Costco is one of the most widely mythologized retailers on the planet today.
Many customers, myself included, as well as almost all of the long term employees of Costco, are shareholders in the corporation. We marvel at the ability of Costco to sell a giant hot dog and soft drink combo for $1.50 when the individual components (beef sausage link, hot dog bun and condiments) exceed $1.50 in cost AT THE WAREHOUSE, and that’s before cooking, plating and factoring in the cost of the beverage. We scarf down one, sometimes two hot dog combos on a shopping trip. As many as 250 million hot dogs will be sold in 2022, a surprising percentage of the snacks to employees of Costco themselves. The 304,000 full time employees and tens of thousands of seasonal employees chow down on so many hot dog combos that regional Costco break rooms refer to it as the ‘company lunch”.
Customers in China cannot understand how Costco will let individuals purchase as many rotisserie chickens as they can wedge onto a shopping cart, to be carved up and resold at small vendors throughout the city, because the cost of a raw chicken everywhere in Shanghai remains higher than the retail price charged for a cooked and seasoned rotisserie bird from Costco. We all are amazed at how Costco consistently undercuts the mega gasoline stations, the vast networks with tens of thousands of gas pumps that are owned by refiners who will readily supply them with as much fuel as they can sell at wholesale prices. “Just how does Costco sell gas below the price of the refiners wholesale charges“, one or two of us might wonder, as we fill our tanks to the brim at a price a full $1 per gallon below competitors. “No matter, they must make it somehow, or they wouldn’t do it, right“?
That is the multibillion dollar question, why sell items at permanent losses, without interruption, without limit, just to maintain revenue growth and add new members? Is that a business model worth idolizing, admiring, replicating or most importantly, owning?
A great customer experience does not necessarily equate to a great investment.
Boston Market, in its relatively short storied life as a publicly traded company, represented one of those businesses that customers loved, absolutely loved. Who didn’t enjoy a full roasted chicken, carved up on your behalf, stacked alongside 3 full family side dishes, a one pound loaf of steaming cornbread, a quart of gravy, cutlery, condiments and several drinks of choice for the incredible low price of $7.99 US? The fact that Boston market lost money on each and every dinner wasn’t an issue, because shareholders willingly oversubscribed to an IPO to raise expansion capital on even more money losing locations. Customers lined up daily to get their chicken orders. Media buzz always reported on the long lines at each Boston Market and customers clamored for more stores to be opened, all to provide even more money losing chicken dinners.
Long after the fact, former executives disclosed that they wanted to build up a large store footprint and then raise prices. They were successful in growing to a chain of more than 1100 stores, but as soon as prices went up, store sales plummeted. Lacking a profitable business model, because selling items perpetually below cost is the opposite of a profitable business model, Boston Market went into chapter 11, and the IPO-to-bankruptcy became a footnote in certain financial texts. Costco is not really a Boston Market story, but it does share one feature of that former high flyer hype: people of all stripes, analysts included, equate foot traffic, crowded parking lots and jammed warehouses with a highly profitable venture. A business only becomes highly profitable when they sell their wares for more than the all-in cost of producing their output, traffic through any retailer doesn’t equate to profitability.
Costco has built up a sizeable investment following from those who subscribe to the writings of Peter Lynch: “invest in what you know“
My issue with undisciplined adherence to a Peter Lynch mantra is that it expects (but is seldom stated), of the investor, that they have some knowledge about the underlying business. Being a customer is not at all like being an owner, a customer experience is primarily transactional; if we feel great about a retailer, we generally do so because we believe we got a deal. How much, or how little profit that retailer earned; THAT doesn’t factor into to the customer experience. Employees at Costco are treated super well, they get a $1.50 hot lunch daily, are handed a total of 5 memberships per employee, they get to purchase discounted shares on a great matching program, employees only need to bust their humps a few times a year and given the per store staffing, for much of the year, staff have a pretty cushy gig by retail standards; their positive anecdotes are also not what makes for a great investment, it is a bias that arises from getting a good thing at the expense of underlying profitability. What makes for a great investment is a business model capable of generating an increasing profit margin and in possession of some defensible moat; if employees benefit on that ride, then good for them.
Most non-employee investors who subscribe to the “own what we know” is based on a customer-experience bias. Therein lies the problem with “invest in what you know”: If you don’t know how much or how little profit is being earned at a business and how/where that profit is earned, then you really don’t know much at all about a company.
At the end of the day, one number determined from going working through the Costco SEC 10K for 2022 glares at me like a sore thumb: $43.38
$43.38 represents the net, after tax, all in, profit earned by Costco per the “reported” 118,900,000 cardholders stated in the SEC filing for fiscal 2022. I use parentheses on the word reported, because Costco, inexplicably and never questioned by analysts, combines paid active memberships as well as expired memberships going back a full 364 days after they have lapsed, when determining their membership count.
As members in Costco, we shop regularly, some of us too much, and we buy a lot, or that’s what we are told. And after all that spending, those SEC filings, based upon the Comprehensive profit figure for 2022 ($5.158 billion, not the $5.844 billion thrown about by various media that excludes forex) can only come up with a per cardholder profit figure of $43.38?
In 2021, each Costco cardholder generated a profit of $46.29, all in, for Costco. The decline in per cardholder profit over one year has been 11.4%.
Going back to 2020, the net profitability per cardholder was $39.42.
For fiscal 2022, the gross sales per cardholder was $1873. Costco sold, to each cardholder in their system, $1,873 worth of goods and services and earned just $43.38 on those sales. That is a 2.3% net profit margin per cardholder.
In fiscal 2021, the gross sales per cardholder was $1,689. The net profit generated ($46.29/$1,689) of goods and services = 2.74% per cardholder.
In fiscal 2020, the gross sales per cardholder was $1,580. The net profit generated ($39.42/$1,580) of goods and services = 2.5% per cardholder.
In fiscal 2019, the gross sales per cardholder was $1,516. The net profit generated ($34.75/$1,516) of goods and services = 2.3% per cardholder.
The 2023 fiscal year data looks very disappointing thus far.
Analytical average forecasts for 2023 are modelling on gross calendar sales of $245 billion. Net profit forecasts remain clustered around the $6.1 billion mark, which seems absurdly high given the most recent two fiscal quarters, current trends in non-food retail and the sales flatline from international operations. Analysts also expect that Costco could exit the fiscal year with 125 million cardholders. This would result in revenue per cardholder of $1,960 and a gross profit to be generated of about 2.4%.
If, on the other hand, my own estimate of flat earnings vs 2022 comes to pass, then the net profit of $41.26 per cardholder would result in a net profit generated by each cardholder of just 2.1%, the lowest earn per cardholder since 2000.
“Harumph” Costco disciples will protest. “It is a recession! We’ve gone through a pandemic! I’ve owned it for decades and made lots of profit! It remains a core holding of Charlie Munger at Berkshire Hathaway, and he is certainly smarter than you! This is still the best company out there, much beloved by all. Just who do you think you are? (because at some point, confronting a long held belief usually devolves down to catcalling and threats of SEC involvement). Just what out there is better?”
Well, as a point of fact, I, as well as mirror accounts, own shares of BJ’s Wholesale as well as Costco. Costco and BJ’s operate under different fiscal years (Costco typically ends in August, BJ’s in January) In the last fiscal year ended January 29th, 2022, BJ’s reported revenues of $2,564 per cardholder. The net profit generated per BJ’s cardholder (6.3 million) for the trailing fiscal year was $67.71, a full 46.2% higher than Costco’s per cardholder contribution, at its best fiscal year over the past five years. The net profit margin on sales equaled 2.64%, earned on sales just 7.3% that of Costco. Accretion should, more likely than not, continue to grow and power up that net profit margin over time.
On an apples to apples basis, last years per cardholder comparison indicated that the typical BJ’s customer spent almost 37% more at the store than did the average Costco customer. For the first three fiscal quarters of 2022, BJ’s is growing their revenue and profit contributions per member even faster. Revenue per cardholder, for the soon to be ended fiscal year, are running on target to reach $2,925 per card. Again, on an apples to apples basis, with Costco members in this year forecast to spend about $1,960 per cardholder vs $2,925 at BJ’s, the spending differential between warehouses grows to almost 49.2%, or $965 per cardholder. So let’s pop the “Costco customers spend more at their stores than any other retailer” balloon that is continually floated by investment media, because it is a bogus story.
Let us also bust the “Costco is the best run retailer out there” bubble.
Costco worldwide has roughly 306,000 full time employees at a total of 838 stores, 365 full time employees per warehouse. Each employee supports gross sales of $741,830 and gross profit of $75,667 per employee on a four quarter basis. BJ’s operates its 234 warehouses with an average of 150 full time employees per location, almost 65% leaner due to an emphasis upon automation, self-service and the elimination of value added services that are loss centers. While each BJ’s employee supports lower gross sales ($575,221) than a Costco employee, the more profitable mix of products sold generates a per employee profit of $98,362, almost 30% more profit per staff member than earned by Costco.
BJ’s devotes almost 2x the retail space in its warehouse vs Costco for selling groceries, perishables and sundries. BJ’s accepts manufacturers coupons, so a trip to BJ’s has every potential to become become the weekly shop by those requiring food. Finally, like Sam’s Club, BJ’s not only sells premium brands, but also “value” brands to compete against bargain retailers trying to capture the lower end of the consumer market. Importantly, BJ’s relies upon offshore suppliers for less than 4% of its SKU: foreign supply chain interruptions are not a thing for BJ’s. BJ’s operates its gas courts as a profit center and uses discounts advantageously (this weekend, fill up with gas and receive an additional in-store credit to be used at the warehouse by close of business Sunday). The BJ’s gas marketing model differs from the Costco “permanent, no strings attached, don’t even bother to hit the warehouse for a shopping trip” loss leader model on retailing fuel.
Costco generated 13.5X more revenue for the most recent fiscal year than did BJ’s Wholesale. So, why does Costco earn a lower gross profit margin, a lower net profit margin and report a lower spend per cardholder than BJ’s? Is that demonstrative of “the best retailer out there”? Are Costco customers really the most free spending demographic possible? The math doesn’t even remotely add up to support that assumption. Removing one’s “Buffett Blinders“, it would seem that Costco is not only not the greatest, it is actually, not great at all.
The issues at Costco are structural, both top down and bottom up. As to top down, management won’t change their loss leader policies, which sap profit margins. Management continues to bloat the payroll with too many staff per warehouse, which saps profit margins. Management is not capturing the retail spend in groceries, which are the only current beneficiary of an inflationary/recessionary cycle. Too many high end goods sitting unsold in a warehouse and not enough floor space devoted for well priced groceries and perishables saps profit margins.
As for bottom-up, Costco does not carry deep-value brands in bulk formats. Since going public, Costco has steadfastly refused to cultivate the lower end of the retail grocery market. The demographic are upper middle class (and beyond) customers with the Kirkland brand name designed to compete against the better quality private label brands sold at competing grocers and warehouse stores. The handful of brand SKUS in each assigned grocery and sundry category are the most well know retail names, cherry picked from a small selection of national food producers. What is conspicuously absent at any Costco warehouse are the “deep-value” categories, items that we all know to be subpar in quality with lesser ingredients and priced accordingly to meet a budget or a specific purpose. The Costco tire centers do not carry Chinese or Korean starter tires that sell for 1/5 the price of a Michelin, nor does it carry a 20 pound bag of no-name breakfast flakes used to feed an entire home based day care facility for a week. That corporate unwillingness to stock value brands is precisely what prevents Costco from having any chance of effectively competing against Wal-Mart grocery, against BJ’s, against Smart & Final, against any of the large national to larger regional grocers and retailers in a market that is seeking deep value offerings. Consumers, globally, are trading down in quality while they wait for their earnings to catch up with the cost of goods and services. Costco does not sell deep value, they sell mid to upper quality names at what was previously thought to be fair value, but is, increasingly, overpriced and undersold. In other words, Costco doesn’t have the right product mix for this market; others do and they are taking market share from Costco.
When all is said and done, Costco has muddled along for multiple years, generating a roughly 10.2% gross margin on sales, with greatly overstaffed warehouses, “permaloss” leaders eating up more and more profit each and every quarter, a retail gas pricing policy that approaches clinical insanity, a complete absence of deep value food and sundries brands to capitalize on a global market trading down in quality, a consumer market that is cutting back on discretionary items and that is spending a greater percentage of household income on food.
Undeserving of its hype as a genius on retail and consumer behavior, Costco perpetually seems woefully taken aback by trends, acting reflexively, when at all, rather than looking ahead. The company doesn’t get better, it just gets larger, and, inexplicably, becomes less efficient with each passing year.
BJ’s in sharp contrast, generated a 16.9% gross margin in their worst comp quarter of the fiscal year and has the right mix of national and local food brands to compete head to head with grocers in each region they operate. BJ’s gets the weekly local food shop, BJ’s gave away frozen turkeys during Thanksgiving with a certain minimum purchase (can you even find a frozen turkey at any Costco in the United States?), BJ’s accept food stamps; all of the little as well as the big things are being executed, to ensure that BJ’s dominant retail presence on the east coastal region of the United States can roll out seamlessly to many other markets in America.
Net profit margins matter. Operating margins matter. The retail mix matters.
Consumer retailing is a grubby, cost conscious business and when a retailer drops the ball, for an extended period of time and profits suffer accordingly, it should be monitored. When a superior investment presents itself, then there isn’t any shame is closing the books on one investment to surf what looks to be a superior wave on the secular trend.
$43.38 of net profit per cardholder in 2022; that is what Costco made per cardholder during 2022, on the cardholder retail spend of $1,873. That number doesn’t even earn what is supposedly levied for membership fees. In my view, the 2022 sum is unlikely to be replicated for 2023. This is just an awful return on capital, an abysmal result for a retailer that should be absolutely running the table in a food price inflation environment. The lack of profit growth indicates that they are not, and this is due, in my belief, to an astounding lack of quality in management.
An employee owned retailer, Publix, out of Lakeland Florida, with roughly 1/4 the total sales of Costco and determined to be just the 15th largest pure grocer in America, may potentially earn as much at Costco in 2023, that’s how well a grocer should be doing in this market.
Costco needs a shakeup, maybe even an activist investor to force change, but a shakeup is not in the cards and until those at the top make the tough decisions, such as to reprice loss leaders, run fuel courts rationally and be more nimble with their SKUs (for gosh sakes, they operate cement floor warehouses, how difficult is is to remove pallets of high end electronics and replace them with more pallets of food during an economic tightening?), Costco is squandering chances. It is not a dominant force in grocery, Costco holds just a 6% market share in the United States, and margins on grocery have always exceeded any other department in a Costco warehouse. Everyone, even the wealthy, are trading down and Costco doesn’t offer a down market category of food brands to capture or maintain that shopper.
Some analysts are now writing off 2023 as a turnaround year for Costco, floating the notion that the warehouse retailer will recapture market share from grocers.
The premise is stupid, the theory is flawed. Street analysts, too long hung up on Costco as an investment to be owned “no matter what” have recently posited that Costco will outspend grocers in 2023 and capture, or steal via pricing, market share from grocers. Misdirected hope, when it ignores the math and belittles the strengths of competitors, then hope ceases to be analysis and turns to nothing more than self-interested cheerleading.
The misdirection begins by ignoring the fact that most grocers earn about 2.5X to 2.8X the gross profit margin of Costco and as a sector, can collectively outspend, outgrow and out price Costco on every product, in every SKU, in every region of the United States.; that is what high profit margins and actual efficiencies permit. If you produce a 70% higher profit margin than Costco in New York State or Florida, where BJ’s is dominant, Costco can only drop its food prices by a couple of percent in those markets before they actually lose real money. BJ’s can outcompete against Costco in Florida, in New York, in most of the US states where they have greater market share. If you are Publix, a private grocery giant operating in 7 US states, reporting a 28% operating margin, vs Costco at just over 10%, who can outprice whom? It is MUCH more likely that the grocers, benefitting from the inflation tailwinds, will be far more aggressive AGAINST Costco than Costco will compete against them, in 2023. Lacking deep value brands across the entire category list at Costco, it is only hype to boast of Costco’s ability to wrest market share from grocers in any market, unless Costco chooses to lose even more profit margin and further hurt the bottom line.
The second misdirection lies in the capital plans of Costco vs other grocers and food retailers. Costco’s 2023 capital plan is to spend $3.8 billion dollars, of which less than half will be destined for spending in the United States. Let’s split the difference and assume $1.9 billion for domestic capital spending. Publix, just one regional competitor, with one quarter the sales, will be spending more than $2 billion in their stronghold for 2023, outspending all of Costco USA. Add in just one or two more regional grocers to the capex plan, and the result is that Costco in 2023 will be seriously outspent by a far more profitable sector. If Costco chooses to go toe-to-toe in a price war, Costco will lose the only decent profit center left in the warehouse, and profits will compress as a result. So, if they cannot outspend the competition, and they cannot out-earn the competition, what remains?
It is far more likely that Costco will continue to lose grocery market share in 2023 against the competition than gain share; their nationally branded grocery SKU and private label house brand is overpriced against other grocers already. When you are the high cost seller, you are the marginal vendor. Costco, increasingly, is that high cost vendor; they cannot engage in a grocery war, they cannot outspend other grocers without leveraging the balance sheet and the grocers, as a sector, are formulating capital plans for 2023 to grow their own market share. Costco is NOT a dominant force in grocery worldwide and with their profit margins so small, they may never be. Analysts, caught completely off-guard by persistent food inflation, are trying to position Costco as a winner in a grocery war, when the simple math suggests that they are a serious underdog. The high cost producer with the lowest profit margins can never win a price war and it has been proven historically disastrous to even attempt it.
2022 was mind-numbingly maddening as a long time Costco shareholder.
The most recent quarterly result indicates a struggle to increase profitability. Gross merchandise margins fell by .5% vs the prior year’s fiscal quarter. Earnings rose just 3% on an 8.1% overall increase in revenues. Notable is the point that gross membership revenue, totaling $1 billion in the quarter ended, is presently annualizing below the 2022 fiscal revenue figure of $4.22 billion. None of this is good enough to support a 34X multiple, not by a long shot.
Inflation placed a “retail windfall” football on the 1 yard line, directly in the line of sight of Costco merchandising executives. To make things even easier, inflation whipped up an extremely sharp tailwind and made sure that there was absolutely no opposing defense to stop the warehouse chain from having their best year ever. All anyone at Costco had to do was pick up the bloody ball and walk for a single yard to score a touchdown, the end zone was groceries. Instead, Costco executives stumbled in the opposite direction, away from the ball, and fobbed off analysts in the last conference call with the phrase: “we stocked up on candy”, a misdirection designed to bamboozle analysts into thinking that one, somehow, could sell $260 billion of Belgian chocolates over a fiscal year and that chocolate, not turkeys, are what consumers need to fill their pantries in 2022-2023.
In the last fiscal quarter, I cautioned that Costco had run out its margin of error, with just 15/100th of a percentage point of operating margin representing the difference between whether Costco would show any profit growth at all in 2023 vs 2022, even with an almost 10% increase in sales. That has proved to be an accurate assessment.
The business model was great, once. Upon surveying the competition and the competitive landscape, that statement is no longer definitive; Costco is just ponderous. So, without further adieu, I am done monitoring a highly uninspiring business that is supported by media cheerleaders and shareholders who will not acknowledge that their love for loss leaders is badly impairing both corporate investment performance and investor judgement. This economic environment should represent a massive tailwind for Costco, maybe the best ownership case ever, and they have botched it, utterly botched it.
Index funds and exchange traded funds are forced to maintain a holding with a market cap as significant as Costco, analysts are highly reluctant to downgrade any index stock.
As a result, too many passive funds have a serious overweighting in corporate deadwood. I am not a passive investor. I will not maintain an entitled nephew on the payroll simply for the sake of familial cohesion or from hope, typically against hope, that a work ethic will spring forth from indolence. Nor will I hold an investment that has outlived its usefulness to the long term objectives of the account.
The Gnostic Portfolio has, prior to the close of the market today, sold off the entire position in Costco Wholesale Corporation. Costco might be good enough for some, but I currently own better, have written about better and I don’t need to have my results dragged down with the ordinary. I, and others, have made out like bandits on Costco for far more than a decade; I am getting off the ride. Until the loss leaders are dealt with, at the very least, I won’t need revisit the Costco thesis.
Most importantly, I can stop bypassing the concession court and may purchase, not just 1, but 2 hot dog combos when the mood strikes me.
$43.38 divided by 52 weeks equals an average customer profit of $.83 US per week, assuming a weekly shop, that’s how barely profitable Costco customers are to the corporation based upon the cost structure. So, for almost two years, I have refused to buy the combo, so as to do my part and preserve some shareholder profits. A purchase of just one hot dog combo eliminates the weekly profit per cardholder to Costco, that’s how slim the margins are.
My days of stoicism at the food court are now at an end; if crazed Costco executives intend to lose billions of shareholder profits annually on loss leaders, all so that an employee perk remains in force, I will now gladly take them up on their offer.