This is going to sound like blasphemy to most but I only very recently became a Costco (COST) member- several months ago to be exact. In fact, I didn't really know much about Costco for the many years that I lived in New York and Philadelphia. I guess there wasn't much reason to. In New York, Gristedes and Duane Reade covered all my needs. But moving to the west coast, people were shocked that I wasn't a Costco member. “What do you mean you're not a Costco member?” Fervently loyal Costco member friends and co-workers offered to take me there just to show me around and get an absurdly cheap lunch to persuade me that I needed to join. In fact I've never seen people so loyal to anything else, especially a retail store. What gives? It made me curious. So I went.

Upon my initial visits, I came back somewhat unimpressed, so friends went on to sing the praises that I am sure you already know:

“I love their return policy...I don't need a receipt. Just take it back anytime. That’s why I buy all my electronics there”

“I love that I can know that everything there is going to be the best quality because they've selected and screened only the best products. They’ve done the work for me and I trust them.”



Me: “I don't really have a need for a 50 pack of whatever item. It's just three of us in my family. Maybe if I had a big family.”

Friend: “Well I mostly just like the finds [she's referring to the treasure hunt environment which we will get to] and buying really good wine there”



Friend: “I don't think I spend much there. Last year I got back $195 through the 2% back on purchases on the exec membership”

Me: “Dude, that means you spent about $10k there.”

Friend: “Oh shoot, I guess you're right. I didn’t realize”

So I decided to check it out a few more times. What was I missing that Target, Trader Joes, Safeway and Whole Foods wasn’t already providing me with. Why would I pay for the privilege to shop at a store? Why does everyone wait in such long lines and fight through crowded parking lots even first thing in the morning? It’s a pain in the butt.

Then, happening upon a long line of cars outside, I discovered the COSTCO gas station and their incredibly low prices and I was sold. I shelled out the $55 for a Gold Star membership and never looked back. The frugal in me rejoiced as I realized that the gas savings more than covered the membership price after only a few months. In fact, I started going in the store every now and then (only first thing in the morning when I could beat the crowds) and started discovering stuff that I never knew I needed! I’m sure this last part rings familiar for many people.

Let’s take a step back though and figure out how I got here waiting amidst a sea of people at 9:50am for Costco to open its doors. The reality is that there isn’t that much new I can add to the Costco conversation given all that has already been written about it and that many value/GARP investors already own or have owned the stock. Also – based on their ~48 million membership households, more than half of you readers out there are probably already members so you already know the story whereas I am playing catch up. Although I was a skeptical consumer for a long time (not necessarily a skeptical investor), I’ve been thoroughly impressed by Costco’s business model and their members first philosophy. Let’s delve a bit deeper to review the dynamics of the industry and the business. And buckle up because there's a lot I have to say.

Industry Overview

Retail, how I hate thee

I’ve never been much of a fan of the retail industry. The competition is tough, differentiation is lacking, margins are razor thin, the returns on capital tend to be low and the competitive advantages are non-existent or difficult to maintain. Generally, competing retailers are selling the same products attracting consumers primarily on the basis of promotional deals or sales that further drive down margins. Even in the case of vertically integrated retailers (think clothing retailers like GAP or J Crew), that sell exclusive products, the business is challenging because retailers are forced to make large upfront commitments for inventory on fashions that may not play out well with fickle consumers months down the line. We don’t need to look far to find the retail behemoths of the past that are basically irrelevant today. Sears was once the Amazon (AMZN) of its day- selling pretty much anything one could desire from a catalog. Just check out this Sears catalog from 1897 – they had even cracked groceries! AmazonFresh could learn a few things.

And K-mart was the original mass/discount retailer with nearly 2,200 stores at their peak. Today, ask anyone under 20 what Sears or K-mart is and you’ll get some puzzled looks. It’s obvious why when you see this K-mart in pictures.

Despite these inherent challenges of the retail business, there are some retailers that have been successful – TJ Maxx, (TJX), Walmart (WMT) and Dollar Tree (DLTR) to name a few. They’ve done this primarily by focusing on providing value and savings to the end consumer versus competitors. Amazon (AMZN) has also been successful by providing value (and convenience) to its consumers. In fact, Costco is probably the prototype that Bezos has followed for Amazon Prime (more on that later). Amazon is Costco’s Washington state neighbor. I’m sure the proximity didn’t hurt.

Members Only - Introducing the Club Channel

Costco sells all types of general merchandise, so in effect, they compete with nearly all other retailers whether that is mass market retailers like Walmart (WMT) or Target (TGT), grocery chains like Kroger (KR) or in some cases hardware stores like Home Depot (HD).

More directly, though, Costco operates in a niche of the retail industry called Warehouse Clubs, Wholesale Clubs or the Club Channel. There are some notable differences between warehouse clubs and traditional retail stores:

The key differentiating aspect of these warehouse clubs versus other retailers is that you must be a member to shop there. They charge an annual membership fee in exchange for lower prices.

The warehouse clubs predominantly sell items in large quantities/pack sizes at higher tickets. Many items are not stocked on shelves, but rather sold right off the wooden pallets they come in on to limit operational costs.

Limited variety. Given the larger pack sizes, varieties for a given product tend to be very limited at club stores. You want ice cream – you get vanilla ice cream and you’ll like it. Moving volume is the name of the game at Club so companies will typically offer the most popular flavor or variety for a given product given that niche flavors or varieties typically don’t have the same broad appeal. Sometimes companies will develop products, flavors or unique pack sizes that are exclusive to the Club Channel. This is driven partly by a desire to limit price comparisons and price transparency between clubs and traditional retailers.

The footprint of the club stores tends to be much larger than a typical retail store – ranging from 100k to 150k square feet.

Over the last several years, the club channel has experienced strong growth and taken share from other channels of trade like grocery and mass. This share shift has been driven partly by very competitive pricing. Most items sold at club are sold at a decent discount as compared to other retailers as long as you’re willing to buy it in a larger pack size and ok with limited varieties/assortment.

As a result of this large opportunity in club, consumer products companies and other companies have continued to place a greater emphasis on the club channel, which can be a great volume driver (but potentially at the expense of margin).

A Cast of Three- Key Players in the Club Channel

There are three major players that operate in the US Club channel – Costco, Sam’s Club and BJs.

Costco is by far the largest of the three club competitors when it comes to members and revenue and operates 723 warehouses across the US and eight international markets as of December 2016. However, the US is by far Costco’s largest market and they have only cautiously tiptoed into international markets. Costco’s primary category is food (food comprised over 40% of sales in 2015), but it also sells many other items across many other categories including hardware, appliances and electronics.

Sam’s Club is owned by Walmart and named after the original founder, Sam Walton. Sam’s Club operates 655 stores predominantly in the US. As Walmart tried to leverage its clout with real estate developers, they built many Sam’s Club’s stores in very close proximity to Walmart stores (in the same exact shopping center in many cases). This puts Sam’s Club at a competitive disadvantage relative to Costco in that many of these Walmart neighborhoods have less desirable demographics (lower HH income). The average HH income of a Sam’s Club member is $80k/year, lower than that of a Costco member. Sam’s Club’s recent strategy has focused on repositioning itself to attract more affluent members by changing its assortment and also building stores in more affluent areas. The former includes revamping the Sam’s Club private label brand to better compete with the goliath that is Costco’s Kirkland Signature brand.

BJs Wholesale Club is a distant third competitor in the club channel. BJs has a much smaller footprint of ~200 stores predominantly located on the eastern seaboard of the US. BJs operations aren’t very different from Costco or Sam’s Club – many of the locations sell gas and offer many ancillary services like optical and discounts on car rentals and vacations. As of 2014, BJs is fully owned by Leonard Green & Partners, a private equity shop.

See chart below for how the three compare on some basic metrics.