Costco – An amazing business

Charlie Munger said that the only real threat to Amazon in retail in his opinion was Costco. I think he has a point. Costco has a remarkable business model.

This part in the 2018 annual report summarizes the business pretty well

We operate membership warehouses based on the concept that offering our members low prices on a limited selection of nationally branded and private-label products in a wide range of categories will produce high sales volumes and rapid inventory turnover. When combined with the operating efficiencies achieved by volume purchasing, efficient distribution and reduced handling of merchandise in no-frills, self-service warehouse facilities, these volumes and turnover enable us to operate profitably at significantly lower gross margins (net sales less merchandise costs) than most other retailers. We generally sell inventory before we are required to pay for it, even while taking advantage of early payment discounts.

We buy most of our merchandise directly from manufacturers and route it to cross-docking consolidation points (depots) or directly to our warehouses. Our depots receive large shipments from manufacturers and quickly ship these goods to warehouses. This process creates freight volume and handling efficiencies, lowering costs associated with traditional multiple-step distribution channels

The model can be illustrated as below

Costco’s customer base enables the retailer to buy goods in bulk and at discount from suppliers. The lower prices make Costco appealing to customers. The cycle keeps going on. Costco has every reason to keep the margin low so that the cycle is robust and going strong. To solve the margin issue, Costco resorts to membership fees which are mostly purely profit.

Source: Costco Q4 earnings

The graph above shows that the membership fees make up the most of the net income. It’s not unreasonable to think that the SG&A expense for memberships is minimal.

The membership fees give Costco breathing room in a cut-throat business. There is only so much that a retailer can do on a margin side given a litany of fearsome competitors. Plus, there are so many foreseen and unforeseen factors that can put Costco’s margin at risk. If Costco removed the membership fees and raised the margin, they would become less competitive.

Being able to convince shoppers to pay an annual fee is a competitive advantage. So is the freedom to laser-focus on keeping the costs low. An additional advantage of a membership fee is that Costco can have more cash for their operations. Operating in a business in which a lot of goods are moved around every day and plenty of capital is required for upgrade, openings and renovation, Costco benefits greatly from the instant dose of cash the members bring in.

Weekly Readings – 6th July 2019

Rising U.S. Inequality: How We Got Here, Where We’re Going

How Costco gained a cult following — by breaking every rule of retail. Costco is Charlie Munger’s pick as Amazon’s biggest threat. He may have a point here.

Student Loans Are Not A National Crisis. I am a bit reluctant to add this story to the post as I don’t really like the headline. However, his points are valid. So why not? In the summary, I agree with him that wiping out college debt does nothing to address the root issue. It’s about the system that leads to the current debt situation and the lack of personal finance knowledge.

The rise and rise of a Vietnamese corporate empire. FT pulled the curtains on one of the biggest corporations in Vietnam. Both the good and the bad.

Amazon in-sourcing nearly half of its parcel transportation needs. A look at Amazon’s transportation capabilities

Understanding Financial Statements. A very good primer on the fundamentals of financial statements.

Global App Revenue Reached $39 Billion in the First Half of 2019, Up 15% Year-Over-Year. A great study on app revenue and downloads in the first half of 2019 from Sensor Tower.

Global Entertainment & Media Outlook 2019–2023. An interesting and informative report on global entertainment and media by PwC.

Making 5G pay. A look at how 5G can be monetized, how much consumers are willing to pay (an estimate) and how different 5G packages can be introduced for different needs.

All about Direct Listings. A great overview of direct listings by a16z