Costco Wholesale

A different kind of retailer

When you think of the world's biggest retailers, you'll probably first think of Walmart and Amazon. Walmart, by far the company with the highest revenue in the world, is the clear number 1 in the industry - with over 2.2 million employees and almost twice Amazon's revenue. That Jeff Bezos's former online bookstore is now the ruler of e-commerce has long been no secret either. But for dividend investors in particular, looking beyond the obvious can be especially worthwhile.

The Costco Wholesale Corporation ranks 3rd on the list and impresses with a completely different business model than Walmart and Amazon. The retailer, headquartered in Issaquah (near Seattle), currently operates "only" 795 stores and, on top of that, forgoes profit margins on the sale of its products. How the company still manages to grow constantly while keeping its customers, employees and of course its investors happy - more on that in today's article ...

The origins and business model of Costco Wholesale Corp.

The origins of today's Costco Wholesale Corp. go back to Sol Price. He was born in New York City on January 23, 1916. His parents Samuel and Bella Price were Jewish immigrants from Belarus. In the early 1920s the family moved to San Diego on America's West Coast. There Sol graduated from high school in 1931 before earning his degree in philosophy and law at the University of Southern California. Afterwards he worked at a law firm in San Diego until he inherited a vacant aircraft hangar in the early 1950s. One day he visited clients in Los Angeles who ran a wholesale jewelry business and supplied their jewelry and watches to a retailer called Fedco. When Sol took a closer look at Fedco, he realized that his hangar would also be suitable for a business like that and pitched his idea to his clients. They were immediately excited, and planning began right away. Sol raised the 50,000 dollars in startup capital and opened his first FedMart in 1954.

Although the product range of jewelry, furniture and liquor wasn't really extensive at first, the business flourished, and Sol managed to bring in 4.5 million dollars in the very first year. From the start he relied on memberships, which he offered to government employees. Members paid a small fee of $2 to be allowed to shop at his FedMart. In return, Sol gave up most of the profit margin on his products. This concept worked so well that FedMart gradually grew into a widespread store chain. Over time Sol expanded the product range and did pioneering work in many areas of retail. In 1975 the company was bought by German entrepreneur Hugo Mann, and Sol was fired shortly afterwards. Of course he didn't just accept this, and as a result he founded the company Price Club together with his son Robert and a few other business partners. Here too he followed his recipe for success, charged an annual membership fee of $25 and sold bulk packs at discount prices. It didn't take long before other retailers copied this concept and implemented it with more or less success.

For example, Walmart opened its own Sam's Club stores, which were set up similarly to Price Clubs. James Sinegal, who had previously worked his way up at FedMart from bagger to Executive Vice President, also teamed up with his partner Jeffrey Brotman to found the company Costco. By the early 1990s the market was slowly becoming saturated and growth was steadily declining. Walmart made takeover offers to both Price Club and Costco, but both turned them down. Instead, they considered a merger themselves and its sensible synergies, but at first couldn't agree on who would run the new company afterwards. After Price Club's profit had fallen further in the second quarter of 1993, they came to an agreement and Sinegal became the new CEO of PriceCostco. Since 1997 the company has operated as Costco Wholesale Corporation and has been posting solid growth again ever since. By now the company operates 795 locations in America, Canada, Mexico, Australia, England, Japan, Korea, China and a few other countries. More than 53.9 million paying members provide strong cash flow, which Costco uses both for opening new stores and for expanding its online business.

What are Costco Wholesale's prospects for the future?

First, let's take a quick look at the most recently published figures for the fourth quarter (ended August 30, 2020). Costco once again managed to increase its revenue significantly. The retailer brought in a whopping 52.3 billion US dollars, which corresponds to an increase of 12.5 percent compared with the prior-year quarter. On an annual basis, too, revenue rose by 9.3 percent to a total of 163.2 billion US dollars. Net income for fiscal year 2020 came to 4 billion US dollars (2019: 3.66 billion US dollars).

Costco pursues various strategies to keep its customers happy and get them to renew their membership ($60/year or $120/year with cashback) for more years. Successfully, too, since the renewal rate is 91 percent in the US and Canada and 88 percent in the rest of the world - those are really remarkable numbers. On the one hand this is achieved through the massive price savings that Costco passes on to its customers, but on the other also through lucrative extras, like its own gas stations with cheaper gas prices. Apart from that, you can also eat out extremely cheaply at Costco, actually too cheaply. For years, for example, it has been selling chicken for $4.99 and making a hefty loss on it - all just to keep its customers happy. Since the company spends hardly any money on advertising, customers often feel like they're on a treasure hunt and comb the stores for the best deals and discounts. Costco can push these through by buying in bulk from its manufacturers. If Costco isn't satisfied with the quality, the retailer simply produces private labels like Kirkland Signature.

Another area where Costco really shines is how it treats its employees. They get a significantly higher salary than is usual in the industry. In addition, Costco attracts them with many attractive extra benefits. In this way the company tries to keep turnover as low as possible. No wonder Costco is regularly recognized for its excellent working conditions. Of course, this too serves the strategy of getting more customers to renew their membership - after all, happy employees also make for happy customers.

In the long run, Costco will of course try to expand even further worldwide. Most recently it entered the Chinese market, which definitely beckons with huge opportunities. The only question for me here is what trade relations between the US and China will look like in the future. But it's also a fact that Costco doesn't only grow through expansion. Even the established locations continue to post solid growth.

What about the dividend?

Apart from a single dividend in 1989, Costco Wholesale Corp. for a long time used its profits exclusively to keep growing itself. Only since 2004 has the retailer started paying regular dividends to its shareholders. Since then it has also managed to raise the payout year after year - and at a remarkable pace. The dividend growth rate over the last 10 years is 13 percent. And yet the payout ratio is just 29.9 percent. With figures like these, the relatively low dividend yield of 0.8 percent is easy to live with. In addition, Costco has occasionally surprised with special dividends in recent years.

Conclusion:
Costco Wholesale runs a truly unusual business model that works extremely successfully. Customers are happy to pay membership fees to be allowed to shop there. In my eyes, Costco really is a wonderful long-term investment that guarantees I can sleep soundly at night.