for Costco. They have some of the lowest employee turnover, in the business as well, some of the lowest shrinkage in the business as well. And so shrinkage is loss of inventory. Basically, people are picking up and walking out of there or spillage or other things that happen.

But, you know, a lot of times that stealing and so really things are not walking out of the store without being sold. And so that's really, you know, a sign, and a testament to the culture that they have built there at Costco. And so that's something that's an important feature that, again, that culture has been set by management really back all the way to the price Club before, before it became Costco in 1983.

And so you're really talking about how do we make sure we take care of the people that take care of our customers? And those are the.

People on the team at Costco?

The staffers and the team that builds it. So another part is then we take care of our customers. Obviously, we want to make sure our customers are taking care of our employees are taking care of, and we want to take care of our shareholders. And so I think that is pretty unique in the business. I'm not aware of any of the company that has quite that, specific mix and the emphasis on taking care of the employees, taking care of the customers and then shareholders.

That can be, you know, other companies out there certainly don't know every single company. There can be companies that are similar. But for a large publicly traded company to be so focused on making sure you take care of your employees is something that is unique, is distinctive about Costco, and seems to be working for them specifically.

And if you've been a shareholder, you have benefited, from that because, you know, what do you care about? You care about the sustainability of this enterprise. And if you have fantastic employees who are taking great care, of the stores and taking great care of the customers. Well, as a shareholder, that's a fabulous thing for you because those people keep coming back.

They are loyal, those customers. And as a customer, that's fantastic because you get a high quality, very consistent shopping experience. You know what to expect when you get to a Costco. And that, again, is part of their bread and butter. So for management, when you talk about inventory turnover that's obviously a direct function of the business model.

Plus the management people that are executing. And at a little over 12 times, that's again best in class for a retailer. You know Walmart let's say eight. They're a little over 12 or maybe Walmart's a little over eight and they're a little over 12. Again, that's a best in class type of setup. So management's clearly doing a good job of taking care of their employees employees making sure you have, the right culture, making sure then you're executing on the business.

You have this negative cash conversion cycle. Again, if you get 30 days, which is a month, and you're turning more than 12 times a year, well, that means that you have this negative cash conversion cycle, meaning that when the product gets dropped off, you have 30 days to pay, typically, that those are the terms and you're selling it before that on average.

Now some items will go faster and slower, but on average that's the case, which again creates this negative cash conversion cycle, which is a fabulous business model because that means your suppliers are lending you effectively, a free loan and you have this float for your business. Again, great job by management. Really fantastic. And so at the moment, even though the new CEO is has been there less than a year, you would definitely give management a very high grade for Costco.

I would say in the 8 or 9, possibly even ten for the new person. Let's wait and see how everything goes. But for the culture that they have built, for the type of organization that they are running for, the business model that they are executing on, you can probably give them an eight, nine or even a ten, for this, but probably let's say 8 or 9 for the business.

All right. Now let's get into the valuation piece of this. Now, this is where sometimes people get very excited about the valuation. So, what's the current valuation you're talking you know, this is not an inexpensive company. And this is one of Charlie Munger's favorites. And he talks about, giving these speeches, you know, about the the great, the greatness of Costco.

And rest in peace, Mr. Munger. But you're you're going to pay up. Everybody seems to know that it's a fabulous business. And it's well run. And the forward PE right now is 49 times approximate. So that's not cheap. When you look at the S&P 500 you're talking about 25 times. Is it a better than average business.

But the things that we've talked about so far absolutely yes. Not for the profit margin but for the way that they run the business, the consistency and the growth, and the return on equity. So and let let's just actually mention what, what the return on equity is at the moment. So when you talk about what's the ROI for for Costco.

And we'll jump back, to the PE here. But let's just take a quick peek at what's the return on equity, for this type of business. And so. Again, it's a fabulous business, and it's really up to, management to, to drive these things. And again, when you don't have a high profit margin, you really have to drive, in these other areas.

And so it's really important, that you do that. So can they do it? Can they keep doing it? Well, you know, again, time will tell. And is it worth, you know, that 48 times I don't know, but when you look at the ROE you're talking 30%. So when you talk about low profit margin you're getting it really in that asset turnover, of the business.

And so really fabulous for them. And if you use the DuPont formula you can get there for that. So but again, when you're talking about, return on assets, ten return on equity, a 30%, and that comes in, to the balance sheet. So the valuation of the company, people get excited and say it's way overpriced sometimes and, well, but you have to pay up, for a really high quality business.

And at 48 times you are paying up. So that's something that you have to determine. This is a current holding for us at the investment in suits. So we have to, as our students really think about, you know, where does this belong in the more recent past, the vote has been to actually add to this position even at a higher valuation.

And so right now the vote is it stays in. And not only does it stay in our portfolio, we would like to increase that. And part of that and we'll come back to that is the growth of the business, which we'll touch on as we get back to the business. But let's get through the rest of the framework here.

So now let's move on, to the balance sheet. So the balance sheet is, you know, not much to report here. 11 billion in cash and 8 billion in debt. You know, using round numbers at the beginning of September here in 2024. So, you know, net cash here, of, let's say 3 billion. So that's not something to be concerned about.

Obviously as a shareholders, we can sleep well at night. Net cash on the balance sheet, not really concerned about Costco's conservatism. Conservatively run business. Great balance sheet. So you're given the balance sheet. You know, we know we didn't give a score. We'll go back to valuation balance sheet. We're probably talking 9 or 10. Back to the valuation for the score okay.

Let's b make a recognition that it's a little bit high. But it's something like you know 48 times this is 25 times for the S&P. We'll give it a 6 or 7 on that. Now let's loop back around, to the business. Just talk about people's one of the favorites, that people like to talk about is growth.

So again, they've been growing revenue at 10%. And now and that's mostly a domestic story. But now you're starting to see, you know, growth outside of the US, including in China. While their store in Shanghai was gangbusters, super popular right out of the gate. So the concept people thought, well, maybe it doesn't work outside of North America, the US and Canada principally, but it it seemingly does very well.

This business model seems to travel, and time will tell how they can continue to grow and execute in these other countries. But so far it looks like it's working and people are very excited lining up, to get into Costco. So the growth of the business, again continues to, to compound well, let's say average of 10% growing into new markets.

It looks like they have a good runway, to go there. And again, when we review all of the pieces of the framework, we talk about the business. We're talking about seven, 8 or 9, probably 8 or 9. When we talk about the management. Again, the super important part, or let's say an emphasis needs to be made around the way that the management has created this culture at Costco, starting with taking care of the employees, taking care of the customers, then taking care of shareholders.

And when you get this trifecta, when you make sure that those things are aligned, this self-similar activity, part of fractal geometry, you're talking about that these things work in harmony, and the employees feel like they have ownership. In this company, they feel like that they're being looked after, and they might have direct ownership as owning shares, but in this case, they feel compelled to do a great job because they're being taken care of.

And that, again, that's part of that culture. And then you get into the customer experience. People love Costco. They're loyal. They have their memberships. They feel like they're getting those deals. They're buying in bulk. So this was originally designed, you know, for, you know, business to business type of set up. They're selling to small businesses, in the original long ago format and the price club world.

But really you're talking about is people love getting these deals. They're loyal. They're going to pay their membership. And again, you something that is comparable to that would be Amazon Prime. When you think about Amazon Prime, it's the same kind of thing. You're paying a membership to access to all of these things, the variety of things that are Costco in this case.

And so again, people are super excited to do that. So you would give the management team probably an eight or a nine, possibly even a ten, because they have created such a unique culture. On the price versus valuation. Again, you probably give a 6 or 7 here trading at 48 times, not an inexpensive company. You would he could even save for a retailer that's very expensive.

But in any case, a fabulous business we have to pay up for. And then you look at the balance sheet, we're talking about 3 billion in net cash on the balance sheet. Not concerned we're sleeping like babies at night with this this cash in the balance sheet. So we're not worried about it. You add all this up depending on which one you use.

The weighting is 25% for each one of those categories. You're probably coming out, again, depending on how you've scored each one of those as an 8 or 9, depending on, again, if you gave 1 to 10 or you gave most nines, it depends. But let's say you between an eight and a nine, let's say an average of an eight and a half.

Right. Well, that's a fabulous score. Oh for an overall set up with a concern, let's say, about the valuation or something that we should look at in making sure that we're not overpaying in the short term for this. But if you look at the historic, there's for the valuation, you look at the PE, it is a little bit high.

On that terms as well. So when you look at the average and the median, 34 is the average, 34 is the median approximately. So it does look a little bit high right now. However you have to think about is this international growth going to deserve this multiple. And so that's where you these things are interrelated. You really got to think about the growth of the business where they are headed.

What's that path look like. Can this newer management team execute, on this business not only to continue to grow in North America, in the US, but to grow outside of those borders in a place specifically not just like China, but China. And it looks like they're having some success early days there. So again, this is, something that is up for debate when the when the multiple gets this high.

But the valuation, is something to consider. The other components of the business, unless Costco changes their stripes and really, you know, takes down their, you know, focus on taking care of their employees, taking care of their customers and then shareholders. If that changes, then we'll have to revisit this. But right now, it looks like the Costco is going to continue forward with this same mantra, with this great culture, with this really loyal customer base.

It has been an excellent investment for the investment. Astute again, not investment advice, but it looks like these things will remain in place, which makes me optimistic about this. It's something we'll have to continue always to check out here at the Investment Institute and our students to look at our portfolio. But it's looking good right now. Well stay, you know, attuned to all these things and really watch what management does, especially when that growth outside the US.

But until next time we'll wrap it up here. Thank you for watching Market News with