A Slight Detour: That Pesky Little Company called Amazon
No conversation about the retail industry is complete without a mention of the elephant in the room that is Amazon. The more I analyze Costco’s business model, the more and more it starts to look like the prototype that Jeff Bezos followed in developing Amazon Prime.
Both companies have a very dedicated focus on growing their membership base while essentially breaking even on selling merchandise and in the case of Amazon- potentially even losing money on selling merchandise in the short term. It’s estimated that Amazon has somewhere around ~60 million Prime members growing at double digits (not too far off from Costco’s ~48 million paying members) – although Amazon has managed to build up this base in only ~10 years versus ~40 years for Costco.
Both are focused on diversifying their offerings and services to make their value proposition more compelling and their memberships stickier (and thereby increase switching costs) to ultimately drive greater willingness to pay for a membership. As previously mentioned, Costco has added travel, optical, gasoline, etc. over the years. Similarly, Amazon Prime started with free two day shipping and over the years, added additional services like Prime Music, Prime Video (unlimited streaming of movies and TV), cloud storage for photos, access to the Kindle Library, etc. Every additional benefit added to the membership, makes it slightly more compelling and stickier when members adopt some of those services. The key to creating stickiness is adoption of new services– which is why Amazon often goes extra lengths to remind Prime members of their existing and new benefits – not to mention Prime Day (a special sale day for Prime members).
- Once all of your pictures are loaded to Amazon’s cloud, the hassle tax of switching to another service goes way up and you are much less likely to cancel Amazon Prime. And the incremental costs to Amazon of providing this benefit are minimal given all of the sever capacity that the company maintains for its Amazon Web Services business. I wouldn’t be surprised if Amazon and Costco both had employees dedicated to sitting around all day and coming up with new benefits that they can add for their respective members.
Similar to Costco, Amazon Prime also benefits from latent pricing power due to strong loyalty. Amazon raised prices by ~25% in 2014 (from $79 to $99) and members still grew (we believe significantly but Amazon doesn’t report Prime membership counts).
Amazon has been incredibly successful when it comes to ecommerce retailing. There are a lot of metrics out there but Amazon is estimated to represent somewhere between 30% and 40% of all online commerce. Amazon’s ambitions are grand so I wouldn’t be surprised if they have Costco in their sights. But both Amazon Prime and Costco have managed to grow their membership base significantly over the last several years. In fact, we wouldn’t be surprised if there is a high degree of overlap with households that maintain both an Amazon Prime membership and Costco membership. This poses a few important questions as we think about the future of Costco’s business:
Is Costco un-Amazonable?
- In other words, is Costco competitively insulated from Amazon or Amazon proof? After all, Costco has managed impressive growth despite the rapid growth and increasing encroachment from Amazon. I think that both Costco and Amazon would say no – Costco is not un-Amazonable. In fact, Costco CEO Craig Jelinek recently addressed this directly on their Q4 2016 earnings call.
- “ I read the reports that some of you have written about that we and maybe one or two other retailers out there that are unique are Amazon proof or Internet proof. We don’t buy that for a minute. We do believe that we do rely and we do expect we are going to be impacted. We also don’t believe we have to go crazy on the other side, but we want both. But our value proposition is best served for us when it’s in-store getting members to come in and buy when they can see everything there that we have."
- It becomes abundantly clear to even the casual observer, that the two companies will increasingly find each other in their respective cross-hairs over the coming years as they seek to grow their footprint in retail. While many households today maintain both an Amazon Prime membership and a Costco membership, will this continue to be the case five or ten years from now? The answer will largely be predicated on Costco’s ability to continue to provide value to its members in ways that they desire and ways that are differentiated from Amazon. There is an argument to be made that people/consumers will still want to go into stores to shop and discover. Also, perishable food remains Amazon’s Achilles’ heal. They have cautiously expanded AmazonFresh to just a handful of markets over the years and recently announced brick and mortar convenience/grocery stores but they haven’t quite perfected the model or the economics. After all, grocery isn’t a very profitable business. My hunch is that Amazon has no interest in making its money on the groceries – they want to make their money from the AmazonFresh memberships and potentially make the Amazon Prime membership even stickier.
- Part of Costco’s defense will rely on its ability to extend the Costco value proposition to e-commerce- something they’ve struggled with in the past. While an improvement from their previous iterations, even the recently revamped website suffers from an imperfect layout and lacks the speed of delivery/convenience that Amazon can provide across many of its items. Costco could look to expand its membership tiers further to provide a level with free shipping of all its items, but the economics could be tough to justify in the short term.
Can Costco’s strong growth continue even though family formation is happening later with younger generational cohorts like Millenials?
- Costco’s growth may slow as family formation is delayed. The value proposition of a Costco membership is much more compelling for families and far less compelling for single person households that are buying less quantity or living in denser urban areas without easy access to a store. As Costco has done in the past to attract new consumers, it may need to find a way to extend the value proposition to a younger consumer – e-commerce and a different assortment come to mind. Today, an Amazon Prime membership makes far more sense for a young, urban consumer.
Does the addition of services like Google Shopping Express and Instacart defend Costco against the Amazon Prime threat?
- Google Shopping Express and Instacart (and some others that Costco now partners with) are third-party solutions to get goods delivered from Costco. They are good interim solutions to compete with Amazon Prime, but ultimately Costco needs to control its own destiny when it comes to e-commerce. They can’t be dependent on incomplete solutions (everything can’t be delivered) from third parties that add significant additional cost to the membership. Delivery/free shipping needs to be part of the value proposition of membership. This benefit may cost more than a standard membership and may be a loss generator in the early years, but there is likely a willingness to pay for some portion of the customer base.
Do online retailers like Boxed that combine some of the benefits of Costco with the benefits of Amazon pose a threat to Costco?
- Today, Boxed seems too small to pose a serious threat to Costco, but the model seems directly targeted at taking share from the warehouse clubs. They provide free delivery on orders over $50, charge no membership fees and as their slogan implies, they seek to solve one of the main consumer gripes with the warehouse clubs: “Don’t waste your weekends stuck at the warehouse club.” In fact, Boxed looks like it could be an acquisition target by one of the clubs looking to build out a better e-commerce presence (similar to how Wal-Mart recently acquired Jet.com)
Investment Merits and Considerations
I’ve mostly covered what I really like about Costco, but I always like to do a rehash of the merits of the business/investment and also the risks to my thesis. Laying it out this way forces me to confront my thought process in a very rational way divorced from confirmation bias.
Strong internal fit with a focus on continuously increasing the switching costs of memberships (sticky memberships)
- Costco’s self-reinforcing business model provides it with a very defensible moat. Every element of Costco’s business model is aimed at one thing – increasing and improving the value proposition of a membership. This is a done through both improving prices on existing products and services and providing new products and services at great prices. This ultimately makes switching costs higher and the membership stickier.
Membership business model
- While Costco is a retailer operating in the retail industry, its business model is structured very differently than most other retailers. As previously discussed, retail is a low return industry where success is elusive. Costco makes money from selling products but the majority of its profits are derived from annual membership fees that its members pay for the privilege to shop at Costco. We like membership fees because they don’t have a cost of goods associated with them. They drop straight to the bottom line.
Fervent Loyalty of its Membership Base provides a reliable revenue stream
- Not only do Costco’s members pay a membership fee to shop there, but they do so with consistency year over year. One of the primary investment merits of Costco is its fervently loyal customer base that views Costco as a way of life and derives an immense amount of value from their membership. It’s rare that a company in any industry renews ~90% of its customers or members from year to year and especially in the case of Costco where customers are not contractually obligated and have relatively low financial switching costs. This is a testament to the incredible brand love for Costco and the compelling value proposition that Costco provides to its members.
- On the surface, this seems like a very superficial competitive advantage, but the loyalty of the membership base provides a recurring and reliable revenue stream making the company less susceptible to recessions and volatile retail sales as was evidenced by resilient membership revenue in 2009. Putting my Warren Buffett hat on, high membership renewal rates make the stock of Costco more like a bond with a predictable earnings stream stemming from membership fees.
Strong management team focused on the long term
- The management team of Costco is adept at retail and has a long-term orientation. Key elements of Costco’s operating strategy make it clear that they aren’t interested in juicing earnings to hit a given number in a given quarter– sustainable new store builds, restrained membership price increases, consumer oriented shopping, liberal return policies and a hot dog/soda combo that has been priced at $1.50 for over 30 years.
- The management team has a clear understanding of the retail business and what its members want and has historically delivered. They aren’t your typical ivory tower elites but rather folks that have been in the retail trenches and uniquely understand their business. Current CEO, Craig Jelinek started his career at FedMart, working as a box boy in Lancaster, Calif., during high school and joined Costco in 1983. Jelinek and Costco management is relentless about costs and frugal to a fault so they can provide their products at the best possible prices to their members. The trait of frugality is indoctrinated into the Company’s culture from the top-down.
- Having Charley Munger on the board of directors doesn’t hurt either.
- Costco treats its employees well and definitely better than any other company in the retail industry. They pay the highest wages in the retail industry and promote from within. Many warehouse managers started out as cart pushers. They generally have good working hours- stores usually open at 10am and close by 6pm or 7pm and are still closed on holidays. And the numbers prove it - the attrition rate is 5 percent among employees who have been there over a year – this is unheard of in retail. Happy employees make for productive and loyal workers. I refer you to the quote by Peter Lynch at the top of this post.
International business has a lot of potential
- International warehouses represent ~30% of the store count but generate 39% of the operating profit so they contribute more than their fair share. Despite being a smaller part of the footprint and a general inability of retail concepts to translate across borders, Costco’s warehouses in international markets have been very productive at driving memberships and sales. While most companies generate losses and move too quickly when they expand abroad, Costco has approached it in a very measured way that has likely enabled greater success.
Investment Considerations/Risks to the Thesis
Costco’s undefined e-commerce strategy amidst a consumer shift to e-commerce
- If Black Friday sales over the last few years are any indication, consumers are shifting their spending online in a big way. E-commerce is easier and more convenient for consumers and Amazon has been a big driver of this secular shift. Yes, to be clear, it is secular – consumers are permanently changing their shopping behavior to online channels. Does this mean that consumers won’t go into physical stores anymore? No, it will be a long time before that happens so Costco still has some runway. How much runway is the question that is difficult to answer? Nevertheless, the majority of growth in retail will be driven by e-commerce and retailers that don’t adapt will be left behind. I give Costco a C in this department of adapting to e-commerce. Only 4% of sales are currently derived from from e-commerce. I understand why they have lagged- when you’re so good at doing one thing (operating physical stores), it becomes difficult to shift that thinking to something that is viewed as siting outside of the circle of competence. The same strong internal fit that benefits its store based business model in some ways is a detriment to its e-commerce ambitions. Simply having a website with merchandise for sale and partnering with third parties (Google Shopping, InstaCart, Dolly) isn’t enough in a rapidly shifting retail landscape. Ecommerce needs to be deeply integrated into the business model. It seems like they are starting to get the hint as they expand their merchandise selection on e-commerce, improve the UX and improve upon the logistics to speed up delivery times. Nevertheless, e-commerce is a long-term risk and existential threat to Costco and one that I’m sure keeps the guys in Issaquah (Costco HQ) up at night.
- Just in case you haven’t heard the A word enough already, it’s worth mentioning once more here. We don’t often talk about just one competitor when it comes to reviewing risks. In the case of retail though, we would be remiss if we didn’t mention the elephant in the room head on. Amazon and Amazon Prime pose a definite and foreseeable threat to Costco’s business model in the long term. Even if Costco evolves its e-commerce strategy, you can bet that Amazon will continue to be a thorn in Costco’s side seeking to siphon off as much consumer spend as possible.
Long-term demographic changes in the US
- The younger generation cohorts (Millenials/Generation Z) are having families later, having smaller families and more likely to live in urban centers with less space. The value proposition of Costco is not as compelling for these smaller families with less space that may not want to purchase in bulk quantity or have the storage space to do so.
Store capacity/congestion limits store productivity growth
- Anyone that has gone to a Costco warehouse on the weekend thrills in the free samples but also dreads the congestion at every turn of the shopping cart. Costco attracts shoppers in droves on the weekends and certain peak times during the weekdays but the crowds inevitably result in revenue left on the table as the crowds discourage shoppers. This limits the productivity of stores if they are super congested during peak times and not as active during off-peak times. As many of Costco’s warehouses mature, they have significantly increased their sales over the years, but the sales productivity of these stores will plateau as the store size limits the capacity and sales. Costco may need to invest to either relocate or expand these stores to accommodate increasing demand or better manage capacity utilization. This could require capital, which may depress returns.
- Costco’s profits are derived primarily from membership fees. Their ability to maintain strong member loyalty rates or increase membership rates over the longer term may be hampered by encroachment of other memberships and subscription type services. As services like Amazon Prime and other membership services proliferate, consumers may be forced to revisit their memberships and prune where necessary to save costs where they aren’t getting incremental value. For example, why do I need a Spotify subscription if Amazon can provide me with the music I already listen to as part of my Amazon Prime membership. Or do I need a Costco membership if Boxed can provide me with what I need. It’s difficult to assess the severity of this threat but Costco is an annual/monthly expense and its value will ultimately be judged by consumers versus their other alternatives. Costco could become a casualty if it doesn’t continue to deliver the differentiated value proposition that it historically has. We haven’t seen any evidence of this yet in the renewal rates but it’s worth acknowledging the risk to remain vigilant for signs of it.
Growth will continue to be capital intensive if the current playbook is followed
- The majority of Costco’s growth has come from building new stores in new markets or adjacent markets. Building new stores requires significant capital. I can’t say exactly how much because I can’t find specific numbers around it but I estimate that a new Costco store build costs anywhere from $50mm to $80mm depending on the market and the size of the store.
Retail brands have historically been unable to stand the test of time
- If Sears and K-mart are any clue, retail is a tough business. Even when you are on top for a long time, you can just as soon be forgotten. Wal-Mart is the biggest retailer today but I’m already starting to see the signs of stagnation and playing catch up with their business. Can Costco beat the odds? Hard to say for sure but it is a definite that new retail models will inevitably disrupt existing ones. How much is the question and how quick can Costco adapt to changing consumers and preferences.
Catalysts for Growth
As I have spent time analyzing Costco’s business in depth, the key strategies that will drive Costco’s growth and earnings into the future have become clearer. A few of these build on the existing playbook that management has used for the last several years and a few of these can further accelerate that growth (new playbook). I don’t usually include a section like this in my write-ups but in the case of Costco, I thought it could be an interesting exercise.
Opening up more stores in the US and International markets (Existing Playbook)
- With several hundred stores in the US, Costco seems pretty saturated on the mainland. But I think management would contend that there is still plenty of opportunity. More of the opportunity though seems to lie with international markets where Costco still has a nascent presence. Costco has been very measured about its international growth to make sure it is getting the formula right and not over-expanding. I am ok with measured growth. However, at a macro level, earnings growth driven by building more stores is growth that requires capital investment and I much rather prefer growth that doesn’t require significant capital investment.
Capturing a greater portion of HH spend by adding more categories and more verticals; Can they move up-market to higher ticket items or items that currently provide a poor customer experience? (Existing Playbook)
- Costco has been doing this for years – adding gas stations, optical, photo centers, insurance, etc. The playbook is to 1) make the membership stickier; 2) generate some additional operating margin (albeit slim) on the additional items sold. As a trusted retailer, Costco has tremendous opportunity to basically sell anything to its members and we have seen them do this – occasionally selling cars and other items. Costco has the ability to become a one-stop shop for anything consumers want to buy. Auto maintenance (outside of just tires) and healthcare are just two categories that are ripe to provide a more transparent consumer experience. Furthermore, there is the opportunity to add categories that could more specifically attract a younger demographic.
Raise membership prices- historically, they have done this every ~6 years (Existing Playbook)
- Costco last raised prices in 2012 so they are due for a price increase in the next ~1 year or so. Costco does demonstrate that rare thing that Charley Munger loves: “untapped pricing power” so they do have the power to raise prices but this power is partly mitigated by the fact that it is a retailer with significant competition – club and otherwise. Costco demonstrates some modicum of pricing power versus these club peers by way of a $5 membership price premium so the ability to raise prices indefinitely or significantly is held in check. However, a $5 membership price increase could contribute something like ~$215mm in additional revenue (=48mm members x $5 x ~90% renewal rate) that drops straight to the bottom line.
Better capacity utilization of over-crowded stores (New Playbook)
- Go to a Costco store on the weekend and it is jam-packed. So packed in fact that it dissuades consumers from shopping there, shopping as much as they might or leads to a degraded shopping experience. Costco needs to figure out a way to smooth out this demand a bit to maximize revenue. There are a lot of ways to achieve this: Open the stores earlier, provide benefits for shopping at off-hours on weekdays, better delivery options, etc.
Drive more e-commerce spend- both directly and through partnerships like Google Shopping and Instacart // Free shipping membership tier (a la Amazon Prime) (New Playbook)
- As discussed, younger consumers are becoming accustomed to the ease and convenience of shopping online. Costco needs to serve this target market with an offering of its own and it doesn’t have to be free. They can monetize this service with a new tier of membership and it seems like there is a willingness to pay.
Better target younger demographic (New Playbook)
- Related somewhat to the previous two points but if Costco does believe that its value proposition is best delivered in-store, is there some opportunity to provide this to a younger consumer who may not want to visit a warehouse in the suburbs. Target (TGT) is approaching this through smaller format stores but there may be other ways to skin the cat.
The Really Really
Net net, Costco is a wonderful business- as wonderful as they come. It is a diamond in the rough that is retail. Costco is a disciplined operator that is intensely focused on providing its members with a compelling value proposition on whatever they buy. Every facet of its business model is tightly integrated and self-reinforcing to serve this broader mission. Members have returned the favor with their fervent loyalty over the years. The business model of memberships and loyal memberships to boot provides some inherent level of predictability and insulation from economic cycles and provides Costco with a defensible moat.
As with all companies that I analyze I like to run it through my most basic filter and see if it checks the boxes on my 3 most important questions for investment analysis:
1) Is it a good company that benefits from a competitive advantage? For all the reasons above, unequivocally-Yes. Check.
2) Is what makes the company good sustainable or durable for the long term? This is where it gets more difficult for me and I should say very difficult. High membership renewal rates and the mobs of people in the stores should have me believe that Costco is here to stay forever. But I can’t say with 100% confidence that what Costco benefits from today is sustainable for the very long term. Retail is notorious for lacking competitive advantage. Costco’s key competitive advantage is its loyal members and their willingness to pay for their memberships. I think they are fine for the near and intermediate term- ~5-7 years. But I am looking for businesses that will be around 20 years from now. The model of retail is going to evolve considerably and look meaningfully different in even 10 years, not to mention 20 years. As we have articulated, Amazon will make sure of this. And it’s possible that Costco’s strategy of building up its store footprint may no longer be relevant even 10 years from now. Unless they are able to shift their strategy and maybe find a way to leverage this real estate in additional ways – perhaps as fulfillment or distribution centers for e-commerce. This sustainability or durability is actually the part that keeps me up at night about Costco. I do have some faith that consumers will want to continue to shop in stores in the future because shopping can be entertainment as much as errand but the nature and assortment may have to change to accommodate this. Ultimately, as with many businesses, I put some faith in management’s ability to successfully execute as they have historically done. I think Costco will continue to find ways to do this even if the landscape changes meaningfully. They have continued to drive membership growth using clever tactics like fuel stations and I think they should be able to continue to do this even as the landscape changes. So Check #2.
3) Is it reasonably priced? This is where I can say with conviction that Costco is overpriced relative to intrinsic value at its current price. I couldn’t look myself in the mirror and call myself a value investor if I bought the stock of Costco at current prices. Costco has definitely outperformed its retail peer set and generated strong comps as of late. This combined with their more stable and reliable membership fees justify a price premium relative to other retailers. However, that premium is too high right now at a share price of ~$175. My DCF yields a fair value estimate of $115-$130 and I would be willing to pay at the high end of this. I should note that my forecast reflects new store and member growth that is more or less in line with their historical performance. If Costco can consistently outperform on these metrics (as they did with Jan comp sales), then a higher valuation could be justified. Inevitably as with happens with many businesses, Costco will underperform on comps for a quarter or two relative to the forecasts of the “smart” prognosticators on Wall Street and a buying opportunity will present itself. I love Costco but we can’t be blinded by love. I’ll just remain a Costco member for now; the current stock price doesn’t provide the compelling value proposition that a membership does. I’ll keep it on the shopping list until it does.
Disclosure: This thesis has been researched and written using publicly available information. As of this writing, I don’t own any shares of Costco. This could change at any time.
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