Charlie Munger's love affair with Costco

The anatomy of a great company.

By Motley Fool Pick of the Day Jul 7, 2011 3:23PM

By Morgan Housel

 

Berkshire Hathaway (BRK) Vice Chairman Charlie Munger isn't one to mince words, but his recent plug for Costco (COST) had an almost fanatical level of bluntness.

 

Asked about his favorite company outside of Berkshire, Munger literally interrupted the questioner and answered, "That's easy. It's Costco."

 

"It's one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet," he gushed. "I just can't say enough about my admiration for Costco. More of you should look at Costco. In fact, every time Donald Trump says something and you get discouraged, you should think about Costco."

 

He wasn't done. "It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It's almost a religious duty. He's sacrificing short-term profits for long-term success."

 

This wasn't the first time Munger let his admiration run wild. Last year he said, "Generally speaking, I believe Costco does more for civilization than the Rockefeller Foundation."

 

What's behind these accolades?

 

Part of Munger's obsession with Costco is its corporate culture. "It's a total meritocracy," he said. Co-founder and CEO Jim Sinegal earns a few million a year -- a rounding error in the corporate executive world -- answers his own phone, spends 200 days a year visiting stores, and strikes you as a retired middle-class neighbor more than the head of one of the world's largest companies. Costco employees don't wear uniforms. Street clothes and a nametag get the job done -- an idea that saves money while humanizing workers. "Our intention is to try to build an organization that is going to be here long term," Sinegal told The Motley Fool two years ago. "And we think you do that by paying attention to some very, very basic things."

 

Those things, in order, are: Obey the law, take care of your customers, take care of your people, and respect your suppliers.

 

Shareholders, you'll notice, aren't part of the list. But that hardly means they're forsaken. Costco might be one of the best examples of how happy customers and employees naturally lead to happy shareholders. Sinegal likes to note that Wall Street constantly jeers Costco for being more generous to employees than shareholders, yet its stock consistently trades at one of the highest multiples in the retail industry, well ahead of Home Depot (HD) or Wal-Mart (WMT). Since 1995, Costco has returned 1,000% to shareholders; the S&P 500, less than 200%. Whatever Costco's doing -- deliberately shareholder-centric or not -- works.

 

The rest of Munger's admiration has to do with Costco's business model.

 

Retailing is a simple industry. You sell merchandise for a little more than you paid for it. The difference, minus the cost of operating the store, is profit.

 

Costco is different. It doesn't make much money from retailing. Revenue from retail sales comes precariously close to matching cost of goods sold plus operating overhead:

 

Year

2010

2009

2008

Retail sales

$76.3 billion

$70 billion

$71 billion

Cost of goods sold

$68 billion

$62.3 billion

$63.5 billion

Selling/administration expenses

$7.8 billion

$7.3 billion

$7 billion

Retail margin

0.55%

0.43%

0.73%

Source: Company filings.

 

Those margins are so thin they're nearly irrelevant. For comparison, Wal-Mart's margins are almost 6%.

 

The winners, of course, are Costco's customers. Take a company that prices goods just barely high enough to cover overhead costs, add in the natural savings from selling in bulk, and the odds are overwhelming that Costco customers are getting the lowest prices possible. That, in essence, is the company's goal -- or religious duty, as Munger would say.

 

The lengths it goes to to uphold that goal are nearly boundless. In 2009, Costco wasn't happy with Coca-Cola's (KO) prices. Rather than stick customers with higher costs, it simply stopped carrying Coke products altogether. "At this time, Coca-Cola has not provided Costco with competitive pricing so that we may pass along the value our members deserve," read signs over empty store shelves. Most retailers ask how high they can push prices without sacrificing sales. Costco asks how low it can push them while still covering operating expenses.

 

All the while, the company is still quite profitable. The secret is that essentially all its profits come from membership fees. Total net income in 2010 was $1.3 billion; membership fees that year were $1.7 billion. The year before, total net income came in at $1.1 billion; membership fees, $1.5 billion. That's Costco's deadly weapon: price goods cheaper than any competitor reasonably can, but still reap respectable profits off membership fees.

 

It's a win-win for members and shareholders. For an average member who spends $1,200 a year at Costco, membership fees -- as low as $50 a year -- aren't much, and well worth it financially. For shareholders, 63 million of those membership fees, with a renewal rate of 88%, equal big, stable profits. And there's a psychological benefit to the membership model: Paying a token fee once a year and enjoying cheap goods year-round feels better than buying average-priced goods all the time.

 

The question is whether Costco stock deserves your money. "The world has figured Costco out, which is why it trades at 25 times earnings," Munger said. "If you're comfortable with that, Costco is one of the most admirable capitalistic institutions in the world."

 

Valuation is what has always kept me away from the stock. At some point, however, you have to get comfortable with paying for quality. Costco is a terrific company. Is it worth the price? You tell me in the comments section below.

 

Fool contributor Morgan Housel owns shares of Berkshire and Wal-Mart. The Motley Fool owns shares of Costco Wholesale, Berkshire Hathaway, Wal-Mart Stores, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores, Costco Wholesale, Coca-Cola, Home Depot, and Berkshire Hathaway. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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44Comments
Jul 7, 2011 6:39PM
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The article didn't mention that Costco sells quality goods.  Their prices may be low, but the quality of the merchandise is tops.  Their return policy is outstanding: if you bought it and it doesn't fit or fit your needs, or you don't like it for any reason, or it breaks just return it for a full refund and no questions asked.  The stores are neat, clean, well lighted, well organized and well stocked.   The article  also doesn't mention that everyone of their employees is happy to work for Costco and happy to take care of any customer's needs.  They are bright, energetic, personable, clean, neat, knowledgeable and helpful.  There's no bitching, complaining, bad-mouthing the company or showing any frustration with their job, the company or the customer. It's a great experience and a top company to do business with.  I wish they were everywhere. 
Jul 8, 2011 10:23AM
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I have worked at Costco for 13 years.  Take care of our employees:  I am 32 and my wife is 27.  Combined we have nearly 150K in our 401K.  Costco matches our wages at 6-7% per year.  Not to mention we make over 110K/yr. combined (sup/mgr).  I have been offered tips many times.  I simply say, "Just keep shopping at Costco!".  
Take care of our Members:  Our return policy, need I say more?  As for our prices, sure you pay about the same or more for toilet paper.  But, what about gas, jewelry, we are the largest retailer of wine, clothing, the list goes on and on.  Quality is also #1 at Costco.  Some of the items in the Deli could be served at a high end restaurant.  For all of those naysayers, you can make one purchase at Costco and pay for your membership.  
Costco has provided my family with the American dream.  That is why the share price is 25 times the multiple.  People overlook the fact that we do not rape the consumer and the employee.  If there were more Jim Sinegal's the United States would not be mired in this economic mess.   
Jul 8, 2011 4:42AM
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I completely agree with the article.  I admire Costco business.  I converse with the employees of where I shop and I find out their true feelings.  Workers at Costco love the place as much as the many customers.  I saw the 60 minutes interview of the owner and I  completely concur with the praise in the article. If i need anything I go to Costco first: if it is not available I wait to try several times before going elsewhere
Jul 8, 2011 8:16AM
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Prior to Chemo, my Dr. handed me a list of prescriptions designed to help prevent the side effects of Chemo.  I priced the generic brands at several of my local grocery stores and chain pharmacy stores and was horrified that the prices ranged from $230.00 to $130.00 for 24 pills.  As an afterthought I called Costco.  What a shock! The price for the very same 24 generic pills was $25.00.  Needless to say, I am forever a Costco Fan. I was also informed by the very friendly staff that anyone (even non members) can purchase their prescriptions at Costco and save Tons of $$$.

Since then, I always do my homework before making any purchase over $100.00 and 99% of the time Costco wins and the quality is always top notch. In addition, my local Costco always has the lowest gasoline prices... As long a Costco is around, I will continue to pay the $50.00 renewal fee and continue to save. 

Jul 8, 2011 9:10AM
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I bought a Toshiba Computer at Costco which failed about 3 months after the purchase. Toshiba was not able to repair the machine and wanted to give me a "refurbished machine" as a replacement. Costco defended my  complaint and eventually the purchase price was refunded. Of course I returned and bought another machine from Costco: this time a HP. 
Jul 8, 2011 6:06AM
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I concur with louis with regards to quality products and exchange policy at Costco.  One time had some light-bulb fall out of my cart flat, and break, in the parking lot, after I paid for them.  While still sealed in its packaging, I took them back into the store and they replaced them at no charge and no questions asked.  Another time I forgot to pick up postage stamps from the cage.  I went back a week later with my receipt in hand, and through its computerized inventory system, determined that I had not picked up the stamps and handed them over to me with no hassles.

You won't find any slacker employees on the floor of Costco.  Always energetic and knowledgeable!  The merchandize turnover and product changes they have in there also makes it  an interesting place to shop with what they carry now that they did not have last month.    It's a fun place to shop!
Jul 8, 2011 10:07AM
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I love Costco.  I wasn't sure we would use our membership as often after our girls left home, but I use it so much that we upgraded to an executive membership.  The savings on electronics and jewelry are amazing and I can't buy high quality steak or seafood anywhere for the price that I can buy it at Costco.  I buy Christmas and birthday gifts there and I can buy a much nicer gift for the same money I might spend at Target or Penney's.

 

I buy all my staples at Costco.  I just wish they had the half-caf Folgers coffee that I use.  I'm forced to pay ridiculous grocery store prices, but it's a sacrifice I'm willing to make--lol.  

 

I suspect those that dislike Costco are the sorts that need their hand held and think that the warehouse feel is beneath them.  I'll take a warehouse with cheap prices over a grocery store with Musak and fancy displays any day.

 

 

Jul 8, 2011 8:14AM
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I have been a loyal member for over 20 years. There really is no store like them. Treat customers and employees the right way. Never have to worry about quality. THE BEST!! Bad investment? Take a look at your returns! Top quality low prices. Gotta love the combination. Wal-mart should take notice. Maybe then they wouldn't have issues with declining sales.
Jul 8, 2011 10:59AM
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I haven't shopped in a Wal Mart or related store in 19 years and don't ever intended to do so as long as I live. I have a lot of respect for the Costco business model and believe in supporting those companies that take care of their employees. Long live Costco!
Jul 8, 2011 8:43AM
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I have a Costco and ****'s membership - love both stores. Costco is my favorite - the quality of goods is superior to the other stores. Sure they have some of the same things but Costco is so much better. I hate Sam's checkout - they just throw stuff into the basket - Costco always has two people at the checkout - cashier and person who loads the cart. Costco's meat and bakery goods are superior to Sam's. I drive 1 hour out of my way to go to Costco - dropped my membership with Sam's due to the poor checkout lines - it was ridiculous waiting in line. I've been a member of Costco for 20 plus years - their dog food is superior and much cheaper than any where else.
Jul 8, 2011 6:36AM
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We always shop Costco first. Love the "top of the line" Kirkland brands. We also belong to

Sam's Club, but hate to shop there. Sure wish Costco would build a store in Ft. Wayne, Indiana, I do get tired of driving 100 miles to Indianapolis just to shop at Costco.

Jul 8, 2011 10:11AM
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Ok so I moved from Oregon to Oklahoma 1 year ago.  DO I EVER MISS MY COSTCO!!! Where are you guys in this state??  Get a move on Sams so needs to be removed.  Here's the thing.  I've got a family of 3, and yes we shopped religiously at Costco even for a  $50 membership fee, if you priced the goods per ounce or lb, depending on what you're buying, you'll find that 70% of the items bought in bulk at costco generally beat out the local grocery store.  But you still need to do your homework.  Sams on the otherhand, well no chance there and they charge a memebership fee too.  Am I suckered due to the membership fee, not really if I add up my savings over the year minus the memebership fee I really save about $400 a year in groceries by purchasing in bulk at Costco, not so much at Sams.  Rumor has it they planned on moving into OKC, but that has yet to be seen due to the economy.  I wish they would just hurry it up.  I hate going to Sams on a monthly basis and watch the prices rise.  Classic example, I use the Cascade dishwasher tabs.  December 2010 they were $15 for a box of 180, last night $19.  Toilet paper, was $12 in December for 36 rolls now it's $18, and my 2.5 lb coffee beans went from $11 to $15 in 2 months.  That's sams sticking it to you.  Costco would never have raised the prices like that.  At this point in time, well I know that next time I won't be buying at Sams due to the increase in prices I can find the same amount for the same price at the local grocer as I paid last night for the items my famiily uses. 
Jul 8, 2011 10:55AM
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@isitcollegefootballseasonyet...you are NOT listening to what everyone is saying....yes there are things that are cheaper at Wal-Mart...but there is a long list of things that are far cheaper...pet food, gas, tires, on these 3 alone I save far more than the $50 fee. so it pays for itself.  I am a single parent on a tight budget, trust me I go over the numbers carefully, I buy my produce elsewhere and papergoods as well, but for the quality on some things, and the savings on others, plus the very generous return policy, which is unreal, even if you ate it, wore it, used it, they take it back....they are a corporation, but read the article again, they do NOT pigishly keep all profits for themselves, their margins are lower than walmart etc, they pass it on to employees and customers.
Jul 8, 2011 9:58AM
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I have been Costco customer for almost 20 years by now, I have spent a lot money at Costco, never regret with the quality and prices. Going there to shop things like you got things with insurance, you can count on its quality and good price. it is not cheapest price, but good value in term of quality and customer service. I even have several FRIENDS at store where I go all the time. I buy everything at costco, they have best value on steak, seafoods, furnitures, watches and Jewelry and even phone services. If you are looking for cheapest goods, then Costco may not be the place you should go. It is a place to go if you appreciate top qualities with good prices. This combination has kept me going there almost 20 years. Matter of fact, the first thing we worried when I moved from big city to country side was if I could still shop at Costco, it turned out there is one about 30 minutes out, so we made a decision to move where we are today.

Costco has become staples in my family life for a long time, and my children now are out of colleges and on their own, one of the things that I bought for them when they were away from me was Costco membership cards. I just bought a nice ring for my mother from Costco, how you can beat that price elsewhere. To me, If you can find a place where you can get to Costco without too much trouble, plus Wegmans or Harris Teeter for things that Costco doesn't carry, then you are OK. That is how impportant Costco to me, I am sure it is true to many people like me.

Jul 8, 2011 7:56AM
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The money I save per year on lower gas prices combined with the percentage off for the AMX card easily pays for the membership. Just have to do the math

Jul 8, 2011 8:03AM
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I love to shop at Costco, the quality of their products is magnificient, I like their customer service, that is what I look for when I shop at a store or eat at a restaurant is GOOD QUALITY CUSTOMER SERVCE.  As for their annual membership fee, if you are a Executive Member you get 2% back of your yearly purchases.  I have been a Costco Member since it opened here in Houston Texas.  I am also a member of Sam's Club but the only reason I am a member is because I have one of my children as a member also so he can shop at College Station.  If Costco would add Scott Tissue Toilet Paper to its merchandise, I would not have a need to buy at Sam's Club at all.  As for getting cheaper prices at Cash & Carry, I buy at Costco for bulk so I won't have to drive around town in order to save.  Just like my father used to say " You drive around town to save pennies, but what about gas and time?" And his comments were back on the 70's when gas was cheap.
Jul 8, 2011 8:55AM
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we used to have a sam's membership , but i was excited to get to go back to costco (seriously, we'd had one where i used to live on vancouver island for probably close to 15yrs and chattanooga (tn) just got one lol) . we dropped sams and got costco - we've probably saved our $50 membership fee just in gas. 
like anywhere , you do have to do a little homework .. or at least retain some info on prices elsewhere.  Some things are a great deal and we go for them .. others i know wont be so we don't get that item.  the bulk of our weekly shopping is done elsewhere , costco is a once a month trip for generally the same items


Jul 8, 2011 12:10PM
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I will never stop going to Costco, lowest pricing, great quality and lots to choose from.   Once I read about the business model I like it more.  Simple  and fair.!  Love getting money back too!
Jul 8, 2011 10:51AM
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....correct me if I am wrong, but they do all this without the interference of any Union-thugs!  Go Costco, and they don't need Obummer's bailout $ either...
Jul 8, 2011 7:43AM
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tigerpilot: I don't know where your Costco is but our gas pumps take debit cards. I am an executive member & get 2% back on all my purchases. The employee even told me when I signed up if I didn't get XXX amount back @ the end of the year to lower my membership. WHAT BUSINESS IS THAT HONEST?! And I know 2% isn't much but I shop there anyway why not get back something?! I have never found any store that beats their prices for electronics & if they do they match their price.

I wait for their coupon book & take advantage of that by going only once a month because it's true somehow it does become the $300 store.

I HAVE NEVER HAD A RUDE EMPLOYEE EVER and have been to 3 different Costco's in 3 different states.

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