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Introduction
It never tires me to go over Costco (NASDAQ:COST) and understand more and more how this company has grown to be a true behemoth among retailers. This is why I was eagerly waiting for Costco’s Q4 earnings report and the earnings call that presented the results. This time, while I was looking at the results Costco achieved, I found myself surprised because, during the earnings call, Costco management offered some valuable lessons about the company’s business model. As a consequence, I would like to share with SA readers through two articles (one would be too long) that aim at deepening our understanding of Costco much beyond the fact that this company keeps on achieving ever growing numbers. In other words, I think that we either understand its business model or some of its metrics make almost no sense, especially the ones regarding margins.
Reported earnings
Let’s look at some basic numbers. Costco reported a 15.8% comparable sales increase in Q4 and for the whole fiscal year 2022. If we exclude gasoline, then Costco reports a 9.6% growth in Q4 and a 10.4% for the fiscal year 2022. This means that for the quarter, Costco’s revenue reached $79.76 billion (vs. $61.44 billion in 2021) and $222.73 billion for fiscal year (vs. $192.05 billion last year). Let’s keep in mind that in 2014 Costco reported a revenue of $112 billion, which means that in 8 years Costco has been able to double its results.
Let’s move to the bottom line.
Costco reported a net income of $1.87 billion for Q4 which leads to a $4.20 EPS (vs. $1.67 billion and $3.67 EPS in 2021). For the fiscal year, net income was $5.84 billion – $13.14 per share – compared to $5.01 billion and $11.27 per share in the prior year.
Most of these results were largely expected since Costco has the habit to report month after month its sales results. As we will see in this article, this is one of the most important data to look at to assess Costco. In fact, it probably is the most important one together with the number of memberships.
In today’s environment, everybody looks at the top line and the bottom line to understand how margins are doing. In most cases, we have seen margin shrink significantly as inflation ate a chunk of many companies’ profits. However, we are also seeing that in the past quarter or two, most companies are catching up with it, especially through pricing.
Let’s see what happened to Costco.
In Q4 gross margin on came in at 10.18% down 74 basis points from last year’s reported gross margin of 10.92%. I actually consider this to be a minor drop, compared to what we have seen in other cases this year. However, with Costco, we have to be as precise as possible, since even a small reduction in margins could affect the whole company. Now, if we exclude gas inflation, Costco would have had a reduction of just 22 basis points. Why is gasoline impacting negatively on margins? As Costco’s CEO, Richard Galanti, explained that in the company’s gas stations
We turn our inventory about every day on average and the average in the U.S. gas stations is like every 8 or 9 days. […] So, when prices are going up each day, when spot prices are going up stay, it’s costing us a little more because we bought it today at the highest price versus 4 days ago. I’m being very simple here. And when it’s going down, just the other happens that we make more money when it goes down.
During the past quarter, gas prices at first went up and they just started to come down recently. This has cost the company a bit in terms of margins. However, this is not the only reason why gasoline affected margins negatively. The other is that Costco utilizes its gas stations with low prices to drive more traffic into its stores. In fact, about 50% of the people who fill their car’s tank at Costco gas stations stop to shop at Costco, too. In a certain sense, it is part of Costco’s marketing expense in a very “Costcoly” manner: the real advertising is by offering incredible value to the customers.
During a very tough year, Costco managed, in any case, to reduce the impact of SG&A compared to last year. This year SG&A came in at 8.53% vs 9.22% reported in 2021. This is an improvement of 69 basis points which is quite remarkable considering that Costco raised its wages during last year to keep its employees extremely satisfied.
A top-line company
Now that we have some numbers clear, let’s move to the first lesson Costco delivered during the earnings call. Clearly, some of the analysts participating at the event wanted to talk about margins. It was the case of Scot Ciccarelli, from Truist Securities, who during the Q&A asked
your margins are actually holding in pretty well. So I guess, the question is, are there other areas where you’re being even more aggressive than normal on the pricing side? And then, the flip side of that is, what categories are you guys using to maybe harvest some extra margin to offset the presumed margin squeeze from holding the line of sand on pricing?
This is a very natural question: if you are keeping your margins at usual levels, where are you taking some extra margins from, given the fact that you are feeling, like everybody else, inflationary pressure? In other words, what are you doing to offset inflation?
The answer from Mr. Galanti revealed from the first words that Costco doesn’t solve this problem as most of the other companies:
Lightning just struck me. No. We don’t — we really don’t look at it that way. […] At the end of the day, no, I don’t think we necessarily look to find places where we can harvest margin.
So, if Costco doesn’t look for places where to harvest margin, how can it hold its marginality steady? Mr. Galanti gave us the answer: Costco is a top-line company:
We’ve always been told and we’ve told you guys that we’re a top line company. […] We’re looking to always drive sales. we want to raise margins by lowering prices, but keeping a little of it. That was the old saying, you’re in an inflationary environment, and that changes a little bit. But at the end of the day, it’s all about driving volume. If we can incrementally get another percentage point of comp sales, that does more than any kind of harvesting we would ever want to do, which we don’t do.
What do these words mean? There are some companies that even though they have a flat top line, they keep on increasing their bottom line through improved efficiency. The best case I know of this kind is McDonald’s (MCD), on which I wrote a detailed article a few months ago. But Costco is no such company and, though highly efficient, it has volume as its most important weapon against inflationary pressure. As consumers are worried about inflation, they tend to turn to retailers that help them save money. So, an inflationary environment is a tailwind for Costco and it is precisely the tailwind the company needs to handle its own struggle with inflation. In this way, the tight relationship between Costco’s guests and the company is strengthened, as more consumers flock in Costco’s warehouses to enjoy the savings that the company is able to pass on to them. At the same time, consumers provide Costco with the increased volume it needs to keep margins steady. It is a win-win situation.
Costco’s profitability driver is well-explained in one of the last earnings report, where the company writes that
We believe that the most important driver of our profitability is increasing net sales, particularly comparable sales growth. Net sales include our core merchandise categories (foods and sundries, non-foods, and fresh foods), warehouse ancillary (includes gasoline, pharmacy, optical, food court, hearing aids, and tire installation) and other businesses (e-commerce, business centers, travel and other). We define comparable sales as net sales from warehouses open for more than one year, including remodels, relocations and expansions, and sales related to e-commerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). […] The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative (SG&A) expenses, reducing them as a percentage of sales and enhancing profitability.
Comparable sales growth is indeed a goal of Costco because the more they grow, the less fixed costs impact on profitability.
The warehouse model: new stores and products
Another way Costco has to grow its top line is by adding new stores. In fact, the company has not done growing both in the U.S. and internationally. In Q4, Costco opened 9 net new warehouses, 5 were in the U.S., 2 were in Canada and 1 each in Korea and Japan.
For the full fiscal year, the company opened 26 warehouses, but that included 3 relocations, so a net increase during the year of 23 locations. In fiscal 2023, Costco plans to open 29 new warehouses, including 4 relocations, so we should see a net of 25 new warehouses. We should see 15 of these 25 planned net new openings in the U.S. while the remaining 10 will be in other countries including Costco’s first locations in New Zealand and Sweden, and 2 new locations in China, where the company will end the year with a total of 4 warehouses.
In every warehouse, consumers find the best possible deals because Costco keeps its margins as low as possible on purpose, usually applying a 10%-14% markup on goods sold. In addition, Costco doesn’t focus on having as wide a variety of goods as possible, risking the overloading of its inventory, but prefers to offer well-known products that consumers are familiar with and that have great demand. This leads to a very quick goods turnover of around a month. In the annual report, the company states this from the very beginning, declaring that the business is run
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.
As we can see, inventory is quite important for the company and investors need to pay attention to this metric. To be fair, Costco reported a Q4 inventory up 26% YoY. This number may seem alarming, but, if we understand how it comes up, things change. In fact, the company estimates that about 10-11 percentage points are due to inflation. In addition, the warehouse count increased and this added another 3 percentage points to the inventory. Finally, the company is lapping some low stocks in certain departments as a result of last year’s high demand, specifically in nonfood areas where last year, Costco was at about 90% of its targeted inventory levels. I think these three factors can lead us to state that Costco’s inventory grew by something around 8%-9% and, as the company reported, this is already heading down. Once again, we are in front of very healthy numbers compared to the problems a retailer like Target had in the past quarters.
To be continued…
In this first episode, I wanted to point out why comparable sales are so important to Costco and why the company is choosing this path to offset inflation, instead of relying on pricing or selling certain high-margin goods to balance the reduced margins on others. Even though Costco’s margins are graded with Cs or Ds by Seeking Alpha’s Quant Ratings the overall profitability grade is actually an A+. Why is that? What is driving the rating up? Three factors have a strong impact on Costco’s grade: return on total capital of 16% asset turnover ratio of 3.6% and cash from operations at $7.6 billion. I think we have seen in this article why Costco has an outstanding performance regarding these metrics. The return on capital shows how much return a company has generated through the use of its capital structure. Costco is able to achieve a high return on capital as it knows exactly what goods to buy for its members, leveraging its experience and its knowledge of customers’ behaviors and desires. In addition, due to the fact it has a very low number of goods to be sold compared to regular retailers it is able to clear its inventory at a faster pace compared to other peers in the industry. This leads to the fact that Costco is always full of cash to the point that it has gotten many investors accustomed to the fact that every 2-3 years the company pays out a special dividend with the excess cash it has generated.
In the second and final episode, I will consider the second pillar of Costco: the membership. Meanwhile, for those who want to have a taste of what we will consider, I suggest reading my recent research on Costco’s influence on Amazon Prime. It is a piece written after I read that Jeff Bezos was inspired by Costco’s efforts to sell goods as the best possible deal for its customers. I think it is some kind of bridge between this focus on low margins and our next dive into the membership program.
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