Weekly Update: Costco's Changing Philosophy

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3. 26 years at Costco Canada

4. Costco Wholesale vs Sam's Club

5. Investor Dialogue: HEICO, Transdigm, & Terminal Values

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Costco's Changing Philosophy

We recently interviewed a Former Costco (COST) executive who spent over 30 years at the company with experience working under Jim Sinegal, founder and former CEO, and Craig Jelinek, the current CEO of Costco.

One key takeaway from the interview is that there are signs of Costco’s operating philosophy changing under Craig’s leadership.

One example contrasts Jim Sinegal's response to the 2008 crisis to Craig's response during the recent pandemic. During the 2008 GFC, Sinegal cut the gross margin for core SKU’s like butter, milk, and chicken breasts well below the 14% target margin. Some products were even cut to cost. With Jim, the customer always came first.

[In 2008], when everyone started realizing this was a longer situation than originally thought, after about 90 days, he came back and said, I know we’ve done 10 items and then 20 items; I want 300 items. Granted, we are a limited SKU environment with 3,000 items. He wanted 10% of the items cut down to 5% margin or less. Before, it was reduced by 5%. Some of the items made 12% or 13% margin but, for that period, nothing could be over 5%. Some of them even went down to 2%. It got to the point where he wanted some of them to be at cost and he wanted us calling our vendors, to find out about their solvency to see if they can lower their prices to us, so we can lower them even more. He wanted everybody working on this; it was our main mission, at that point, because the people needed it - Former Executive at COST

Under Craig’s management, during the COVID pandemic, Costco’s response was different.

If you read the reports during the pandemic periods, no prices were reduced for the members. Craig was very late to let employees work from home, even though there was no travel happening. Everybody was perfectly capable of working from home, doing well, being productive, feeling safer and reducing fear, stress and anxiety; all those things that have diminishing returns on people’s performance and their health and well-being. - Former Executive at COST

In fact, COST reported record dollar and percentage EBIT margins in 2020.

This potential shift in philosophy suggests Costco is transitioning from a relentless focus on members and employees towards a greater emphasis on shareholder return.

I lived the [culture] transition. I felt it, because I started 30+ years ago, with Jim being my CEO and having a tremendous amount of access to him. I also had a very strong and good relationship with Craig. After he took over the CEO position, we met to discuss some concerns. He said, I have a boss too; do you know who my boss is? He said, the shareholders are my boss. Jim would never have said that. - Former Executive at COST

Another fascinating example of the potential shift in philosophy is in COST’s pricing strategy.

…every item, in every region, in every geographic area stands on its own; that’s how Costco functions. Some regions make 12% on an item and some regions might make 8% and some might make 13%, depending on the distance from manufacturing. Craig let one of his SVPs, talk him into weighting the average of the margin – not the cost, not the sell – to reach, say, 13% on an item if it showed a significant value in the marketplace. That meant some regions might make 10%, depending on their volume and some regions might make 16% or 17%, which is outside the bounds of the philosophy of the company that has been in force for over 40 years. Even though it may have created Member pricing continuity. - Former Executive at COST

A core tenet of COST’s philosophy has been to limit the gross margin per item to ~14%. This aims to ensure that COST maximizes the “slope of value”, the value per item relative to input costs and competition, and ensures COST is putting its members first.

A more specific pricing example comes from recent changes to Kirkland Signature water pricing.

For instance, the Kirkland Signature water, the 16.9oz bottle. I saw buyers working tirelessly to get to $2.99. This became the Holy Grail because $2.99 is unheard of. But the vendor made a case to make more margin so Craig [and the leadership] let them take a 20-cent price increase – which is a huge percentage of $2.99 because the cost is $2.80+ pushing the price up to $3.19. Jim would never have allowed that and would have challenged everyone to find efficiencies and cost savings. - Former Executive at COST

It’s hard to handicap just how significant such potential changes in philosophy really are. COST has ~3,000 SKU’s, operates globally, and treats every item individually. It would also take years for such changes to show up in the financials.

Also, some may legitimately argue Craig cannot be exactly like Jim Sinegal. And nor should he be. Craig has been running Costco for a decade and the business has doubled in size since he took over; arguably, he is qualified to make judgments on when to uphold Sinegal’s original principles and when to deviate based on specific circumstances.

However, there certainly seems to be a fundamental difference in the historical values set by Jim compared to Costco today under Craig. Jim’s moral compass ultimately led him to explicitly place employees and members above shareholders. He believed if you are effective in serving customers and employees, the value will accrue to shareholders.

I think it was his moral compass. He worked for Sol Price for a long time and he loved Sol’s business idea, but he hated the way Sol treated people. He wanted that business idea with the antithesis of Sol’s behaviors. He knew that Sol meant well, but he knew that you didn’t have to get results out of people by berating them. He knew you could get results out of people by respecting their humanity and he wanted to be able to do that. - Former Executive at COST

If there is a slight change in philosophy, how much does this matter to the COST investment thesis?

Firstly, there is no indication in the financials today of COST increasing pricing to take more margin on merchandise. If we deduct the merchandise cost from net sales excluding membership fees, we can see the stability in the COST’s product margin over the last 15 years. This ~12% product margin also includes gas sales, typically sold at a much lower gross margin, which accounted for ~10% of sales pre-COVID.

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Since Jelinek took over, Costco’s EBIT margin has grown 60bps to 3.46% in FY21. In 2012, SG&A as % of net sales was 9.60% and last year it was only 18bps lower at 9.42%. Most of the margin expansion has simply come from the consistent ~7.6% per annum growth in memberships.

Because the geographic mix hasn’t changed much in the last decade, the majority of the margin improvement is coming from operating leverage in the US business.

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Adjusted for inflation, COST has grown sales per sqft by 2.78% per annum in the US since 2009. Put simply, COST is putting more dollars through its US fixed cost base which is driving higher EBIT margins.

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Another observation that could suggest that COST is much more attuned to managing the Street comes from the last three quarters of FY22: inflationary pressures has led to a 60bps decline in the product margin to 11.9% and SG&A costs have declined 55bps to 8.87% of total sales. This almost perfectly manages the EBIT margin so it’s stable year on year and meets Street estimates.

Any CEO who takes over from Sinegal has a tough act to follow. A transition too far away from COST’s core principles of putting members and employees first could pose a long-term threat to the business. However, this erosion could take some time to show up given COST’s structural advantages, weak competition, international growth opportunity, and 35%+ ROIIC.

COST is set to grow mid-double digits in FY22 with stable EBIT margins. If we do face a recession and Jelenik doesn’t cut prices like Sinegal in 2008, maybe Costco can grow throughout a potential FY23 recession? In 2009, sales and EPS declined 2% and 15%, respectively.

The fact that current management is focused more on the Street could in fact lead to even more resilient results in an upcoming recession.