Monday, 17 June 2013

Costco - Culture and Competitive Advantage

An enduring competitive advantage is a must in any would-be investment.  Generally, there are just a few kinds of "moats" including a low-cost position, high switching costs, high barriers to entry and network effects.  In rare cases, a corporate culture can be included on this list.  Part of the reason investors ought to be wary of investing in a company based on its culture is because it's inherently difficult to measure, particularly for outsiders.  Nearly all companies insist in public that they have a one-of-a-kind culture, and the loyal, motivated staff that goes with it, but usually it's not true.  In addition, while a winning culture only exists if it has spread throughout an entire organization, it takes just one imperious, foolish or unethical CEO to destroy it, so even if it exists today, it may be gone tomorrow.

A recent BusinessWeek article makes a compelling case that Costco belongs to the very short list of companies with a culture so favorable to employees that it gives the company a competitive advantage, and is so ingrained that it's almost certain to endure over many decades.  In general, and unlike many of its competitors, Costco sees workers as an asset to invest in, rather than a cost that must be reduced.  (Costco's unique culture also includes a genuinely customer-friendly approach, and a commitment to keeping costs low that’s double-stitched into the company's DNA, but this particular article focuses on employee relations.)

In the US, Costco pays workers an average of nearly $21 per hour, almost three times the minimum wage and about twice what most notable competitors pay.  In addition, the company's health care package is far more attractive than what rivals typically offer.  In fact, many competitors are cutting workers' hours to below 30 per week, the threshold at which Obamacare would force them to offer coverage.  The company insists that its generosity isn't charity, but is motivated by bottom-line results.  Not only does a generous approach lower turnover and training costs, the company notes, it increases loyalty and productivity.  There's much truth to this claim.  Turnover is a mere 5% for workers who've been with Costco over a year, and a vanishingly small 1% for executives.  These saving indeed hit the bottom line: net income was $1.7 billion in the year ended 2012, up 33% from 2008, despite a stagnant economy.  

However, it's clear that there's a moral element to Costco's approach.    The CFO acknowledges that the company could make more money if wages were lower by a few dollars an hour, but says simply "We're not going to do it."  In short, the company simply believes that it's the right way to behave.  Jim Sinegal, Costco's long-time CEO and head culture-maker, recently retired.  This represented a rare occasion where, if handled poorly, the company's principles could have been undermined.  It didn't happen.  The new CEO believes the same things as his predecessor.  It doesn't hurt that the board includes Berkshire Hathaway's Charlie Munger, who, along with Warren Buffett, has been instrumental in building one of the business world's most unique and impressive corporate cultures.

While its culture is likely to give Costco an ongoing edge over its brick-and-mortar rivals, a long-term competitive threat exists online.  Amazon and similar firms have largely cut out workers, since they've cut out the physical retail channel altogether, and sales over the internet are growing significantly faster than in-store buys.  However, the faster growth is happening from a very small base, and Costco's large scale will allow it to offer low-priced wares online just as it does in the physical world.  In summary, Costco has a wide, shark-infested "moat" that's likely to ensure stellar long-term performance.  Currently, the stock is trading at a designer price, not at a discount, but Costco possesses all of the other elements of a superb investment.  

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