Companies

The Resilience of Costco

For 40 years, Costco has succeeded with a simple formula: reinvest merchandising profits into lower prices and better products; be a disciplined operator; and treat customers and employees well. 

But with greater share of shopping moving online, it’s fair to wonder if the company's best days are behind it. The deck below will explore this in detail. 

A Conversation with Charlie Munger and Michigan Ross Dean Scott DeRue

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SCOTT DERUE: As you look back on your life experience, what's the most important piece of advice that you would offer everyone in the room tonight as they look forward and into their futures?

MUNGER: Well, there are a few obvious ones; they're all ancient. Ben Franklin, marriage is just like the most important decision you have and not your business career. It'll do more for you—good or bad—than anything else and Ben Franklin had the best advice ever given on marriage. He said, "Keep your eyes wide open before marriage and half shut thereafter”.

It's amazing how if you just get up every morning and keep plugging and have some discipline and keep learning, and it's amazing how it works out okay. And I don't think it's wise to have an ambition to be President of the United States or a billionaire or something like that because the odds are too much against you; much better to aim low. I did not intend to get rich. I just wanted to get independent; I just overshot.

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What's Amazon's Plan for Whole Foods?

INTRODUCTION

It’s clear that Amazon’s $13.7b acquisition of Whole Foods will result in lower prices at the notoriously expensive grocer. What’s less clear is how Amazon will accomplish this. Most expect them to bring-to-bear their formidable supply chain and delivery know-how, driving prices lower by revolutionizing how groceries are shipped and distributed. While these are surely some of Amazon’s long-term goals, this presupposes that Amazon has already solved the unique challenges of storing and shipping groceries. The reality is Amazon does not yet have the core competencies required to operate a grocery supply chain. These they will learn from Whole Foods. 

But if improvements to the supply chain or logistics are still a ways off, then the question remains: how will Amazon reduce prices? We posit that by automating in-store operations via technology (e.g., self-checkout) and pushing more private label products, Amazon will drive down expenses by billions of dollars. They will then pass these savings right back to the customer in the form of lower prices and better value for Prime members. 

THE GROCERY CHALLENGE

Grocery is the holy grail of retail—nearly every individual must buy groceries on a regular basis, and what does get purchased is often the same from week to week (e.g., meat, eggs, milk, bread). At $650b, annual US grocery sales are 6x Amazon’s revenue, yet only 2% of those sales are done online. So grocery presents a massive opportunity for Amazon, but despite the company’s operational efficiency and extensive distribution network, they have not been successful in this space. Why? 

Look no further than the unique challenges of selling groceries. Amazon may have mastered shipping uniform, non-perishable, and scannable items like books and electronics, but shipping goods that spoil, have inconsistent availability and fluctuating costs, require refrigeration, and varying quality of individual units, is a significantly more difficult challenge. Had Amazon already solved this, they wouldn't have needed Whole Foods in the first place. 

WHAT IS AMAZON’S STRATEGY?

As Amazon experiments with logistics and distribution, their near-term strategy is likely to focus on three areas: improve in-store operations via technology and automation; introduce more private label goods like AmazonBasics and 365; and increase the value of Prime. 

1) In-store Operations 

In January, Amazon revealed AmazonGo, which is a suite of technologies (e.g., cameras and sensors) that enable customers to walk into a store, grab what they want, and walk out—all without needing to wait in line or see a cashier. By automatically detecting what a customer took off the shelf, Amazon can bill their account, monitor in-store inventory levels, and reduce “shrink” (i.e., theft). We expect AmazonGo technology to be pushed out across Whole Foods’s 465 stores. 

If we assume half of Whole Foods’s 100k employees are cashiers—and that their total hourly cost to the company (including wages, benefits, perks, etc.) is $25/hour—then Whole Foods likely spends around $2.5b/yr on this expense—13% of total sales. 

2) Private Label Goods 

No longer seen as cheap, low-quality knockoffs, private label goods are now sought after by savvy customers because of their attractive value proposition: same quality, lower price. Brands like Kirkland, Trader Joe’s, 365, and AmazonBasics, are going toe-to-toe with expensive name brand alternatives; and in many cases they’re winning. And it’s not just customers who benefit. By selling private label goods, companies earn higher margins, gain product exclusivity, and have greater control over packaging and distribution. Since Amazon and Whole Foods have been independently selling more low-priced, high-margin private label goods, we expect the acquisition to accelerate this trend. 

By improving in-store operations and selling more private label goods, Amazon stands to increase the profitability at Whole Foods. But rather than keep the profit, Amazon has other plans…

3) More Value for Prime Users

We expect Amazon to “give back” any profits to customers through lower prices and increased value for Prime members. To understand why, look no further than the company that serves as Prime’s inspiration: Costco.

Costco sells products “at cost”, meaning if it costs them $1 to supply customers 1lb of turkey, then that’s the same price they charge those customers. While this virtually guarantees Costco can offer the lowest prices, it also seemingly guarantees they’ll never make money. But there’s a catch—to get Costco’s low prices, customers must pay $60/year to be a “member”. It’s a unique but brilliant business model; customers win because they receive more than $60 worth of savings each year, and Costco also wins because there’s no incremental cost to provide a membership, so all membership fees fall directly to their bottom line.

This is the same model that Amazon Prime means to replicate. Since the company doesn’t need to make money directly off the goods it sells, it can keep prices lower than its competitors. The low prices drive more memberships, which increases sales, which in turn gives the company more leverage to get even lower prices from its suppliers. Rather than keep that margin, the company gives it right back to the members through lower prices, thus driving more memberships and restarting the virtuous cycle.

Because of the acquisition, Amazon will have a number of new opportunities to increase Prime’s value, such as: free grocery delivery, member-only sales/pricing, exclusive brands, online ordering/pickup, and easy re-ordering. And by increasing Prime’s value, Amazon attracts more Prime members, which increases sales, which in turn gives the company more leverage with suppliers, which drives prices lower, which….well you get the point. 

CONCLUSION

While predictions of drone-delivered swiss chard may make for good headlines, the future success of Whole Foods does not depend upon it—nor any other single technology for that matter. What it will depend on is whether or not Amazon can create value for customers through low prices, great selection, and convenience. Over the next few years, we think it is far more likely for Amazon to achieve these goals through slightly less exciting—though no less impactful—methods like self checkout technology and selling more private label goods. Both changes will substantially reduce costs in the near-term, which Amazon will use to accelerate the virtuous cycle of AmazonPrime. 

2017 Berkshire Hathaway Shareholders Meeting (Full Transcription)

2017 Berkshire Hathaway Shareholders Meeting (Full Transcription)

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WARREN BUFFETT: Thank you and good morning! That’s Charlie, I’m Warren. You can tell us apart because he can hear and I can see, that’s why we work together so well. We each have our specialty.

I’d like to welcome you to Omaha. It’s a terrific city and Charlie’s lived in California now for about 70 years, but he’s still got a lot of Omaha in him. Both of us were born within two miles of this building that you’re in. And Charlie, as he mentioned in his description of his amorous triumphs in high school, graduated from Central High, which is about one mile from here. It’s a public high school. My dad, my first wife, my three children, and two of my grandchildren have all graduated from the same school. In fact, my grandchildren say they have the same teachers that my dad had. It’s a great city; I hope you get to see a lot of it while you’re here.

In just a minute we will start a question period—hopefully, a question and answer period—that will last until about noon, and then we’ll take a break for an hour or so. We’ll reconvene at 1 PM, and then we’ll continue with the question and answer period until 3:30 PM, and then we’ll break for 15 minutes or so. And then we’ll convene the annual meeting of Berkshire. We have three propositions that people wish to speak on, so that could last, perhaps, as long as an hour.

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Associated Capital (AC)

"I don't throw darts at a board. I bet on sure things." - Gordon Gekko

In November 2015, GAMCO—an investment management and advisory company owned and managed by famed value investor Mario Gabelli—moved a substantial portion of its cash, investments, and 4.4m of their own shares into a newly created company named Associated Capital. As of this writing, Associated Capital currently has a market value of $770m, which seemingly indicates that the company’s stash of cash and investments is being fairly valued by Wall Street. 

Yet in addition to the spin off of cash and investments, GAMCO also created a five year $250m promissory note (i.e., loan), payable to Associated Capital at 4% interest.

Despite the note representing a very real economic benefit to Associated Capital, its true worth is obfuscated by the GAAP accounting because it’s a “related party loan”—i.e., a loan between two companies controlled by the same person—thus excluding it from the asset side of the balance sheet. But as the note matures, Associated Capital will receive payment from GAMCO, thereby increasing the company’s cash balance by an additional $9.83 on a per share basis.

Additionally, Associated Capital’s downside risk is relatively low because its other assets are highly liquid and thus easy to value: cash can be taken at face value, and many of AC’s investments have market quoted prices. And Mario Gabelli—who owns 75% of both companies—has a proven track record of creating long-term value. Recognizing that Associated Capital is trading at a discount, the Board of Directors has authorized a buyback of 500k shares, which will help to close the gap between value and price. 

With 25% of its value not yet realized by the market, a value-centric owner in Mario Gabelli, and a highly liquid asset base, Associated Capital makes for an attractive opportunity with very limited downside. An investment in the company would be like buying a house worth $500k for $500k, and then a month later discovering that there’s shoebox buried in the yard stuffed with $125k. The GAMCO note—much like the shoebox—represents hidden value not yet appreciated by Wall Street. 

It’s very likely this accounting quirk has created an opportunity for prudent investors to almost literally buy $1 of assets for $.75, which, according to both common sense and Warren Buffett “is a very good thing to do.”