Costco Wholesale Corporation Investment Recommendation

MEMORANDUM

To: Ms. Margarita Torres

From: Nick Baudoin & Olivia Wesley

Subject: Costco Wholesale Corporation Investment Recommendation

Date: October 12, 2018

In concern of the Costco investment that you have held since 1997, we believe it would be a good time to sell your investment as we feel Costco’s most recent 2001 financials suggest decline in operating efficiency.  

Wholesale Industry

Before we get into the details of our recommendation for Ms. Torres’ Costco investment, we wanted to spend some time looking at wholesale clubs as compared to other types of retailers.  Since the popularity of retail department stores in the 1800s, three large categories of retail store have developed over time, each with a distinct strategy.  

First is the department store with examples such as R.H. Macy & Company, Bloomingdale Brothers, Inc. and Sears which was the dominant retailer in the 20th century. These were established in the 1800s and drew people thanks to the past time of window shopping and their focus on providing high quality customer service.  

The next category of retail store is the discount store, with Walmart as the leading example.  Walmart’s strategy is to target low income consumers by offering many products at the lowest price possible in rural locations within clean stores staffed by energetic employees.  A subset of the discount store is known as a “category killer” which focuses on discounting one product category such as electronics, furniture or hardware and some examples are Home Depot, Best Buy or Walgreens.

The final category of retailer on which we will focus more thoroughly is the wholesale club which has gained popularity in recent years.  These clubs have the same goals as discounters to offer products at the lowest price but the goal is executed differently.  The wholesale clubs require an annual membership, carry a smaller selection of goods (4,000 SKUs vs 40,000 SKUs), keep operating expenses at a minimum by creating warehouse style facilities and reducing stocking costs, and sell items in bulk which allows them to negotiate discounts with suppliers that they then pass on to their shoppers.  The key players in the wholesale club space are Costco, BJ’s and Sam’s Club.  

Looking at trends for the retail industry as a whole, since 1950 retail as a percent of GDP has stayed stable between 15%-17%.  The shifts have occurred within retail spend between categories of department, discount, and wholesale club.  Looking from 1990-2000, Costco compound annual growth rate (22.8%) has exceeded the Federated Department Stores growth (9.9%) and GDP (5.9%).  Walmart (19.4%) is also growing faster than both Federated and GDP but not as high as Costco.  Sears’s growth, on the other hand is declining (-3.1%).  The higher-than-industry growth of wholesale clubs and discount retailers demonstrates how people prefer the lowest cost model to that of department stores like Sears which prioritizes customer service and have higher prices to support their strategy.

The wholesale club strategy is clear when looking at Costco and BJ’s 2001 Gross Margin, Operating Margin and Inventory Turnover compared to department store Sears and discount store Walmart.  The two wholesaler’s gross margins (Costco 10.4%, BJ’s 9.2%) are less than half Sears (26.6%) and Walmart (21.1%) because they are trying to sell at the lowest price but additionally they are trying to earn their profits by executing with extremely low operating expense.  However, since Operating Margin for the four competitors are getting within a couple points of each other (2.85%-5.94%), operating expense efficiencies must be allowing Costco and BJ’s to move low Gross Margins to similar Operating Margins.  Finally, Inventory Turnover is much higher for the wholesalers (Costco 11.7, BJ’s 8.9) as opposed to other types of retailers (Sears 5.0, Walmart 7.3) because they sell in bulk to be able to pass on negotiated supplier deals to the customer.  This analysis shows different ways that we can see the wholesaler’s strategy at work in the financial ratios.