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 8, 2011 4:12AM
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I was at Costco today with a friend, and I left (again) feeling disappointed - they just don't sell the things that I need.  They have virtually no tools, their motor oil is no cheaper than Walmart, liquor is no-name branded, their clothes are definitely not what I want - and the only thing that I can see that I like is the peanut butter.
The $50 annual fee is discouraging.
Their appliances are well priced, but there is no range of options, and I see similar prices offered at major retailers for sale items.
We went to the gas pumps, and they don't accept cash, and take only Costco debit cards or American Express credit cards (which I don't use) so I left without even gas (which was only 6 cents cheaper than at the Shell station where I went after) and 6 cents is not a savings that excites me about Costco.
The point is - if I have this result, why pay $50 a year to be a member of a chain that sells things that does not sell the things that I need? The $50 is a barrier to trade since I won't pay it unless I can have confidence that Costco will stock what I need to buy, and since I don't have that confidence I won't be a member and I won't shop there.
Costco is a frustrating shopping experience, and that's the problem. No service, poor range of goods, quality is obviously variable (as is Walmart's) - and if I feel this way, I'm sure that others do also. That limits Costco's growth, and that reflects on the earnings multiple.

Jul 8, 2011 9:44AM
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Lost in this love affair is the fact that costco single handidly is responsible for the most amount of supplying companies bancruptcy,they lure companies in,encourage them to build a relationship ,give them contracts,then squeeze,or refuse to do business with them ,unless they get their price,which in most cases is below the actual cost to produce the product,most people forget that the originalprice club was the better company,also what do you get for your membership,lessdays open,less hours,and less choice.....sorry the consumer has been sucked in ...can get most of what they sell elsewhere cheaper,and a better selection,for an odd product not a bad place toshop ,but if you look deeper you have been hyped
Jul 8, 2011 5:10AM
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Ever heard of Kirkland Signature? Well, hello from Kirkland! Beside the fact I get a small giggle from seeing our city's name all over the place (we need some recognition for the high taxes and some of the highest property taxes in the state) but in all truth, I was never a Costco fan. I love my mayonnaise but I really don't need a vat. You can go to Cash & Carry, no membership, and get large "wholesale" goods (every couple of years or so I get an itch to make my own lattes and use the same cups, lids, and products that my favorite coffee "stands" use). And there, ANYONE can walk in and shop without paying a fee first.

But back to Costco: As their motto goes, you can't leave without spending $100 (more like $300!)- I've used the $100 motto at my favorite store, TARGET, although I've noticed their prices getting a little too high for my liking but that's another story I guess). Then you get to the car and go "what the *** did I buy?" while you're attempting to fit frozen and refrigerated foods or 100 dinner rollls without bags wherever you can find a spare spot in the car! In the past, accompanying others, I've priced things I use and would like to have lots of: Coca Cola, paper towels, toilet paper etc. And then I shop at Target or Safeway, respectively, and it's just a better deal. BUT, I just got a membership gifted to me and I've been to Costco far too often in the last month. With some things, I'm excited by the deals and some great finds but do I REALLY need it? Others, like the paper towels, didn't last me very long so I'm back at Target for those things at the same price or less and they seem to last me longer. But one thing that's hard to pass up...the lower gas prices at Costco's pumps. I have a bit of a drive to get there but it's not all that much further than the safeway gas station I've religiously gone to for years for a 3 cent savings. Overall, the membership fee wouldn't be worth it for the savings on gas alone but if I can take advantage of the retail aspect, then it's worth it and I no longer have to be about the only person on the planet, or at least in Costco country, who says "I don't have a Costco card". 
Jul 8, 2011 4:40AM
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Is this an article or an advertisement?  It certainly sounds good, and I hope it's true, but they don't give the impression of having been objective and researched the topic to ensure that it's all accurate.
Jul 8, 2011 8:24AM
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I shop both Costco & Sam's.  I have to drive about 70 mi. to get to Costco and find that their selections are lacking in a lot of the products I use.  Their prices aren't that much different from Sam's, generally only 1 or 2 cents.

I can save the price of my membership feeS just in the difference in the prices of OTC drugs that we use...ibuprofen, benedryl, tylenol, etc....and this is the difference in price from Walmart to either Sam's or Costco.

I'm not into organic (unless I grow it) and I don't care for a lot of the fancy stuff they sell.  I really don't care for their fresh prepared foods section or their bakery items. 

I do the majority of my bulk purchasing at Sam's!  Besides, they are closer too....about 45 mi. away!

Jul 8, 2011 1:50AM
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I have a membership at Costco and also at  Sam's Club.  Personally I don't find a huge difference between the products they each sell.  I do think however that Costco has a small edge in the grocery department over Sam's.  Sam's has a better electronics dept and also a better tire dept.  Costco has the edge in clothing.  I think the stock valuation of Costco is too high and therefore I would not own the stock.  There are better stocks out there if you are looking for retail. 
Jul 8, 2011 11:26AM
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Just like anything else, it depends.  Some things are better priced some are not.  Also, you're gonna have to buy a 2,3,or 4 pack of something in order to get the better deal.  I think people just have an affinity to the store & perceive like they're getting a better deal when in reality they're probably paying the same or more on alot of things. 

 

I also find it hard to believe they are only breaking even on selling merchandise and their only real profit is from membership dues - that to me doesn't sound like a good business plan.

Jul 8, 2011 12:58PM
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I read people's comments and look at the thumbs up and down, and it clearly shows that people that shops at Costco are like Costco, looks out for themselves. There is too much imported products in Costco. That is because the economy has gone down, and that everything is outsourced to other country for cheap.  This country does not produce anything anymore, that is the problem with today's American unemployment. I read here business owner who was screwed by Costco. Costco does what Costco wants to do, and you can't tell them anything, they will tell business owners that they can only sell their products 10 weeks out of the year, and not depend on Costco to be their bread winner. So while the American consumer buy a product that is very successful at Costco, The American product it will only be supported for 10 weeks. It is a shame that American's who likes products that are produced in US have no say, yes members have no say in what products should be in the store. The membership fee is a fee that is basically paying for your discount in the store, so in reality your cheap products that you as a consumer purchase is not cheap anymore, you have already paid for the discount in advance by your membership. Don't think that Costco is doing you a favor.

Jul 8, 2011 6:06AM
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"มันเป็นหนึ่งในสถาบันนายทุนที่น่าชื่นชมม​ากที่สุดในโลก
Jul 8, 2011 10:58AM
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Belonged to Costco, moved and had to join Sam's Club, moved again and joined Costco again as there was no Sam's.  I like Costco, but its not that much better than Sam's.  Some of the inventory is higher quality, not all, and their prices are definitely higher than Sam's. 

I wish them well, but if they were replaced by Sam's in my town, I would not be very upset

Jul 8, 2011 2:56PM
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I too love Costco's but the store is not responsible enough to stand behind their services.  My wife, an asthmatic, was given advise from the then pharmacy that she followed which resulted in a ten day hospital.  Costco's denied any responsibility because there was no paper trail.  I still shop at Costco"s but I was disappointed in their response.  
Jul 8, 2011 12:08PM
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What a ramrod, the worst of it is that you are all feeling it and seem to like it....lol 
Jul 8, 2011 11:00AM
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college football - you're losing the battle here - btw - how's the weather in fayetteville?
Jul 8, 2011 12:47PM
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Bought tires at Costco and then after learning of a pending out of state move I let my membership expire. Just before moving I had a problem with one of the tires going flat but since I didn't have a membership card they refused to service the tire. Since I paid for the service when I purchased the tires, I feel burned, and would never buy another membership to Costco again. I never imagined that I would give up my rights to my tire warranty if I chose to not renew, and believe this should be posted on the wall of the tire department.
Jul 8, 2011 12:10PM
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I know what it is like to do business with Costco, had a meeting with them.  They loved my product and never heard from them again. Later on I saw that they had duplicated my product and are now selling it in their stores. Again, this is not the first time I have heard this, but unfortunately I heard it after I had met with them. When people ask me about Costco I tell them my story, and then I don't have to hear "why don't you like Costco".
Jul 8, 2011 11:55AM
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I love Costco too, but we let our membership lapse last year....perhaps it's time to renew!!!!
Jul 8, 2011 11:17AM
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I worked at costco for 14years and I lost my love for them. corp.  management is good but on a store level it is sub par. I have seen store managers Break neearly every law on the books and like the catholic church they just move them to the next location or give them a slap on the wrist. In my store they fired all dept mgrs so the store mgr could make more on his bonus by saving payroll.  They carry a very limited amount of merchandise and where they used to take pride in buying nearly all American they now buy mostly imported. They have gone the way of walmart. When I started it was see what you can do to help the people in your dept. do the job better. The last mgr meeting I attended we were told to tell the employees "If you don't like the way we do it here there are a thousand people out there to take there place, and pointed at the door.  A complete 180 from when I started. The benefits have gone way down and I would imagine getting worse.

Jul 8, 2011 11:51AM
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I love Costco's quality, the variety of products that they bring in seasonally and their pricing. I also like that the employee's treat you the way you would treat yourself. You can tell that Costco employee's enjoy the workplace. We are a family of four so shopping at Costco in addition to our local supermarket makes sense. Not all products are as cheap as as our supermarket but I think Costco has superb product overall and the pricing can sometimes massively undercut the supermarket. Not only that, I just love cruising the aisles. The man in me loves the t.v.'s, camera's, power tools, etc. and the Mr. Mom in me loves the food products like sliced honey turkey, Dino Chicken, Italian pasta, Aspen Mills bread, flower arrangements, carrot juice, etc. My wife loves the excellent meat products. My son likes the movies on the big screens. My daughter likes the summer dresses. We like to think of Costco as our church, since we go there as a family on Sundays. LOL.

Here's my Costco tip for the day...get a bag of their yellow synthetic towels/rags for washing/waxing your car, as a dish rag, keep a few in your car. They come clean with a little bleach and detergent and can be used over and over for pretty much anything. 
Jul 8, 2011 8:40AM
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I work at Costco, but I am one of the medical professionals.  Unfortunately customers think that, because they are at Costco, and getting a good deal, they can belittle my profession and my product.  Costco is a good employer, but I often feel that if a member wanted me to stick sharp needles in my eyes, management would want me to do it, no questions asked.  Most members are great and a joy to work with, but some feel they can be rude and unreasonable because they paid a membership fee.
Jul 8, 2011 11:16AM
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I feel so strongly about how Costco treats it's employees AND customers that I renew my membership every year even though I only shop there a handful of times a year.
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