By Costco standards, the Q4 earnings conference call represented a woodshed beat-down.
During the call Q&A, not a SINGLE analyst congratulated Costco on the quarterly result. Rather, the tone of the questioning, by Wall Street standards, was more along the lines of an interrogation. During one exchange, the BMO analyst queried if Costco had learned anything from its foray into the hiring of its own charter fleet and seacan acquisitions. Richard Galanti, the CFO, indicated that Costco is always attempting to learn from its mistakes. That is about as close as Costco has ever come to admitting that it made a mistake.
And, what a mistake it was.
Costco, as a retailer, brings much of its product mix from China and Asia. These products are sent on a 1-way trip to North American ports, where they are then trundled onto trucks for its California warehouses and by rail to other parts of North America. In those transactions, entered into with the global multinational shippers, most of them Chinese, the freight paid is for a 1-way ticket and the sea cans are dropped off at depots where they are rerouted by the freight operators.
A blockhead at Costco procurement decided that instead of paying for a global shipping company to freight Costco products, in the most massive container vessels possible, which maximizes efficiency and reduces the cost of freight: that logistics specialist thought to one-up 50 years of common shipping knowledge with the following idea:
“why don’t we charter out some smaller vessels, buy thousands of our own sea-cans and pick up our freight directly at the Chinese docks, to ensure no interruption in supply”? “Wouldn’t that be great?”
The notion was not great, it was terrible. To start, the major problem with freighting from China to North America lies in the fact that most container vessels head from Asia full and return empty. A perennial North American trade imbalance with Asia means that only the largest carriers can hope to consider breaking even on North American freight to China orders. Costco is not a Chinese freight giant. Costco is a retailer with almost nothing to ship to China. So, Costco is paying a full round trip freight cost for what is only a one-way freight ticket. Everyone in logistics knows that issue, everyone except, inexplicably, Costco executives in logistics. Home Depot has some chartered ships, but they endeavor to get around the one-way problem by loading up raw lumber or other raw materials needed in homebuilding from suppliers under reshipment contracts. Costco has nothing to ship back to China, except hot-dogs.
Then, there is the problem of container vessel efficiency. Smaller vessels consume exponentially more fuel per TEU shipped than do the larger vessels. The largest freighting companies get a break on bunker fuel for those vessels as well as on port docking charges, whereas a small shipping company has no negotiating clout.
Finally, there was the timing of the charter endeavor. Costco entered their fleet charter contracts at the all-time high in container vessel rents and purchased their sea cans at the all-time high price for TEU.
While hiring a small fleet has enabled Costco to obtain its own supplies with fewer interruptions, it has done so at the price of a greatly increased shipping fee, an expense that remains permanent until the charter contracts end. This directly impacts margins.
The stubborn insistence upon maintaining decades old pricing for loss leaders is now starting to really, really hurt and back up into other merchandise pricing decisions.
In the conference call, the CFO noted that private label growth, the Kirkland brand, was only 1% in 2022 and is virtually flat lining at present. Private brand labels are employed by all manner of grocery retailer; they endeavor to undercut national labels in price and capture a portion of a brand name profit margin for the retailer selling that label. However, it has been noted by some, and observed personally, that the stable of Costco Kirkland grocery brand names have shot up in price so sharply that they now exceed competing private house brands, and in certain cases, national brands. Kirkland ground coffee at the warehouses is now priced so high that Starbucks, who typically provides an incentive to Costco for quarterly member sales at a package price of $5 discounts, when on sale, is priced well below the Kirkland house brand Columbian tins, as are many other coffee labels. So, pallets of Kirkland coffee, now more expensive than almost all other coffees in the warehouse, they gather dust. Pallets of Kirkland peanut butter gather dust, waiting for their expiry dates to be hit and to be removed from warehouses. Too many “go-to” private label consumer staples, items that should be flying off the shelves due to their value in an economic slowdown, are sitting around in warehouses, because they are too highly priced vs competing private label and national label brands.
One reason for the Kirkland label price hikes, well above that of other food brands, is the possibility, floated in the conference call by an analyst, of “harvesting” price increases in the private label in order to subsidize losses at the loss leaders. Not only is it throwing good money after bad, but it can also backfire on margins and may be reaching that point now in certain, formerly high growth SKU.
Above industry wage growth continues to negatively impact Costco operating profits vs other retailers.
The unions at Costco have wrung out significant concessions over the years, which makes Costco warehouse employee expenses considerably higher than competitors, even among unionized businesses. Costco has taken a view that employees are partners, which reduces friction. However, in retail, when margins are very tight, one cannot permit the cozy relationship to become one-sided and that seems to be the case. Executive at Costco are sufficiently meek that they have permitted employment unions to run the show; but Costco is not an employee cooperative, it is a for-profit business with a responsibility to shareholders.
Costco’s much vaunted strengths, primarily a promoted notion of customer loyalty and buying clout based upon size, are now rendered irrelevant based upon some very notable shortcomings.
If customers were truly loyal, they would pay an additional $10 annual membership fee without outcry. If customers were truly loyal, they would readily pay an average increase across the board for the entire Costco SKU of products, which would at least protect margins. Yet, executive at Costco don’t feel that their customer base is loyal enough, because they are allowing margins to decline quite rapidly and are creating an unequal pricing field whereby more and more products are far too highly priced vs smaller competitors to sell well, if at all. Intentions at Costco don’t equal actions, their pricing actions are far from a sign of customer confidence, it represents indifference.
Costco has also decided to drift away from the low cost “cash and carry” business model by starting up an in-house delivery service division on the most margin intensive of items to deliver, bulky furniture and heavy packages.
Costco executives must truly believe that customers want Costco to hold the line on massive outdoor gazebo prices, with that margin loss to be absorbed through a 60% YOY increase in the price of a Kirland Columbian roast medium grind tin. They are invested in that assumption to the point that an entire new business division has sprung up, in-house delivery of bulky items, which adds to overhead. it would appear that after the container fleet debacle, a lateral transfer of staff must have been made into the local delivery arm. Then, at the next business meeting, perhaps that same executive, not understanding the transfer away from global container charter division represented a demotion, but rather, an opportunity, perhaps voiced what was thought to be an entirely novel concept:
“We hire out a number of local shippers throughout North America to deliver our bulky freight items. Why don’t we start an entire inhouse delivery service from scratch, staff it with unionized Costco employees, buy a fleet of trucks, purchase some storage warehouses and eliminate the “per delivery” expense? Isn’t that a great idea? What could go wrong with that?”
As it turns out, plenty. The creation of an entirely new logistics firm in-house adds permanent fixed costs. Staffing costs rise, equipment costs rise, all costs associated with a unionized staff, such as health care costs, pensions, share purchase plans, that all gets permanently lodged into the Costco quarterly expense reports. Then, variable costs are added over and above the fixed cost, in the form of per delivery fuel costs, depreciation and amortization of the equipment, based upon wear and tear on tires and vehicles. Finally, each delivery must carry insurance paid for by Costco to ensure that the item is not damaged during delivery. It is a bad, bad idea when one doesn’t know exactly how many bulky items will be sold daily, monthly or annually in all of the cities where in-house delivery is to be rolled out. On a per unit delivery fee paid to a moving company, all of the expenses are predetermined up-front, there are no fixed costs, just variable expenses.
So, the brain-waves in Costco logistical planning, when faced with the obstacle of not knowing how bulky delivery would go over, came up with a new idea.
“Why don’t we reduce our profit margins on the bulky items, so as to stimulate demand for them and this will help to absorb the cost of the new division?”
No doubt, at that planning table, some executive must have raised the question, “how will we absorb the lower margin on bulky items and the additional fixed expenses from this expensive logistics venture?”
To which the answer was likely: “simple, we will raise the prices on Kirkland brand name goods. The extra money we will make on those items will subsidize the losses from delivery and help offset the far lower margins on the bulky goods.”
This seems to be yet another reason that Kirkland branded grocery staple prices are being hiked above peers. Large discretionary items are not being priced to maintain margins but rather, to maintain a steady flow of work for Costco delivery personnel and provide support for additional fixed overhead, associated with a delivery service, a service which had historically, when offered by non-cash and carry competitors, becomes a margin sapping money pit.
“What could go wrong with internalizing discretionary large item delivery, to be subsidized by price hikes on staples, in a recession. Bueller, Bueller, anyone?”
The combination of paying higher than industry average wages and benefits, the rapidly growing losses in perennial loss leaders whose prices have been fixed for decades, the phenomenally stupid decision to insource freight, the pricing situation within private label to provide margin support for loss leaders; these are all backfiring simultaneously. Margins are under significant pressure for reasons that have little to do with overall global inflationary trends. The cheerleaders on Wall Street are starting to notice.
Q4 2022 provided the clearest picture of how internal decisions are sapping profitability.
Revenue growth was 15% in the quarter, but Costco earnings rose just 7.7% to $4.20 per share from the prior year’s quarter. Gross operating margins fell by 5.6% on the year over year quarter, from 10.9% to 10.18%. A 7.7% EPS growth rate, in a retailer with such buying power based upon its size, is a completely ugly result when compared to more pure grocers that have posted 20%-40% year over year earnings growth in the inflation cycle. Inflation is a grocer’s tailwind, yet, at Costco, almost inexplicably, it is being described as a headwind.
Retail shareholders keep getting fooled by the top line revenue figures.
CFO Richard Galanti, in the conference call, indicated, repeatedly, that Costco will readily sacrifice margins for the sake of top line growth. That flies in the face of almost all rational business thought. Most importantly, it reveals a corporate mindset that might now charitably be described as stubborn.
Margins at Costco have now fallen almost on a continual quarterly basis, for two consecutive years. In Q4, gross operating margins fell by 74 basis points year over year to just 10.18%. As Costco runs far from a lean ship, this amount would almost fall completely to the bottom line. this margin reduction represents a whopping $1.6 billion USD annualized or $3.60 per share, almost one entire quarter’s after-tax profit.
Such a margin reduction completely overwhelms the potential benefit of a $10 per membership hike, if/as/when it ever materializes, which would add just $658 million to the top line and far less to the bottom line due to the executive membership spending rebates.
The margin compression even impacts the profitability of new warehouse locations; it takes years for a new Costco location to obtain enough customers to become solidly profitable.
A proposed new location, in Escondido California, is estimated to cost more than $36 million.
This is a leased location, not owned. When operated at capacity, the Escondido warehouse will have potential to produce about $265 million in annual revenue. With a gross margin of 10.18%, that would result in a gross of $27 million in annual operating profit, but after tax, the net profit falls to just $7 million.
It will take years, perhaps a decade, for Escondido to move from start-up to full revenue. If margins were higher, the capital return would be faster. should margins continue to decline, the capital payback also takes longer. Low margins hurt everything in the business model.
The absence of the CEO, who would not take an hour, from his incredibly busy day, to participate in the second consecutive earnings fail, will be noted by analysts privately.
There is no longer a pretense that the CEO has the slightest interest in answering to public shareholders; Costco is steadily being revealed as a retailer run by committee, with a number of vested interests placing their desires over capital controls, profit margins and to some extent, actual reason.
The CFO, in-call, was forced to deflect small caliber fire from analysts on the significant margin decline, the relative flatlining of Kirkland private label sales, the increased expense growth, the outsized wage increases for staffing vs competitors, the harvesting of margin from products to subsidize perpetual loss leaders. the mistake in chartering ships (BMO analyst phrased it as a learning experience). However, Costco is still paying the ship charters, so learning from a mistake doesn’t eliminate the mistake.
The inordinate time spent explaining the rollout of bulky delivery is meaningful; why spend so much time getting into the weeds on a largely non-revenue producing division absolutely nobody asked about, unless it is sapping margins?
Analysts may have given Costco a pass in quarters gone by, but the conference call Q&A questions were harder, more on point and there will be revisions for 2023 based upon a lack of clarity from Galanti on margins vs sales; Costco maintains that they are quite willing to accept margin loss in pursuit of sales.
This was, by far, the worst interaction between Costco and analysts, in a public forum, for many years.
All of the news from Costco, in terms of a very modest EPS increase vs what should have been an earnings landslide, indicates that coming quarters may start to challenge the popular notion of Costco as a growth stock for all seasons. Margin deterioration is self-inflicted, management is aware of it, they don’t care enough to change course.
2023 Wall Street estimates look too high on all fronts.
2023 consensus EPS numbers, prior to the 4th quarter release, was $14.52 US per share, a high number of $16.42 per share and a low estimate of $13.14. Costco does not provide formal guidance, so analysts are left to fend for themselves. As a result, most do their utmost to stay with a few dimes of each other on earnings estimates, seeking shelter within the herd. Most were assuming an average revenue growth rate of 8.1% for 2023 with one estimating a 12.6% rate of sales growth.
Given the percentage margin decline reported in the quarter ended, no indication that the 10.18% operating margin will even be sustained going into the coming quarter, the current forex headwinds and an emphasis upon opening new stores internationally, one in a brand-new market (which carries the added expense of a brand-new national division to be developed over and above the warehouse location), there is a greater probability of a further margin decline than there is an assumption of margin stability. Therefore, the street is overly optimistic on their guidance at present and will need to reduce their estimates by an average of 5% in the coming year just to be at the average; no reputable Wall Street firm wants to hit the mid-point on estimates, they all prefer to be conservative. Costco has the potential to earn as little as $13.91 per share in 2023, or an overall gain of just 5.6% vs 2022. Under the current analyst assumptions, only a 15-basis point further margin decline is required to take earnings growth to zero for 2023.
Is this an inflation issue, or is it conceit?
Behavioral economists have provided a useful moniker for the reticence of Costco to eliminate its numerous loss leaders; commitment bias, a tendency to remain committed to past behaviors or actions, even when those behaviors or actions produce an undesirable outcome. It is my belief that continuing to lose increasing sums on sacred cows, simply because it is the “Costco way”, is a spot-on commitment bias that works against the bottom line and is contrary to the interests of shareholders.
I further believe that within Costco executive ranks, there exists a corporate culture that is based upon a “Costco can do no wrong because it is Costco”. The corporate culture takes root from the promotion of career employees up the ranks until they reach the executive branch. As all they have ever known is the Costco way, and the Costco way, as a public company, has never experienced meaningful cost inflation, therefore, nobody in the company knows how to deal with inflation. Costco will not accept outside input, because they are “Costco”. Outside input is discouraged, because to seek advice would represent an admission that Costco isn’t perfect. Accordingly, when an executive member verbalizes the most idiotic, margin crushing idea in the world for logistics, such as chartering out their own fleet of tiny container vessels, nobody has the guts to say: “no, that’s the most idiotic thing in the world“. Nobody at Costco, when a logistics executive promotes the creation of a margin sapping corporate owned bulky item delivery service, that has been tried, too many times to count, by other retailers, all with the same dismal result, nobody declares: “that’s the second most idiotic idea in the world“.
Don’t attempt to extrapolate specific Costco margin issues to other warehouse food and general goods retailers.
Costco is a really big deal in the investment world and the retail world. They have an extremely loyal shareholder and analytical following, who will be quick to blame inflation for the margin tightening and who will absolutely refuse to find even the slightest fault with management. Yet, Wall Street critique is long overdue; Costco is doing some really stupid things in their business model. An actual decline in overall food margins, when every grocery peer is absolutely outperforming, is the proof. I know how to read a financial statement, I know how to read footnotes, and a YOY margin reduction from 10.9% to 10.18% is an equally big deal, one deserving of deep inspection. Costco should absolutely be “running the table” in this economic environment, yet they are not, it is almost unfathomable.
The creation of an entirely new division to roll-out bulky item inhouse delivery, margins be damned, is a sign of Costco’s determination to be “everything to everybody”. The last hard and soft-line retailer with that ambition was Sears Roebuck. Incidentally, the last retail CFO I heard in a conference call declaring that sales were far more important than margins was also at Sears Roebuck. For the first time, it very much appears that Wall Street analysts are also looking at the business model of Costco more critically in public forums. A retailer with single digit profit growth certainly doesn’t deserve a 30X market multiple, questions deserve to be raised. Any comparison between Costco and Amazon’s model of in-house shipping is flawed, because Amazon started its history with no profit margins and worked up. Amazon is not a union shop and has the flexibility to add or remove contractors to suit conditions. Costco, in contrast, IS a union shop.
10% gross operating profits are wholly inconsistent with any business moat, yet there are just a handful of membership warehouse retailers on the planet today. Absolute dominance in the state of California should represent a retail moat of some sort, yet the pricing being paid for California leases on new locations, rather than total ownership of locations, coupled with above average gasoline subsidies to warehouse customers, indicates that the Californian locations may be earning the lowest overall operating margins in the United States.
Two analysts in the conference call, rather than complimenting Costco for a mid-single digit profit growth quarter, on solid double-digit revenue growth, noted their criticism of the current operating model pretty succinctly: