Costco Wholesale Corp. (COST-NASD, $463.31) Badly Misses on Margins in Q3. An opportunity to Proactively Reset Loss Leaders was Squandered.

Costco reported a modest earnings increase of 10.5% for the quarter ended March 31st, 2022. Earnings fell below the rate of sales growth.

Investors owning Costco shares assumed that the higher income demographic makeup in the membership base would fully insulate the bottom line from the ravages of inflation wrought upon Wal-Mart and Target in the most recent quarter.

This perception was groomed, to a great extent, through monthly sales reports that glowingly report top line revenue increases but do not report expenses. The top line is always only part of the fiscal report; the bottom line is what matters.

The result, at the conclusion of the most recent fiscal quarter, was that analysts and retail investors alike were caught completely wrongfooted; most neglected to factor in the high percentage of Costco sales that are neither food nor staples, but rather purely discretionary items that failed to be repriced to reflect inflation cost pressures. Furthermore, analysts and investors neglected to cost out the impacts of loss leaders used to draw customers to the store. Finally, adjusted for inflation, e-commerce sales declined.

At Costco, since the Covid-19 pandemic, there has been an emphasis on smoothing of “one-time” events to explain away bottom line softness. In the prior year, one-time wage bonuses to motivate staff were declared to be the culprit, plus costs to purchase PPE. However, those one-time bonuses were subsequently converted to permanent wage increases, so this was truly not an unusual expense; it now is an ongoing operating line item. And, since the PPE requirements were reduced or removed in most locales, where was the increased margin from the end of this major expense? In 2022, a number of other one-offs, primarily “incremental benefits” plus share grants to executive and staff were noted as being the major factors to hamper the bottom line. But are not company shares awarded to staff and executive annually? Is not a staff incremental benefit an ongoing quarterly or annual line item? There are a very large number of supposed irregular items in the Costco reports since 2020 that are, in fact, completely ongoing.

A cultish following exists among Costco analysts and investors.

Such veneration of Costco, artfully cultivated by Costco executives, is fostered to imbue management with decision making capabilities deemed unquestionable, actions that are infallible, the business model beyond critique and a capital plan above reproach.

Disciples of the cult of Costco assume that the warehouse chain will ALWAYS outperform other retailers, if for no other reason that it is Costco. Such a rosy prism ignores certain immutable facts; retailing is grubby work, requires flawless execution, scrupulous cost controls and above all, demands that goods are sold for the appropriate profit margin needed to increase profits and permit growth.

One key differentiation separating a world class businesses from a world class cult is accountability. At Costco, management has an annoying habit of “going to ground” during periods of subpar performance. Such was the case in Q3, 2022.

A CEO is really only required to be placed in front of the public for questions a total of 4x annually, and those 4 days represent the quarterly conference calls. The schedule is largely decided a full year in advance. Analysts are preselected to offer up readily answerable queries designed to affirm the business model; there is little chance of being waylaid by a “gotcha” that could impact the share price or diminish the thesis. Yet, on the one day of four, per year, where a CEO is actually expected to pop up, like the groundhog Punxsutawney Phil, to explain business conditions, assuage analysts and earn the tens of millions in annual stock grants, the CEO of Costco was missing in action; a long postponed holiday, assumed to be on the palatial estate in Lake Maggiore, Italy was the mumbled excuse, by an underling.

Lake Maggiore features ineffable natural beauty. Were I so lucky, I would be tempted to spend much of my year gazing over the vista towards Switzerland and certainly consider reducing my active work schedule to just the 4 required days needed to placate shareholders and provide a certainty that somebody is actually “running the show”. But, since the estate is owned, can it not be visited at any time, was that holiday sooooo necessary to take, in direct conflict with a vital shareholder call? Could a family vacation not have been scheduled on any of those remaining 99%, non critical, days in the remaining calendar year? Furthermore, given the vast network of billionaires with dachas in the region, it is a given that telecommunication access will be world class at the lake; yachts there need to be purchased and bankers contacted, entire countries are carved up among monopolies, etc. Immense volumes of clubby global business are conducted daily at Lake Maggiore. Does the CEO lack access to a smartphone while in Italy or cannot comprehend the international number of digits required to access North American lines? Was the time zone difference just too darn vexing? Was a staffer not available to assist a harried executive to dial in remotely or appear via Zoom? Is a couple of hours of public face time, one day each quarter, too much for shareholders to expect from the CEO of a public company reporting almost $200 billion USD in annualized revenues? Evidently, it is.

Short of being in a hospital on a ventilator, there is no legitimate reason to not be able to participate on a call-in fiscal report in the 21st century, which suggests that the CEO absolutely chose to hide out from interested parties rather than answer pre-selected questions on the disappointing quarter. Such AWOL lapses support a long held belief by some in the investment analytical community that those atop Costco really do have a “God-complex”.

And a weak quarter it was, indeed.

Operating margins fell to 10.18% in the quarter, down from 11.17% for the same period of 2021. That margin rate, for those who are students of history, is the lowest gross reported perecentage profit since 1999. The 1 percentage point decline in operating margins, equaling roughly 9.9% of gross profits, came about from an estimated $273 million quarterly loss on gas sales (.52 basis points) and a $243 million reduction in gross margins (.47 basis points) at the store level.

An inflection point has been reached in the inflation cycle at Costco whereby the “loss leaders” such as the gas bar and the food court are losing more money than new membership sales are bringing in.

Net new membership revenues only grew by $83 million when compared to the same period of 2021. In contrast, the quarterly margin hit, primarily due to loss leaders, may have been as high as $516 million globally.

Of late, there has been considerable debate on the net benefit of loss leaders among some Costco institutional account holders.

The debate centers on the stubborn refusal of Costco to abandon certain long held “sacred cow” pricing loss leaders at the store level; specifically the gas bar, the rotisserie cooked chickens and the $1.50 hot dog/beverage combo.

The use of loss leaders is considered controversial. Typically, a product is temporarily sold at cost, occasionally slightly below cost, to attract customers and to then upsell more profitable products. However, when the loss leader could be a nicely profitable product that is sold at/below cost to entice customers to purchase larger volumes of less profitable products, the selling of a loss leader results in gross margin decline and is counterproductive. Loss leaders are not designed to be a permanent fixture of a business model and are designed to be withdrawn once a prospective or new customer becomes an established customer.

The golden calf of Costco is the $1.50 hot dog and beverage combo. That price has remained unchanged for decades. During a long period of relatively low inflation, Costco was able to provide a fun snack for shoppers while generating a modest profit or at least not hurting the bottom line. Over time, moderate inflation did gradually erode the profit margins. Costco eventually found itself unable to purchase the sausages from a third party vendor without incurring loss. Hence, the decision was made to build out a factory, wholly owned by Costco, in the United States, to offer a global supply and eliminate the vendor margin. This bought Costco valuable time and with periodic factory expansions, Costco was able to still produce a relative break even on its sales.

Overseas expansion, currency forex movements and the dramatically increased cost of logistics has recently removed any pretense that a $1.50 combo remains a break even proposition.

“Current CEO Craig Jelinek recalled the conversion in a Chamber of Commerce speech in 2018: “I came to Jim Sinegal once and I said, ‘Jim, we can’t sell this hot dog for a buck fifty. We are losing our rear ends.

Fast forward to 2022, add in a doubling in price of wheat needed to make a hot dog bun, a 30% hike in the price of beef, rampant inflation in the other costs necessary to produce a hot dog combo, the loss is now “rear ends + X“.

Supplying US produced hot dogs to China, to Europe, to Australia, Canada, Asia and a host of other foreign stores involves cold storage chain shipments, many with multiple legs required to reach the destination, all adding to the cost of the product, reducing profit margins. As international expansion had been made a priority over US development, each foreign store opened adds to the logistic cost of the US supplied product and pushes the combo further into the red for shareholders. On average, each store in the chain will likely sell more than 206,000 hot dog combos over the course of a year. For every overseas store, the pricing is now clearly a loss.

In Canada, as one example, the combo is priced in Canadian dollars, which makes the US dollar cost of the combo $1.18. The two main ingredients (the uncooked hot dog and the bun) are sold at the warehouse and retail for $1.37 US in a Toronto, ON. Costco. After eliminating the retail markup, this basic cost of those two ingredients is now above the net retail price charged at the food court for an entire combo. Over and above that cost, we must then add the expense of preparation, staffing costs, spoilage (breakage of buns and sausages), condiment costs, wrapping foil + the wholesale charge of the soft drink beverage offered with that hot dog. Finally, executive members are awarded with a 2% member credit on the combo purchase, reducing the margin even further.

To summarize, Costco, in their largest single market outside of the United States, and after taking into account standard fast food cost ratios (preparation, overhead and packaging typically costs almost as much as the basic ingredients) loses an estimated $.75 US (cash costs) per combo sold, all in. Each warehouse in the chain has an average paid membership base of 71,000 persons who consume 3 hot dog combos annually. Some members consume far more, some eat none, but that’s the average. An estimated 21.6 million hot dog combos, each losing roughly $.75 per meal, will likely be sold in Canada during 2022. In Canada alone, a membership perk is no longer a breakeven proposition, it is an actual loss of roughly $16.2 million USD, for just one market.

While recent articles have been put out, press release driven fluff, approved by Costco, all talking up the ability of Costco to manage costs, not a single article has actually declared that the combo operates at break even, let alone earn a profit. Therefore, it can be assumed that a loss is ongoing; with the strong cost inflation in every component of that combo, this hit to margins grows weekly.

During the Covid-19 lockdowns and partial restrictions at food court for a great deal of the pandemic, food court losses were mitigated, via state and national mandates.

When chairs and tables were removed, when food courts operate only as takeaway, the volume of hot dogs sold, and the losses produced, actually declined through the pandemic. Customers during 2020 and 2021 were unable or unwilling to avail themselves of the hot dog combos, which resulted in improved overall margins at the corporate level. However, the full global reopening of the food courts as the pandemic winds down (for the most part) means that the losses have resumed and will likely set records in 2022.

Heading into fiscal 2023, the genuine operating losses produced from the selling of the hot dog/soft drink combo could rise to as much as $131 million US. That is no longer an insignificant loss leader; it could mean as much as $.29 US per share in foregone gross profits over the course of a year. At a 20x earnings rate, those hot dogs are penalizing shareholders by roughly $6 per share of foregone appreciation annually.

Worse yet is the growing impressions of cannibalization of profits, away from other food court items, to favor the money losing hot dog combo.

A loss leader is designed to draw customers TO a store and AWAY from a competitor. it is not designed to cause customers already in-store to forego profitable purchases in favor of money losing purchases. Yet, Costco executives, in a frantic and badly unfocused effort to manage losses on the combo, have raised ALL remaining food court items (most of which were being sold for a good profit), so dramatically higher in price, that they now look highly unappealing on a value perspective and particularly in relation to the hot dog combo price. Thus, there has been a recent trend in substitution within the Costco food court; more and more hot dog combos are being sold while fewer and fewer other items are being sold. This not only increases the net losses on the hot dog combos for the entire corporation, but it also reduces the profit buffer at the food court on other items.

My base case estimated loss of $137 million annually, on the combo sales, quickly spirals above $200 million should recent anecdotal substitution commentary prove accurate. The combo is no longer a loss leader, it is a millstone holding back the entire company.

The second golden calf is the gas bar.

The mythology of the gas bar is that the vast buying power of Costco enables the corporation to purchase gasoline, a chain of just 830 stores globally, some countries with only a handful of locations, for less than integrated refinery/gasoline retail colossi charge their own stations, many competitors possessing networks of stores in the tens of thousands. When determined media ask questions about the profitability of the gas bar, the corporate mantra is the same: “we strive to break even or earn a modest profit on gasoline sales in order to generate customer traffic for each warehouse“. This implication guides analysts to the assumption that Costco doesn’t actually lose any money on gas, but that the company is operating, more or less, as a cooperative on behalf of members, offering gas as a service.

The truth of the matter is far different. In the quarter recently ended, my estimate is that Costco lost a total of $273 million USD on gasoline. Costco does not own a refinery; they purchase gasoline at a wholesale price established through competitive bids from the lowest cost supplier in each market area. How competitively can Costco purchase gasoline in Iceland, with just a single warehouse? Does 40 gas bars run by Costco in Mexico have any buying power compared to the 12,500 stations operated by Pemex who has a refinery monopoly in the country? Are 4 warehouse gas bars in Spain able to out-purchase 700 Spanish gas stations operated by BP, who has its own refineries? Can Costco Canada, with 104 gas stations, outbuy the 2520 gas stations owned by integrated refiners? Are 13 Australian gas bars capable of profiting against Caltex, who sells 1 in 4 gallons on the continent?

It seems odd that analysts and institutional investors outside of California have never pressed management on the clear “California centric” bias in gasoline price discounting.

California features the most expensive gasoline in the US. That is due to a rather small number of refiners capable of meeting the blending requirements of California gasoline which results in de facto prohibitions of competitively priced imports from other states or offshore. Yet, Costco discounts the gas per gallon to members, by a far greater amount than they do for any other state in the US. From afar, it would appear, absent any evidence to refute the contrary, that Costco executives are quite willing to lose even more money in that state to curry favor with their large California customer base while also offering a valuable financial perk to management in California and their employees, who themselves fill up at the gas bar. Why does a Costco California member receive a $.57 US per gallon discount, more than $.30 per gallon greater than the nearest state competitor, when a South Dakota member that same day only gets a $.20 discount per gallon, just $.05 per gallon better than the nearest competitor? Discounts for California members are wholly disproportionate to other competitors in the state and grossly out of line with other Costco gasoline discounts nationwide.

Taking the data that is publicly available from the State of California, who details estimated profit margins on wholesale gas in the state going back more than 20 years (the full spreadsheet may be found at the link), and working back from the weekly published fuel differential prices between Costco and peers, I have calculated that Costco, in 2022, lost money on every gallon of fuel sold in that state for the entire year. It was not an insignificant loss either, taking into account the fact that Costco only accepts credit card payments and a 2%-4% fuel rebate on pricing is offered to members with both an executive membership as well as a card that offers a fuel discount or rebate.

By the numbers: What you’ll pay at Costco gas stations vs. average Bay Area gas stations

If Costco underprices gasoline against numerous global refiner owned retail networks, some with 100x the scale, who themselves typically operate at slender margins, then despite happy anecdotes from members, who love purchasing gas for below cost, it should come as absolutely no surprise as to the magnitude of loss selling gasoline. Maintaining a strategy of being the lowest cost retailer of gasoline, lacking a convenience storefront with high margins to offset some of those losses, results in a running annualized loss from gasoline in the range of almost $1.09 billion, assuming that gasoline prices don’t fall.

Rotisserie chicken pricing is a growing thorn in the side of shareholders.

The rate of loss in new consumer and small business savvy markets such as Shanghai, CN will grow in the latter half of 2022 and beyond unless pricing is reset.

All in, at current rates, gasoline and hot dog combo losses, in isolation, appear to have the potential to reduce profits by more than $1.22 billion annually.

That takes the notion of a loss leader to an entirely new level. Almost 15% of the annualized operating income before taxes is being gifted without a commensurate benefit being earned at the store level.

If the price of a Costco hot dog combo suddenly went up to $2.25, would any member actually cancel their membership in protest?

Well, there is always one, but most of us wouldn’t think twice about purchasing another of our 3 annual dog combos should the cost be hiked by $.75 or $1. For the overwhelming number of members, a combo purchase is an afterthought snack while in the store rather vs a specific reason to shop. The lockdown shopping metrics reported at Costco clearly proved that premise out.

Will members discontinue their store visitations, or cut up their cards in protest, should gasoline prices at the gas bar rise to the average level as other retailers in the area?

Yes, some might, but that decision needs to be weighed upon the backdrop of the immense losses being borne at the gas pumps. Offering customers the opportunity to purchase an expensive amount of a loss leader, in the expectation that underpriced instore merchandise and groceries will more than offset that loss, as evidenced by continually declining margins for several quarters, is not an optimal retail design. If a customer at Costco primarily purchases gasoline and little else, that member will be a money loser for the chain and is not worth maintaining.

The final folklore perpetuated by Costco employees, certain Costco management and by the investment media at large, who worship at the altar of Costco, is that the unique business model makes the shares an outstanding defensive investment during a recession.

Such a notion utterly fails to hold up when considering the past several recessions of any significance. In 1999, Costco earnings came in at $2.23 per share. In 2000, the subsequent recession took those earnings down to $1.35 per share, almost a 40% decline. It took until 2006 before Costco earnings recovered to beyond the 1999 figure. Not coincidentally, those who purchased shares in the company at the 1999 high were required to hold the shares until that latter part of 2006, when they were back to breaking even.

In 2008, prior to the 2009 recession, Costco reported earnings of $2.89 per share. In 2009, those earnings declined to $2.47, a reduction of roughly 15%. Investors who purchased shares of Costco in 2008 at the high were required to hold those shares until 2012 to get back to breaking even.

Costco is NOT historically a defensive investment in a recession. Like any other retailer, the business benefits from economic expansion, not contraction.

Investors holding Costco, or considering a purchase of shares, need to break free of the carefully crafted propaganda surrounding the business model.

It is a good company to be sure, but not without its own quirks and flaws.

On the plus side of the ledger: members are quite loyal and they are higher income earners on the whole than the typical Walmart or Target customer. Costco owns valuable real estate in most of their market.

On the downside: Costco has spent or is spending almost $400 million on leasing two warehouse locations in China, whose only purpose seems to be to lose money on underpriced hot dogs and chicken. A total of 20 stores could have been fully built and owned in the United States with that Chinese expensed capital and a profit would have been earned for shareholders. The Chinese capex and opex costs are sufficiently high that no material financial return could ever be modeled into the bottom line at current margins, so for all intents and purposes, China represents a vanity folly of management.

It may be that the two Chinese locations represent a “war hedge” against a potential Chinese government invasion of Taiwan, where Costco presently operates 14 warehouses. Perhaps executive are holding out hope that in the event of Taiwan falling directly under Chinese rule, Costco could maintain Taiwanese business without expropriation, via a sort of indirect bribe on mainland China. However, the losses on China, given the capital expenditures on the land and building parcels, completely offset the Taiwanese profits, making the entire two country chain a break-even at best. There is little logic in reducing a regional profit source to just break-even via geopolitical disaster hedging.

Far worse than the upfront expenses and ongoing losses on a potential pair of leased white elephants in China are the losses on golden calves, ostensibly held out as reasons to shop at the warehouse, but lacking a purpose once customers have become attached to a Costco membership. These loss leaders didn’t harm the bottom line much in a slow inflation environment but are very consequential of late and losses may accelerate in the year to come.

Finally, Costco has permanently added to its operating expenses through the building of a massive hot dog plant, a massive chicken growing/processing facility and the leasing of container ships to move product to their warehouses. Perhaps as much as $1 billion has/will be spent, for the express purpose of losing money on the output. Such decisions are usually reserved for governments, not private, for-profit, corporations. Costco now has the unenviable position of learning, the hard way, that container vessels heading to North America are full on one trip, and largely empty on the return trip, making for a loss of some magnitude without cargo to export. And just what does Costco have to export abroad; refrigerated TEU of unprofitable hot dogs and money losing chickens.

Should Costco management choose to bury their heads in the sand on the two largest loss leaders, and should inflation continue to run hot, bottom line growth will continue to be pressured.

Underlying warehouse operating margins are not high enough to tolerate $1 billion plus on loss leaders annually. Something needs to give and inflation was the perfect excuse, not taken, to raise prices.

An obdurate executive needs to be measured by the effectiveness of their business model, or failing that, for attendance at required events. Historically, Costco shareholders don’t do well at all in recessions. One would think that after several downturns of note in this century, executive at the top would have learned from those periods of challenge and adapted. Yet, it seems that absolutely nothing has changed; such obstinance can only be due to a management belief that their model is beyond critique.

If we are entering an economic malaise, driven by a shift in consumer purchase patterns away from discretionary items to favor basics such as fuel, food and staples, Costco will be hurt as much as any other retailer. The warehouse margins have not been this poor in the 21st century, yet the company has stated, through subordinates and media proxies, that sacred cow losses will persist. The mix of products in the warehouse does not benefit from inflation trends.

As an investment, perhaps the short term risk is higher than cultists assume, given the premium valuation attributed to a business model barely earning a 10% operating margin on revenues at present. Costco shares, from peak economic pricing, to trough recessionary pricing, have typically fallen in half. Therefore, one should assume the same percentage decline is possible in a broadly based economic recession, going forward.

Were gasoline prices to fall and the company opted to increase the hot dog combo and rotisserie chicken pricing, which could plausibly be accomplished by blaming inflation, rather than bad business policy, it should sell well to customers and those long the shares would be once again off to the races.

Under such a scenario, the operating cost of the hot dog and poultry facilities would move from loss to profit, or at least break even, and alleviate margin pressures. Falling gas prices typically result in Costco moving from loss to break even on fuel and occasionally earn profits.

But until that happens, margins will remain under duress while more nimble, faster growing competitors, such as BJS Wholesale, that doesn’t sell hot dogs for a frightful loss and resultingly generates a 17% plus operating profit, will continue to look comparatively more attractive.

BJs Wholesale club Holdings (BJ-NYSE, $59.91) represents an example of what sort of operating margins a membership warehouse retailer is capable of producing.

Rather than casting aspersions on the up and comer, Costco shareholders should carefully review the earnings power of BJs and ask themselves:

Why is Costco, a company with roughly 4X the stores, 2.6X the paid members per warehouse, 11.7x the gross revenues, primarily wholly owned real estate and key wholly owned manufacturing for several high volume retail products, why is Costco apparently incapable of producing similar margins to BJs Wholesale?

“Where are the economies of scale at Costco?”

“Is the massive California footprint truly run as a for-profit enterprise, or is Costco really just a chummy west coast biased cooperative; one where California largesse is subsidized by the remaining US locations?”

As the current CEO seems to prefer the isle of “Absentia”, evidently the final location on the planet lacking modern telecommunications and apparently immune from the ravages of inflation, to the tedium of an occasional obligatory function, is it high time for a change atop Costco?”

These questions are well worth asking, indeed.

Posted in Open Blog

Leave a Reply

Recent Comments