by Will Ashworth | October 11, 2012 1:24 pm
Discount retailer Costco (NASDAQ:COST) announced its fiscal fourth-quarter earnings Oct. 10, the third quarterly report since the retirement of long-time CEO and co-founder Jim Sinegal. As is most often the case, Costco’s results were better than expected. Americans continue to flock to the warehouse concept in search of low prices.
Still, current CEO Craig Jelinek has tough shoes to fill. Low prices alone won’t keep the discount retailer growing. Costco, however, brings more to the table to make itself successful.
No retail operation, especially one as large as Costco’s, survives without good customer service. I’m not talking about the perfunctory offers of assistance received when first entering a store but rather the nuts and bolts of its operation. Often, it’s the things unseen that separate the men from the boys. For instance, we already know Costco has low prices. But how does it get them so low?
One way is to limit the number of stock keeping units (SKUs), which is a fancy way of identifying a retailer’s products. Costco carries just 3,600 SKUs compared to 45,000 or more at many of its competitors. By limiting the number of products Costco offers its members, it’s able to drive a hard bargain with its suppliers. The competition for those 3,600 SKUs is intense.
Suppliers want to be a part of Costco, whose average warehouse store generates $146 million in revenue, or $41,000 per SKU. As a result, members get lower prices and higher-quality products while also spending less time shopping among fewer choices. By doing less, it’s doing more.
My wife and I are infrequent shoppers to Costco. We have a membership, but living in the heart of Toronto, don’t often find the time to get out to the suburbs where most stores are located.
However, when we do go, we always notice (my wife has 20 years retail experience) how genuinely happy the employees are to be working there. Costco’s starting wage for those working on the floor is $11 per hour, which is higher than the San Francisco minimum wage of $10.24 per hour, by far the best in the U.S. The federally mandated minimum wage is an embarrassing $7.25 per hour, 26% less than the minimum wage in Alberta, which is Canada’s worst offender at $9.75 per hour.
According to Holly Sklar of the Business for a Fair Minimum Wage project, when Wal-Mart’s (NYSE:WMT) first store opened in 1962, adjusted for inflation, it paid $8.74 per hour. Since then the Walton family has gotten rich while the workers haven’t. Costco Senior Vice President Jeff Long said the following about raising the minimum wage in New York State:
“At Costco, we know good wages are good business. We keep our overhead low while still paying a starting wage of $11 an hour. Our employees are a big reason why our sales per square foot is almost double that of our nearest competitor. Instead of minimizing wages, we know it’s a lot more profitable for the long term to minimize employee turnover and maximize productivity and commitment, product value, customer service and company reputation.”
You don’t have to be a rocket scientist to understand why Costco’s formula is successful. When people want to come to work, it makes for a better customer experience. Most people who’ve spent a decent amount of time shopping at Costco will probably have noticed that the employee name tags also list the year they started at Costco. Most have been there for over a decade.
Treat people right, and they’ll want to stick around. Costco’s employee turnover is 24%, about half that of Wal-Mart, and much less than the retail average. Training new employees costs money. Interestingly, Costco’s selling, general and administrative expenses for its latest fiscal year were 9.8% of its revenue compared to Wal-Mart’s 19.2%. Despite spending more on its frontline employees (the backbone of any retail operation), it ends up costing Costco less. That’s how you run a business.
Many people think Costco is in the business of selling products at low prices. While its prices are indeed low, that’s not its ultimate goal. Mark Zuckerberg stated in Facebook’s (NASDAQ:FB) IPO prospectus, “We don’t build services to make money, we make money to build services.” At Costco, that translates to “we sell products inexpensively not to generate revenue but to gain loyal members.”
Its real business is selling memberships at $55 a pop or more. As long as it keeps providing great products (the chicken is awesome) at good prices, it will continue to increase its membership. In fiscal 2007, membership revenue was $1.3 billion, or 81.3% of operating income. In fiscal 2012, membership revenue was $2.08 billion, or 75.2% of operating income.
Although it’s grown membership revenue by almost 10% annually, it’s been able to grow operating income at a faster rate of 11.4%.
Costco understands its customer. Rather than trying to maximize profits, it focuses on lowering prices by applying a maximum 15% markup to the goods it sells even when it could get more. In Sinegal’s words, “Many retailers look at an item and say, ‘I’m selling this for 10 bucks. How can I sell it for 11?’ We look at it and say, How can we get it to nine bucks? And then, How can we get it to eight?”
Remember, Costco is in the business of selling memberships. With an 86% renewal rate worldwide, it doesn’t have to sell too many new memberships to keep revenues rising.
What does Costco bring to the table?
Everything Wal-Mart doesn’t, and that’s why Morningstar named Jim Sinegal its 2011 CEO of the Year. Is there a better-operated big-box retailer? I don’t believe there is. Low prices are obviously a big revenue driver, but shoppers who frequent Costco stores know there’s so much more. After all, they don’t call it the anti-Wal-Mart for nothing.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.
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