EVERY SPOKEN WORD
150 min read · 30,005 words- 0:00 – 3:06
Why Costco feels like “Disneyland of consumer value”
- BGBen Gilbert
I don't think I have ever been more in love with a company and a business model.
- DRDavid Rosenthal
What are you, Charlie Munger?
- BGBen Gilbert
It's just the deeper you dig, the more good things you find, and usually, it's the exact opposite of that. [laughing] It's like the opposite of being an early-stage venture capitalist. [laughing]
- DRDavid Rosenthal
[laughing]
- SPSpeaker
Who got the truth? Is it you, is it you, is it you? Who got the truth now? Is it you, is it you, is it you? Sit me down, say it straight, another story on the way. Who got the truth?
- BGBen Gilbert
Welcome to season thirteen, episode two of Acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert.
- DRDavid Rosenthal
I'm David Rosenthal.
- BGBen Gilbert
And we are your hosts. What if I told you that there was one place where you could get all these things under one roof: a two-and-a-half-pound container of cashews, prescription eyeglasses, a tank of gas, new tires for your car, ninety-six rolls of toilet paper, a new refrigerator, an outdoor shed, a ten-carat diamond ring, some fresh prepared sushi, fine wine at a great price, and you could even grab a hot dog with a soda and a free refill on your way out for just a buck fifty.
- DRDavid Rosenthal
Ben, I don't believe you.
- BGBen Gilbert
Hey, it has been the same price for forty years now?
- DRDavid Rosenthal
Forty-seven years.
- BGBen Gilbert
Yes. Most of you are very familiar with this Disneyland of consumer value that I'm referring to. It is Costco. This company seems very simple on the face of it. If you sell in bulk, you have the opportunity to offer great deals to your customers. But what really makes it work are the fifty clever innovations that they've refined over the years that all work together like an orchestra that's been rehearsing for decades. Nothing about Costco is an accident, from the extra-wide parking spaces to the whole rotisserie chickens, and if your goal is to offer extremely great value to your customers on high-quality products at the lowest possible prices, there are a lot of ways that you could go about doing that, and today, we will walk through the very specific path of decisions and trade-offs that Costco has chosen to accomplish just this. So listeners, remember that: extreme value, high-quality products, lowest possible prices, and David, my God, does this method work well. There is a reason Charlie Munger loves this business.
- DRDavid Rosenthal
Oh, does he ever. You know the great Warren Buffett joke about Costco, right?
- BGBen Gilbert
Ooh, no.
- DRDavid Rosenthal
Okay, so here it goes. Warren and Charlie are flying on a plane that gets hijacked. It's kind of macabre. The hijackers each grant one of them one last wish, and they ask Charlie first, and Charlie says, "I would like to give my speech on the virtues of Costco one more time before I die." [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
And then the hijackers turn to Warren, and he says, "Shoot me first."
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
It's so great. This actually happened at a Berkshire annual meeting. It's on YouTube. We'll link to it in the show notes.
- 3:06 – 6:53
The eye-popping scale: growth, revenue density, and Kirkland bigger than Nike
- BGBen Gilbert
Oh, that is awesome. I mean, Charlie Munger, of course, on the board of Costco and longtime fan of the model, as you should be, too. So here are some insane stats. Costco has grown revenue right about ten percent for over thirty years in a row. Their revenue per square foot of their warehouses belongs more in a conversation with Tiffany than Walmart. They seem to have incredible running room ahead of them to expand internationally and here in North America, and David, here's one that is just for you: Their store brand, Kirkland Signature, does more revenue alone, not including anything else in the store, than all of Nike.
- DRDavid Rosenthal
I know. It's so great. I think I found that Kirkland Signature, as a unified brand, I think might be the largest brand in the world by revenue.
- BGBen Gilbert
It's the largest consumer package brand in the world.
- DRDavid Rosenthal
Yes, which is a misnomer because, like, they sell everything. [laughing] You know, most other brands only sell like shoes.
- BGBen Gilbert
But their fifty-two billion a year that they sell, which inches by Nike by just about a billion dollars, doesn't even include the Kirkland Signature gas. All right, listeners, if you wanna know every single time a new episode drops, you can sign up for email updates, acquired.fm/email, and two brand-new things: We will be including little hints at what the next episode will be to the email list now, and two, we'll be including follow-ups from episodes when listeners share things with us after release, be it little corrections or just additional insights. So sign up, acquired.fm/email. Come talk about this episode with us at acquired.fm/slack, and learn from other listeners who may be closer to these topics than even David and I are. If you want more from David and I, check out our second show, ACQ2, available in any podcast player. Just search ACQ2, and our next few episodes are about AI, with CEOs who are leading the way as the world very rapidly changes in front of us. So without further ado, this show is not investment advice. David and I may have investments in the companies we discuss, and this show is for informational and entertainment purposes only. David Rosenthal, what are the history and facts?
- DRDavid Rosenthal
So Costco was founded, as many people know, in Seattle, lovely city of Seattle, in 1983 by retail veterans Jim Sinegal and Jeffrey Brotman. Now, Jeff came from a long line of Seattle retailers. His dad was a retailer. His brother is a retailer. Jeff was one of the first investors and board members of Starbucks. Super cool.
- BGBen Gilbert
Yeah.
- DRDavid Rosenthal
And, uh, Jim, well, we'll talk about Jim as we go here. But if you were around and kind of of shopping age, shall we say, in 1983, you know that the true history of Costco dates way further back than that to someone that we talked a lot about on our Walmart episode, the legendary Sol Price, and his two companies, FedMart and Price Club.... And although Costco, quote-unquote, was founded in 1983, the organization that we know and love today is actually the result of a merger between Costco and its predecessor company, Price Club. And Price Club is really, of course, the actual result of Sol's previous company, FedMart, which FedMart itself really came out of FedCo in the 1940s.
- BGBen Gilbert
In some ways, we sort of have to tell a whole industry history here, but in other ways, these kind of are all the same company because they're all stacked learnings from Sol Price and his various brainchildren over the years to create the Costco that it is today.
- 6:53 – 13:56
The true origin story: Sol Price’s upbringing and worldview
- DRDavid Rosenthal
Totally. We start History and Facts in January 1916, in New York City, in the Bronx, where one Solomon "Sol" Price is born. Now, Sol's parents were Jewish immigrants from Belarus. They'd arrived just a couple years before at Ellis Island as teenagers. They had absolutely nothing. They spoke no English, they had no money, nothing. So Sol's parents, like many Jewish immigrants around then in New York, ended up getting jobs in the garment factories in the Lower East Side, and the conditions in these factories were, like, terrible, just absolutely terrible. If you went to school here in the US, you might remember learning in American history class about the Triangle Shirtwaist Factory fire-
- BGBen Gilbert
Yes
- DRDavid Rosenthal
... in 1911.
- BGBen Gilbert
Oh, yeah.
- DRDavid Rosenthal
You remember that? This is, like, the start of the American labor movement, and the Communist Party and the Socialist Party emerged as a reaction to this in America 'cause it's a terrible disaster. Literally, the factory owners had locked the doors to keep the workers in the building so they wouldn't steal, and then a fire breaks out, 146 people are killed, mostly women and young girls. Like, this is terrible. So Sol's parents didn't work at Triangle, but they worked at other factories just like this.
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
Crazy, and you can't make this up. Sol, [chuckles] maybe the most influential American retail capitalist in history, comes out of the Triangle Shirtwaist Factory movement, and communism, and socialism, and everything that's happening in New York in the Jewish community at this time.
- BGBen Gilbert
Wow, and you say one of the most influential. I do think he's top two, top three with Sam Walton, of course.
- DRDavid Rosenthal
Sam Walton actually wrote in Made in America that he stole more ideas from Sol than anyone else in his business career. [chuckles]
- BGBen Gilbert
All right, so very credible argument that he is the most important American retail capitalist.
- DRDavid Rosenthal
Jim Sinegal, of course, co-founder, CEO of Costco. Jim tells the story that a reporter once asked him if he learned a lot from Sol, and Jim replied: "No, that's inaccurate. I didn't learn a lot. I learned everything." [chuckles] "Absolutely everything I know, I learned from Sol." So we found this awesome biography of Sol that's, like, really rare. It's out of print. It was written by his son, Robert, and if you are a fan of Costco or wanna learn about retailing or just, like, all these business practices, you absolutely should try to get your hands on this thing.
- BGBen Gilbert
It's self-published, too.
- DRDavid Rosenthal
It's self-published. I don't think there's anywhere else in the world that lays out, in detail, exactly how Costco works and its predecessor companies. It's amazing. Also super fun, Blinkist, sponsor of the show, made a summary for us.
- BGBen Gilbert
Yes. I was texting David before this, listeners, and I was like: I don't think a lot of people are gonna be able to, like, get this book if they want it, and Blinkist agreed to order a copy and then turn it into a Blink. So you can get the Blinkist summary. We'll link to the show notes on how to do that. But David, the other crazy thing is I think Robert may have signed every copy of this book because he signed yours, and he signed the one that I got.
- DRDavid Rosenthal
Oh, amazing. That's how rare this thing is. So back to Sol's growing-up years. He says in the book, there's a quote from him: "In the New York Jewish community at the time, there was no such thing as Republicans. The socialists were the conservatives- [chuckles]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
... and the communists were the radicals."
- BGBen Gilbert
So it really illustrates where Sol's political ideology comes from.
- DRDavid Rosenthal
Absolutely. So as a young child, he develops an eye defect that causes his left eye to droop. He's really self-conscious about this, as you can imagine, but as a result, he channels all of this insecurity into being, like, a massive overachiever in school. So he skips two grades in school growing up, and then, in the middle of his high school years, his parents move the family from New York City to San Diego, California. Now, San Diego, it's a town of, like, 150,000 people. This is not the San Diego we know today. There's no Qualcomm. There's no Illumina. There's only, like, just the beginnings of the US Navy and the defense industry there, but it's a small town. When Sol gets out there to San Diego, in a parallel moment to Sam Walton's early life, Sol meets his future wife while he's in high school, and it turns out that Sol's future wife's first name is Helen, just like Sam's wife name is also Helen, and Sam's wife would be very influential on him, along with her family. Same thing with Sol. So just like Helen Walton, Helen Moskowitz, soon to be Price, comes from one of the wealthiest families in San Diego.
- BGBen Gilbert
This is literally just like San Diego Walmart.
- DRDavid Rosenthal
Literally, that's what's about to happen here, just, like, 10 years before Sam and Walmart.
- BGBen Gilbert
Wow!
- DRDavid Rosenthal
So Helen's family owns and operates a scrap metal business. A scrap metal business in the 1930s in San Diego-... is about as well-positioned as you can possibly be because San Diego is about to go through a huge transformation during World War II. It's gonna become the principal port of the US Navy's Pacific Fleet, which is gonna be the main naval operations of World War II. The city is gonna absolutely boom, and it's gonna be shipbuilding, it's gonna be Navy, it's gonna be metal.
- BGBen Gilbert
David, you and I were just down in San Diego doing our episode with Doug Demuro, and I went and stopped by the Midway Museum 'cause we had just done our Lockheed Martin episode.
- DRDavid Rosenthal
Yeah!
- BGBen Gilbert
And you can feel the history dripping off that thing on all the old airplanes and everything. San Diego has been obviously a huge Navy culture for 75 years now.
- DRDavid Rosenthal
Totally. During and after the war, all these sailors and GIs come through the city, and then when the war is over, and they come back home, wherever they lived in the country before, they're like, "Wait, why am I living in Kansas? I should be living in San Diego." [chuckles]
- BGBen Gilbert
San Diego is pretty great. [laughs]
- DRDavid Rosenthal
It's really nice there. So from 150,000 people when Sol moves there, after the war, San Diego is on a path to becoming... Today, it's the eighth largest city in America. It's larger than Seattle. It's larger than San Francisco.
- BGBen Gilbert
Oh, I wouldn't have guessed that.
- 13:56 – 25:19
Fedco → FedMart: inventing discount retail via membership loopholes
- DRDavid Rosenthal
mean, my parents were lawyers in a small town growing up, you're a lawyer for your clients, but you're kinda also consiglieri. You're advising on business, real estate, negotiations, divorces, trusts, estates. You're, like, super deep with your clients. So after the war, Sol starts counseling all these entrepreneurs with these new retail concept startups that are emerging in San Diego. One of these startups is called the Seven Seas Locker Club, which ostensibly the premise for this business is literally a club of lockers where Navy sailors can store their uniforms when they're on leave and wearing their civilian clothes, and then when they go out to sea, they can store their, like, personal clothes and effects while they're away on the ships.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
But actually, that's just a Trojan horse to get all of these consumers into the door.
- BGBen Gilbert
Oh, it's foot traffic.
- DRDavid Rosenthal
And then they offer all kinds of goods and services to them within the locker club. So there's laundry, there's dry cleaning, there's clothing, there's jewelry, there's food, there's haircuts.
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
This might start to sound a little familiar here. Another client is a jewelry store called Four Star Jewelers. Now, in addition to operating their own jewelry store, these guys also sell jewelry wholesale to other retailers, and it turns out that there's one account in particular [chuckles] that accounts for, like, the vast majority of their outside wholesale business, and it's this odd retail concept operating out of Los Angeles called Fedco. And you're like, "Fedco? What is a Fedco? What is happening here?"
- BGBen Gilbert
It's also like, okay, w- how are they doing so much volume? We should go check it out and see what's going on.
- DRDavid Rosenthal
Yeah, exactly. Well, Fedco, it turns out, was a nonprofit membership club. It was a customer collective, and it was called Fedco because it was only open to federal employees, primarily postal workers. After the war, about 800 postal workers in the Los Angeles area decided somehow that they wanted to pool their buying power together, and they're federal employees.
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
And so they start this club so that they can pool the buying power and get better prices on goods that they can all participate in together. Well, it turns out there are a lot of federal employees [chuckles] out there, especially in San Diego. They charged a membership fee. They charged dues to join, but unlike Costco today, they didn't really make any money on the memberships. Remember, they're a nonprofit. So the cost was $5 one time for a lifetime Fedco membership.
- BGBen Gilbert
[laughs] Yeah, hard to see that working, but actually, it's not so different, inflation-adjusted, from REI's membership today. Very clearly, REI is not interested in making money off the membership program. I pay, what is it, $85 or something once just to grant me sort of a higher affinity to the store, and the money's not really relevant.
- DRDavid Rosenthal
That is the perfect analogy. That's exactly what Fedco is.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
So as you can imagine, Fedco becomes quite popular amongst government employees in the LA area, and then not just the LA area. People start driving from all over Southern California, including San Diego, sometimes up to, like, hundreds of miles round trip to do the majority of their shopping at Fedco.
- BGBen Gilbert
It was time to expand, yeah. But Fedco's a nonprofit. They're not looking to, like, expand and build this huge empire.
- DRDavid Rosenthal
Exactly. So Sol and the jewelry guys, they see what's happening with all of the wholesale business that they're sending to Fedco up in LA, and they're like: Man, we gotta find a way to open a Fedco here in San Diego. And Sol's like: Actually, I might have just the location. It turns out that Helen's family owned a 21,000-square-foot warehouse in San Diego's industrial district that's currently sitting empty. So the three of them go over, they check it out, and they're like, "Oh, yeah, we could totally recreate Fedco in this building right here in San Diego." So if Sol were Sam Walton-... That would be the end of the story right there. He'd just be like, "Great, I'm gonna clone Fedco." No, this is how Sol is different than Sam, and I think probably hearkens back to his upbringing in New York, and, you know, everything that was happening. He calls up the Fedco board of directors in LA, and he says, "Hey, we wanna partner with you guys. We think that a Fedco would do great in San Diego. Can we create a joint venture together? We've got the building. We'll operate the store. Let's go into business together and be partners." Fedco, though, like you said, they're a nonprofit. They're not interested in expansion, so they turn him down, and Sol, God bless him, he calls them back, and he's like, "No, no, no, guys, we really wanna do this."
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
"How about this? You can own the whole business. We'll just be a franchise down in San Diego. You get all the upside, you get all the enterprise value. Like, we don't care. We just wanna bring this to San Diego." And they say no again, 'cause, you know, it's, like, a nonprofit board of directors.
- BGBen Gilbert
Yeah, on the one hand, you might think Sol Price, not a very savvy business person, just take the gift and go with it. On the other hand, ridiculously principled guy.
- DRDavid Rosenthal
There's a really funny Sol quote from, uh, later in his life. He's asked about how he feels about essentially being the father of modern American retailing, and he thinks about it, and he sort of laughs and says, "You know, maybe I should have worn a condom." [laughing]
- BGBen Gilbert
Oh, Sol.
- DRDavid Rosenthal
Oh, Sol. But it's not that he's a rube. He's a really good businessman. He's just also incredibly principled.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
And this is gonna flow through directly into Costco, as we'll see. Okay, back to Fedco. So after this second rejection, Sol and the guys are like, "I guess we now can go do it ourselves." So in November 1954, they open the store in this warehouse location, and, uh, they had to think about what to call it, and they're like, "Well, basically, this is a clone of Fedco, but we can't use that name, and it's kind of a bad name anyway. What if we draft off the same brand recognition, though, and call it Fedmart?"
- BGBen Gilbert
An equally bad name. [laughing]
- DRDavid Rosenthal
[laughing] An equally bad name that would have historic impact. So why do you think Walmart is called Walmart? Why do you think Kmart was called Kmart?
- BGBen Gilbert
Oh, it was the first mart?
- DRDavid Rosenthal
It's because of this. Yes, literally.
- BGBen Gilbert
Oh.
- 25:19 – 34:12
FedMart’s playbook: gas, pharmacy, house brands, and values-first priorities
- DRDavid Rosenthal
happen that are gonna prove very fateful, both for FedMart and for Costco. One, Sol fully stops practicing law and goes full-time with FedMart. He becomes the president of FedMart. Two, he hires a young college student from San Diego City College as a part-time bagger in the San Diego store, one Jim Sinegal, and Jim would end up working for the next twenty-two years at FedMart, directly for Sol. Eventually, Jim ends up running FedMart's entire distribution and centralized warehousing operations. Warehouses, [chuckles] you can see the Costco picture coming together here. Put a pin in that. So FedMart goes public in 1959. They raised two million dollars. They plowed that money into both expanding the number of stores across the country, but also, remember back to Seven Seas Locker Clubs, the suite of goods and services that they're offering under the roof, or in some cases, not under the roof. This is when they add gasoline to FedMart.
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
So the Costco gas lines, like this started with FedMart. They would intentionally price a few cents lower than whatever the other gas stations were charging in the area, and a few cents at that time was a lot, 'cause gas was, like, twenty-five cents. And unlike gas stations, FedMart is making money on consumers shopping in the store as well, so they can price at cost on the gasoline, get all the traffic coming to the store, and then monetize through the store.
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
They add a pharmacy to FedMart. Costco Pharmacy today, people are religious about it. So there's a crazy story. The guy who sets up the pharmacy division for FedMart starts getting death threats from people in the industry. He has a rock thrown through his window. [chuckles] It's literal mafia stuff because they're undercutting the fat margins in these pharmacy counters so much. That guy's protege, who then takes over the pharmacy division for FedMart when he retires, that guy goes on to start Costco's pharmacy division- [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
-and run it. [laughing] Amazing. Most importantly, for the Costco story here, after they go public, FedMart uses part of this capital to develop their own house brand for some of the popular-
- BGBen Gilbert
Hmm
- DRDavid Rosenthal
... products that they're selling on the shelves.
- BGBen Gilbert
It's like the FM brand. Is that right?
- DRDavid Rosenthal
The FM brand, yep. If you ever see FM-branded old photos and stuff of, like, newspaper articles referring to FM Cola, FM whatever, that's what it is. It's FedMart. And then one more piece of FedMart, uh, playbook, shall we say, that clearly makes its way over... As Sol is running the company during these first few years, he starts to codify some retail management philosophies, and he, uh, famously sort of canonizes these as FedMart's four priority order principles, and he teaches every new employee throughout the whole company about this. Number one, first priority, provide the best possible value to customers. Number two, second priority, pay good wages to employees and provide good benefits, including health insurance. This is in the '50s, like, this is progressive stuff. Number three, maintain honest business practices. And then number four, the last one, make money for investors. [chuckles] So if you're a Costco nerd out there, and there are probably many Costco investor nerds listening right now, those all probably sound very familiar to Costco's priority order values. [chuckles]
- BGBen Gilbert
Right. Not the same, but kind of rhymes. Put a pin in it. When it comes to Costco, we'll bring those up and go into each of them in depth.
- DRDavid Rosenthal
So you might be listening and saying like, "Yeah, yeah, yeah, that sounds good, but I'm thinking about, you know, I don't know, maybe I go to Walmart today, or I walk into Target, and I see some similar things written on the walls there. Isn't this kind of all the same?" If you really mean them, no. There are some very, very clear trade-offs that Sol is gonna make with FedMart, that Costco makes today, that are very different from what their competitors do. Like, one, do you sell loss leaders in the store? Loss leaders being when you mark down items below your cost in order to attract people into the store with sales. If you're those other retailers, yeah, of course. This is like a time-honored tactic in retailing. Of course, you're gonna use this.
- BGBen Gilbert
Sam Walton bragged about it in Made in America, about we could get this, you know, incredible number of... I don't even remember what the thing was, but build a pyramid of them in the parking lot and blow them out to get people to come and participate in the spectacle.
- DRDavid Rosenthal
Right. If you're Sol and Costco today, you're absolutely not gonna do this stuff.
- BGBen Gilbert
No, they won't sell something unless they can make money on it.
- DRDavid Rosenthal
Because the flip side of doing loss leaders is that you gotta make up for it somewhere. You gotta mark up other goods in the store to fat margins to make it worth doing the loss leader for you.... basically, it means you're treating your customers like they're stupid.
- BGBen Gilbert
Totally! That's exactly my read on this, too. I feel like, David, Acquired number one tenet, treat the audience like they're smart. If you're gonna ever do loss leaders, you're sort of violating that tenet and saying like, "Eh, we're gonna get one over on our customers."
- DRDavid Rosenthal
Totally. This is anathema to Sol. He passes that down to Jim Sinegal. It's anathema to Jim. Okay, so that's one trade-off. Here's another really big one: What do you pay your employees? So in 2006, Harvard Business Review published a really great piece called The High Cost of Low Wages, where they very directly compare Costco and Walmart employee salaries and benefits.
- BGBen Gilbert
Which, for listeners, if you want those numbers today, Costco's average hourly wage is $26, and Walmart's is $19.50. So huge, huge difference if you are gonna go get an equivalent job at one or the other. On top of that, at Costco today, you also are eligible for a 401k with a match and very, very good healthcare, shockingly good healthcare, even for hourly workers. So if you're gonna go work at one or the other today, you'd be very lucky to go work at Costco.
- DRDavid Rosenthal
So obviously, the trade-off of this is for FedMart at the time, and straight through to Costco today, this creates meaningfully higher per-employee labor costs for the company.
- BGBen Gilbert
Yep, totally. But what are the benefits? And this is where we get this beautifully interlinked set of trade-offs that play well together. So what do you get? Well, you get low employee turnover, and when I say low, I mean very low. After the first year, Costco today has only a seven percent attrition rate among their workforce.
- DRDavid Rosenthal
This is wild. This is for hourly labor.
- BGBen Gilbert
Yes. Typical retail is twenty percent, so it is a meaningfully lower cost to onboard and train new employees. Like, you normally have to spend a lot of your money ramping people to get them up to speed. Costco, Price Club, FedMart, doesn't have to do any of that because they're really rewarding their employees. Employee loyalty also reinforces the idea that people shouldn't steal. They feel grateful for this job. They're excited to be in it. The shrinkage, or the, uh, unaccounted for merchandise at Costco today, is astonishingly low. It is zero point one five percent of sales.
- DRDavid Rosenthal
That's crazy!
- BGBen Gilbert
So merchandise does not walk out the door. Their strong bias also is to promote internally. So if you look at Costco today, thirty-six percent of US employees have over ten years of service.
- DRDavid Rosenthal
And this is truly unique, I think, about Costco among major American, at least, corporations, and was true at Price Club and FedMart before it. The senior, senior management, this is the same story. I mean, Jim started as a grocery bagger in the '50s at FedMart. Craig Jelinek started his career as an hourly employee at FedMart. This is how long the tenure is of these people and how linked these stories are.
- BGBen Gilbert
If you look at their executive team at Costco today, basically all of them have been there for over twenty-five years. The only vice presidents at the company who have not are the digital e-commerce people that they had to bring in to address some issues.
- DRDavid Rosenthal
Decades ago.
- BGBen Gilbert
It's crazy!
- 34:12 – 42:49
Why FedMart collapses: capital war, a bad deal, and Sol getting locked out
- DRDavid Rosenthal
So what happens? FedMart truly was the first discounter that scaled nationally. All of these innovations, even though Sol came up with them, as these other companies are scaling, and I think particularly Kmart, they don't really have the large-scale operational expertise nor the access to capital to really fend off the competition. Kmart, if you remember back to our Walmart episode, came out of the Kresge Department Store chain, which was huge, so they had so much more access to capital, certainly than FedMart, and even than Sam Walton and Walmart. You know, Sam had to fight bitterly, last mile by last mile, building out his distribution network to beat Kmart. Sol and FedMart, they don't really have the firepower to compete.
- BGBen Gilbert
So they need capital, or they need to sell the business, one or the other, and it seems like what they kinda did was accidentally both.
- DRDavid Rosenthal
Yeah. In the biography, Sol comments to his son, Robert, who had also joined the company, joined FedMart at this time. He says, quote, "We're good at creating businesses. We're not as good at running businesses."
- BGBen Gilbert
Yeah. So what we're about to get to is where they're sort of looking for a capital partner, and I think they accidentally find themselves selling the business. But before we tell that story, it's time to thank one of our favorite companies, Statsig. And one common thread from all the retail companies that we've talked about, Walmart, Amazon, and now Costco, is their obsession with making decisions based on data, even decades ago. At the time, this was not cheap. Remember Amazon's early Oracle database or that Sam Walton built out a private satellite network to get real-time sales data? But their approach made it possible to take huge bets, reinvest in the things that worked, and shut down the projects that failed. These practices are now table stakes for great retailers.
- DRDavid Rosenthal
Indeed, and fortunately, it's a lot easier to build a data-driven culture now than it used to be, thanks to Statsig. Thousands of companies, from startups to large enterprises, all use Statsig to do experiments in their products, automate the analysis, launch new features, and analyze product performance. If you're building software products, Statsig is the one-stop platform you need for product experimentation, feature flags, and analytics. Instead of expensive, clunky, and disjointed point solutions, or building internal tools that are always under-resourced for this kind of stuff-... Statsig just works, and they help teams move fast with data they can trust.
- BGBen Gilbert
Yep. So one of the world's largest retailers, Flipkart-
- DRDavid Rosenthal
Part of the Walmart empire.
- BGBen Gilbert
That's right, actually uses Statsig today to run experiments and ship features to hundreds of millions of users. When they started working with Statsig, Flipkart already had a strong data-driven culture, but they needed better experimentation tools. Today, they have hundreds of engineers, data scientists, and PMs who use Statsig, and it's helped them dramatically increase their pace of launching new things and measuring them. The Statsig team has a crazy amount of expertise in this area. We did a whole ACQ2 episode in February with Vijay Raji, their CEO, and the rest of the team is also made up of people who built things like Facebook Ads, Office 365, and Facebook Marketplace.
- DRDavid Rosenthal
So if you're a startup, they have a super generous free tier and a special program for venture-backed companies. And if you're a large enterprise, they have clear, transparent pricing with no seat-based fees for small features. Acquired community members can take advantage of a special offer, including five million free events a month and white glove onboarding support. Just go visit statsig.com/acquired. That's S-T-A-T-S-I-G.com/acquired to get started on your data-driven journey.
- BGBen Gilbert
All right, David, so what happens with Fedmart?
- DRDavid Rosenthal
So like you say, by the time we get to the end of the '60s, early '70s, Sol's burned out. He and Robert, they don't want to be running this business at scale. First, he brings in, quote-unquote, "professional management" and moves up to chairman of the board. Second, he starts looking around for a capital partner to help the business compete on a more level playing field with the other discounters. They end up going to Europe, and this is super important, both for the drama that happens, but also leading into Price Club and Costco. At the time, in the '70s, this new retail concept in Europe was getting going, actually pioneered by the French company Carrefour, which is still a huge global retailer today, and that concept is the hypermarket. So what are hypermarkets? Hypermarkets are smashing together everything we were just talking about with the discounters, the, you know, general goods retailing, with a full-scale grocery store supermarket, so fresh food, everything. This is what almost every Walmart is today, the supercenters. It's grocery and hard goods in one huge, enormous warehouse, you might say.
- BGBen Gilbert
Which is funny, you would have assumed that the Americans would pioneer that. It's hilarious that the French did.
- DRDavid Rosenthal
It was the French, of all people! [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
So this concept didn't exist yet, and it wasn't until the late '80s that Walmart would really embrace it and roll it out across America. So as Sol and Robert are looking for partners to take Fedmart to the next level and going across Europe, they're meeting with all these hypermarket operators. So they end up getting into bed with one of the German clones, run by a retail entrepreneur named Hugo Mann. The idea was that Mann was gonna help Sol and Fedmart take this hypermarket concept and morph the existing Fedmart stores into hypermarkets, which Walmart would do to great success, but, like, 15 years later. Had this happened, we would be telling a very different story today.
- BGBen Gilbert
And we might all be shopping at Fedmarts.
- DRDavid Rosenthal
Totally.
- BGBen Gilbert
In practice, what ended up happening is this weird thing where Sol Price was an innovator and a great merchant, but not a deal guy, and so it seems like there's two cardinal sins that get committed. One, not really asking Hugo Mann, "Why do you want to do this deal, and what is interesting about this to you, and what do you want to do with the combined company?" And then, two, selling the majority of it and treating them like a minority investor.
- DRDavid Rosenthal
Yeah, Sol is looking for a growth investor, and he ends up getting a buyout.
- BGBen Gilbert
Yeah, one with misaligned interests.
- DRDavid Rosenthal
So within a few months of when the deal actually closes, perhaps predictably, Sol and Hugo get in a huge fight.
- BGBen Gilbert
At the very first board meeting.
- DRDavid Rosenthal
The very first board meeting, they're, like, yelling at each other. This is not going well. Mann fires Sol, literally fires Sol, I think, and Robert, too, and changes the locks on their office doors.
- BGBen Gilbert
Oh!
- DRDavid Rosenthal
Literally boots Sol out of his own company. [chuckles] It's super ugly. And then the person at Fedmart, of the remaining executives, who they task with, you think, like, doing an all-hands or the equivalent of, and, you know, inform the rest of the company what's just happened... You know who that was?
- BGBen Gilbert
No.
- DRDavid Rosenthal
Jim Sinegal.
- BGBen Gilbert
No way!
- DRDavid Rosenthal
Yes. [laughing]
- BGBen Gilbert
[laughing] Wow.
- 42:49 – 49:37
Price Club is born: turning warehouse ops into the core business
- DRDavid Rosenthal
Yeah, and then would go on to start TSMC. So Sol and Robert, together, they-... get a lease on an office literally the next day after they're booted out, and they're like, "We're doing it again. We're back in the saddle. "
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
"Let's go!" [laughing] But they know they're not gonna compete directly with Fedmart because Fedmart is failing at that. They're gonna get steamrolled by Walmart, and Kmart, and Target, and everybody else.
- BGBen Gilbert
By the way, Fedmart, within five years, was, like, completely dead after this acquisition.
- DRDavid Rosenthal
Totally ran into the ground.
- BGBen Gilbert
And Hugo Mann did make a fortune on the real estate, but yeah, Fedmart's dead.
- DRDavid Rosenthal
Yep. So Sol and Robert are sitting around in their new office, brainstorming what's their angle of attack here, and they keep coming back to one part of the Fedmart business that they felt was underappreciated, and they didn't really exploit enough while they were at Fedmart, and that is the division that Jim Sinegal ran, the centralized warehousing operations. So the two of them are like, "You know, if we zoom out, there really is kind of a different and orthogonal way to think about the Fedmart business. You really could say that Jim ran our warehouse operations kind of like its own business. They were supplying the individual Fedmart stores, which were sort of smaller businesses, and when you look at it that way, almost all of the margin that we made at the company was at the warehouse level. The stores themselves were not particularly profitable and pretty hard to compete with the competition out there."
- BGBen Gilbert
I didn't realize that they thought to sort of slice the margin up into those two, almost like places in the value chain.
- DRDavid Rosenthal
Yeah. So they're like, "Well, is there a way that we could take Jim's operation, recreate it, and make that the core business instead?" And so the business plan that they come up with is literally that: create warehouses for other individual small businesses, other retailers, and they're envisioning like gas stations, restaurants, small variety stores, and the like, independent chains, that they can come and shop to stock their own shelves at this centralized warehouse that we're gonna operate.
- BGBen Gilbert
So just business owners can be members?
- DRDavid Rosenthal
Just business owners. And they're like, "Man, if we did that, I think that would be providing a huge service to these small businesses because one of their big problems that we know from operating the Fedmart stores is actually how you manage your inventory, like physically where you put it. You know, you need a centralized warehouse to hold your inventory. If you're a small gas station, you don't have your own warehouse. We can be your warehouse."
- BGBen Gilbert
Right. And to put a finer point on it, the reason why it's awesome to just run warehouse operations is because the logistics are simple. You are taking pallets of stuff, and you are moving it to a location in a warehouse, and then the customer comes and takes a huge amount of it off your hands. You don't really have to turn and make sure the labels are facing out, and you don't have to deal with, oh, little one-off, you know, we've only sold sixteen units, but there's actually a hundred and twenty-seven units on this thing, so that you just... Everything is nice, easy, big quantities, doesn't require a lot of attention from your staff. Being in the wholesale business is good if you can get it, but their inclination at this time is: Well, the only people who would be willing to shop and buy in that way are business owners. This would never work as a consumer concept.
- DRDavid Rosenthal
Yep. All of that, totally true, and amazing parts of the Costco model. There's one piece in particular that really, really makes this a crown jewel, and it's the reason why they were so enamored of what Jim was doing. If you're operating a wholesale warehouse, you don't have to operate any logistics. The manufacturers deliver the product right into your warehouse. You don't need to run trucks. You don't need to operate other warehouses. You don't need to move stuff around the country.
- BGBen Gilbert
Right, and the business owners just come to you and pick it up right from the warehouse where it was delivered, right from the manufacturer.
- DRDavid Rosenthal
Totally, and because of all this, because this new business, this Costco Price Club, [chuckles] gonna be called Price Club, is providing such a valuable service to the small businesses that are shopping there in managing all these logistics for them, or I shouldn't say managing, because Price Club doesn't manage it either. [chuckles] The manufacturers do. They're like, "We can actually go back to that original Fedco membership idea, and instead of having it just be like a way to skirt around the law, we can charge real money for this membership because we're providing real value out of this to the businesses."
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
So once they hit on this business plan, Sol and Robert poach a few people from Fedmart and elsewhere, including they hire this super bright young guy from Harvard Business School named Giles Bateman as their CFO, and then they go get started. Giles would later go on to become chairman of... Do you know this, Ben?
- BGBen Gilbert
No.
- DRDavid Rosenthal
Comp USA.
- BGBen Gilbert
Really?
- DRDavid Rosenthal
A big part of my childhood. [laughing]
- BGBen Gilbert
Ah.
- DRDavid Rosenthal
And part of the enormous diaspora of retailers that come out of not only Fedmart but Price Club. Jim Sinegal, after, I think he was probably locked up at Fedmart under new management for a while, after that, he would come over and briefly work at Price Club a couple years later, so, like, the best of the best are coming through this place.
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
So they decide, as they're getting started, that in order to keep the operations really tight and realize the maximum benefit, Ben, of everything you are describing of how these warehouses operate-... They're only gonna stock about three thousand of the highest volume items that they think most other retailers are gonna sell to their customers. So at the time, Walmarts and Kmarts had on the order of about fifty thousand SKUs, and even FedMart had probably close to that many at the time. Going all the way down to three thousand, this is a non-consensus move.
- BGBen Gilbert
Totally. But if you're only selling to businesses and they have small stores, it's not like we need to stock basically everything under the sun. It just needs to kinda be sufficient.
- 49:37 – 55:41
The consumer breakthrough: group memberships + the birth of the $1.50 hot dog
- DRDavid Rosenthal
Right, super important. Remember, they are not thinking about consumers just yet. However, when they launch the first store, when they open the first Price Club in San Diego, unlike FedMart, it's not an initial gangbuster success. Turns out it's a lot harder to sell and recruit businesses to come be your customers than it is just putting out a shingle and attracting consumers.
- BGBen Gilbert
And there's not like a viral word-of-mouth necessarily among these business owners. They're not just encountering each other everywhere all the time.
- DRDavid Rosenthal
Exactly. So they're worried after a couple months that this thing might not work, they might need to shut it down. And then they have the greatest stroke of luck. So they're going around San Diego trying to sell memberships to businesses, and they get a meeting with the San Diego City Credit Union. And the credit union management are like: "We're a credit union. We're not a retailer. We don't really buy much stuff. We're not interested in this. But you know what? Our members, if we could find a way to get them access to what you're doing here, that might be a really good benefit that we could offer of, like, 'Oh, you can get wholesale prices on goods.'" So Giles, the wunderkind young CFO, he goes over to the credit union, hammers out a deal whereby any credit union member can qualify for a new, quote-unquote, "group membership plan" at Price Club and be allowed to shop there, just at slightly higher prices than the business members. It turns out that this does two things. One, this unlocks the gusher of consumers into Price Club.
- BGBen Gilbert
Which allows for not only volume, but word of mouth. This is the seeds that are sown of... Costco today doesn't really advertise, and this is the first moment that they realize, "Oh, my gosh, consumers are going to tell each other about this thing."
- DRDavid Rosenthal
Exactly, and it's even better than that, because not only do consumers tell other consumers, it turns out that a lot of small business owners are also consumers. So it also drives small business owner membership. And because the business members get slightly better pricing on things, all of a sudden, all these consumers are running around being like: "Oh, hey, I think my aunt owns a nail salon," or something like that. Like, "Let me get her to go sign up and get a membership, and then I can use her card and get better prices."
- BGBen Gilbert
Yep. And David, do you know what I did this week?
- DRDavid Rosenthal
Uh, I suspect that you drove to a Costco.
- BGBen Gilbert
And do you know what now has a business membership to Costco?
- DRDavid Rosenthal
Oh, hell, yeah. [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
Where's my card?
- BGBen Gilbert
Actually, I think you need to go in and have your picture taken. I was on a personal one before, but while I was there, I was like, "You know what would be appropriate this week?" So we now have a business membership.
- DRDavid Rosenthal
Hey, we are a small business.
- BGBen Gilbert
That's right.
- DRDavid Rosenthal
I love it. Another fun story. As this unlocks the viral consumer word-of-mouth channel, of course, traffic at this first San Diego Price Club store starts growing and growing and growing. Sol and Robert start getting calls from local hot dog vendors that wanna set up carts at the store's exit.
- BGBen Gilbert
If you got traffic, you know, you may as well, uh-
- DRDavid Rosenthal
You're gonna attract hot dog vendors.
- BGBen Gilbert
That's right.
- DRDavid Rosenthal
So at first, they ignore them. Eventually, though, they start getting enough calls, they're like: "Huh, maybe we should do something about this. And maybe rather than letting these guys come set up their carts, what if we do it ourselves?" So Sol calls up Hebrew National hot dogs and asks them if they can supply them with hot dogs to sell at the stores. And Hebrew says, "Not only will we sell you hot dogs to sell, we'll supply the cart, too." [chuckles]
- BGBen Gilbert
[chuckles]
- DRDavid Rosenthal
And thus, the Costco dollar fifty hot dog and soda deal is born. And still to this day, it's a buck fifty, forty-seven years later.
- BGBen Gilbert
There's a decent chance this is the one and only loss leader that Costco sells today.
- DRDavid Rosenthal
Yeah, they're a little cagey about what the actual costs are.
- BGBen Gilbert
Yes.
- DRDavid Rosenthal
I do know that they've gone through many, many iterations, in-housing all the operations to try and keep their costs down.
- BGBen Gilbert
Oh, they actually make the hot dogs now.
- DRDavid Rosenthal
Yep.
- BGBen Gilbert
They also sell a hundred and thirty million of them per year.
- DRDavid Rosenthal
Wow. [chuckles]
- BGBen Gilbert
That's not all in America, but if it were, that's like a third of America going to Costco and getting a hot dog every year.
- 55:41 – 1:07:39
The money machine: negative cash conversion cycle and the low-SKU flywheel
- DRDavid Rosenthal
So on the back of this wild success in San Diego, once again, Sol and Price Club quickly expand, just like with FedMart, first to Arizona, and then beyond. This time, though, it's way different than FedMart vis-à-vis competition and capital dynamics. So whereas FedMart was capital-constrained relative to the competitors, because of the genius aspects of this Price Club model, they are cash flow geysers, these stores. So the suppliers handle the logistics, deliver directly into the warehouses-
- BGBen Gilbert
So let's just follow the cash flow cycle. They deliver to the warehouse. The moment they drop off that pallet is when they invoice Price Club, and invoices tend to be about net thirty. So that means the pallet gets dropped off, and you have thirty days to pay the supplier.
- DRDavid Rosenthal
But the minute that the pallet gets dropped off in the warehouse, those goods are for sale.
- BGBen Gilbert
Right. No more internal supply chain, no more unpacking, no more shelving. It's just available to buy now.
- DRDavid Rosenthal
So in many, if not close to all cases, with Price Club and then with Costco today, those goods are sold before Price Club has to pay the invoice to the supplier. It's amazing!
- BGBen Gilbert
All right, David, I got a bunch of great stuff for you on this one. So we're gonna flash forward a little bit to today, but I have a huge thank you for Costco Chief Financial Officer Richard Galanti, spent an entire afternoon with me walking through a lot of these characteristics that really make Costco work. So I got a bunch of great tidbits while I was hanging out in their campus outside Seattle that I'll-
- DRDavid Rosenthal
Where was my invite? [chuckles]
- BGBen Gilbert
I invited you. You could've gotten on a plane.
- DRDavid Rosenthal
Uh, true. [chuckles]
- BGBen Gilbert
All right, so here's how it all works today. So Costco actually turns their inventory twelve point four times per year, and just for comparison, Walmart turns their inventory eight times per year. Home Depot is more like five times per year. So at this number, north of twelve times a year, David, exactly what you're saying, it means Costco can sell through its inventory faster and more often than every thirty days. To be specific, they're on about a twenty-six, twenty-seven day sale.
- DRDavid Rosenthal
This is amazing.
- BGBen Gilbert
So with typical payment terms being net thirty, it means they literally have zero dollars tied up in inventory, and in fact, they're able, to your point, to make a few bucks on the float. So this is, of course, an average. There are some things that will sell in a week or two. Other big-ticket items might sit for a month or two. Sometimes Costco can even turn things two or three times before they have to pay a supplier for it. So this is called a negative cash conversion cycle, where vendors effectively finance Costco's inventory for them.
- DRDavid Rosenthal
You know what? I'm in. I capitulate. I'm with Charlie on this one. He can come in here and give the speech ten times in a row about how great Costco is. I will listen to all of it.
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
I am in love with this company.
- BGBen Gilbert
So there's a couple interesting components here. There are companies that can achieve a negative cash conversion cycle, but the way they do it is by having predatory terms, where they go to their suppliers and say, "I'm not gonna pay you for, like, three or six months," and that is one way to do it. Costco is using standard payment terms here.
- DRDavid Rosenthal
Right, thirty days!
- BGBen Gilbert
And so there's two unique things that enable them to do it. One is this warehouse model, where things are instantly available for sale. Customers come right to the place where they were dropped off, not quite anymore, and we'll get to that later, but at Price Club, that's definitely what it was, and grab stuff right off the pallet. The other thing that makes it all work is, to this day, Costco has kept their SKU count very low. SKU, S-K-U, being a unique item that a store has for sale. I think, David, you mentioned before, about three thousand at Price Club is what they had available for sale. If you look at a Walmart today, they have something like a hundred thousand to a hundred and fifty thousand different SKUs that they sell.
- DRDavid Rosenthal
Supercenters indeed.
- BGBen Gilbert
Costco, in the last ten years, was around forty-five hundred, and then they sort of looked and said, "Can we bring it down?" And went to four thousand, and today, they're sitting at thirty-eight hundred. So this number is still going down, not up, and if you do the math and you start thinking, well, geez, if you're not selling a lot of SKUs but you have a lot of customers coming through your stores, what does that mean? It means that any given item is gonna turn faster. It's sort of this magical unlock. In addition to the instantly available for sale in the warehouse thing, it is the low SKU count that directly gives you the ability to turn your inventory over quickly.
- DRDavid Rosenthal
It's just so awesome. I mean, like, if you look at a Price Club then, and certainly a Costco today, "capital light," quote, unquote, would be the farthest thing from your mind. You're like, "These are massive structures. There must be so much money that goes into this." Well, yes, that's true, but it's a capital-light business model.
- BGBen Gilbert
It's wild.
- DRDavid Rosenthal
It's all being financed for you by your suppliers because of these dynamics.
- BGBen Gilbert
And of course, today, as Costco opens new warehouses, they can very tightly predict how they'll perform because they know how all, all the other ones perform. And so, sure, there's a lot of upfront money in opening a new store, but once it happens, you sort of know exactly what it's gonna mature to and exactly how your ROI positive on all your fixed costs to invest in that new location, and you have this negative cash conversion cycle, with all of your inventory being effectively free, if not profitable for you while it sits there.
- DRDavid Rosenthal
Amazing.... All right, so let's take the story now from this Price Club moment of genius initial success through to Costco today. But before we do, we have one of our very favorite companies to tell you about, Blinkist, and we are doing something pretty special with them this season. Blinkist, as most of you know by now, takes books and condenses them into the most important points, so you can read or listen to the summaries. It's really great if you want to read more books and just don't have the time.
- BGBen Gilbert
Totally. We have a couple of very cool things to announce today. One, David and I have made a Blinkist page that represents our bookshelf. So if you want to read the books that influence David and I, you can go to blinkist.com/acquired. For this particular episode on Costco, this is point two, we mentioned that there's basically one book about Costco and Price Club, and it is self-published by Sol Price's son, Robert Price. As you can imagine, it's out of print. We managed to get our hands on three of them. Two of the copies are held by David and myself to do the research, and the third is at Blinkist HQ. And Blinkist has turned this book, Sol Price: Retail Revolutionary and Social Innovator, into a Blink, where you can get access for free at blinkist.com/costco. They're also including other books in that collection that are about doing a few things, but very well, like the book Essentialism, which is from friend of the show, Brad Gerstner. That is one of his favorite books. If you click the link, you will get free access to Costco Blinkist collection, and anyone who uses that link or uses the coupon code Costco will get fifty percent off a premium subscription to all sixty-five hundred titles in their library.
- DRDavid Rosenthal
Super cool. And for those of you who are leaders at companies, check out Blinkist for Business. This gives your whole team the power to tap into world-class knowledge right from their phones anytime they need it. On top of that, there's also coaching by Blinkist, which is great for leaders. This is tailored for personal and organizational goals. It's like having a coach in your pocket, helping with everything from management to leadership, and it's used by over fifteen hundred organizations, from Hyundai to Chick-fil-A.
- BGBen Gilbert
Our sincere thanks to Blinkist and their new parent company, GoOne, where David and I are huge fans and angel investors. GoOne and Blinkist are both amazing ways for your companies to get access to the most engaging and compelling content in the world. Click the links in the show notes. Okay, David, so take us from the first Price Club through to Costco.
- DRDavid Rosenthal
So on the back of these eighth wonder of the world, like cash flow dynamics, that these Price Club warehouses have, Price Club goes public in nineteen seventy-nine, three years after founding. And I say go public, not in an IPO, not in a direct listing. They don't list anywhere. They don't raise any money 'cause they don't need any capital. So what happens is there's so much buying and selling activity among the original shareholders because this thing has become so valuable, that this is the first time I've actually ever heard of this happening. Price Club crosses the five hundred shareholder mark that at the time, the SEC mandated if you had more than five hundred separate shareholders of a company, you had to start filing as a public company. So Price Club's just like: "Okay, we'll file. We'll be a public company." They don't list on an exchange. They're just like-
- BGBen Gilbert
Really?
- 1:07:39 – 1:14:22
Costco launches: Jim Sinegal, the Brotmans, and execution at scale
- DRDavid Rosenthal
Now we have to. So this now brings us finally to one more call that Sol gets, also in 1982. There are these, like, years in retailing, 1962, when Walmart and Kmart and Target start, 1982, when all this is happening. Another Bernie, this time a Seattle retailer named Bernie Brotman, and his son Jeff, call up Sol, and they say, "Sol, this Price Club thing is fantastic. We're retailers up in the Northwest, up in Seattle. We'd love to open a franchise up here, a Price Club franchise in Seattle." This is just like the Fedco/FedMart days, and Sol and the Price Club management team think about it, and they make the very poor decision to say no. And in a same echo of what happened, gosh, thirty years earlier, Bernie and Jeff say, "Okay, we understand. We're gonna do it anyway. We're gonna clone the Price Club model and start the same thing up in Seattle." And again, I think Sol is totally fine with this.
- BGBen Gilbert
'Cause was Price Club growing aggressively?
- DRDavid Rosenthal
They were, but they weren't planning to go to the Northwest. They were following the old sort of trade routes of the FedMart playbook of Arizona, Texas, Florida, going out across the South and the Midwest.
- BGBen Gilbert
Hmm.
- DRDavid Rosenthal
So what happens next is pretty hilarious. Jeff Brotman cold calls Price Club's head of merchandising and says, "Hey, my family and us, we're starting up a Price Club clone up in Seattle. We actually think the Northwest is a great market for this. Would you be willing to leave Price Club and come up and be my co-founder?" And the head of merchandising is like: "Well, no. Not because I don't think it's a good idea, [chuckles] but, you see, Sol Price is my uncle." [laughing] And he's like, "But let me give you the number of somebody else who you really should call. I think this guy is the right guy for you. We've worked with him for a long time here at FedMart and Price Club. He's now left. He's doing some retail consulting, so he'll probably be willing to talk to you." His name is Jim Sinegal.
- BGBen Gilbert
Ba-na-na!
- DRDavid Rosenthal
And this is how it all comes together. Jeff calls Jim, convinces him to come up to Seattle. He's ready. He's ready to run his own show, as they say. So Jim moves up to Seattle, they start Costco, and the business plan is really pretty much exactly just clone Price Club.
- BGBen Gilbert
And Jim really is Sol's protege. It's like clone Price Club, but with a guy at the helm who is built for scale and absolute focus on the details.
- DRDavid Rosenthal
Yep, and not only was he Sol's protege, not only is he a tremendous generational talent executor, he also is the guy who ran the division that inspired the whole thing. [laughing]
- BGBen Gilbert
[laughing]
- DRDavid Rosenthal
He really is the perfect guy.
- BGBen Gilbert
And so, listeners, you might be realizing now, when we were saying at the top of the episode, this really is kind of all one company story, it really is. There is a straight line through from Fedco to FedMart, or let's even just start it at FedMart, since it's all the same people, through to Costco today.
- DRDavid Rosenthal
So Jim moves up to Seattle. He and the Brotmans raise seven and a half million dollars to get going.
- BGBen Gilbert
Yep. They sell fifty percent of the company. To do that, they recruit eight people immediately, mostly from FedMart, some from Price Club, and they're all sort of forties and fifties. This is like a gang of ten, twelve people who have all worked together before, industry veterans, have shorthand, and they are just like: "We've got the money. Okay, go. We know exactly what to do."
- DRDavid Rosenthal
I mean, literally, it's like the TSMC story.
- BGBen Gilbert
Or like the Zoom story. It's like Eric Yuan finding forty people who knew exactly how to build Zoom and then just doing it.
- DRDavid Rosenthal
Yep. So great. So within a couple months, they open the first Costco warehouse in Seattle. Then a few months later, they open the second in Portland. Of course, both of them take off immediately. Then they go to Utah, to Northern California, to British Columbia, and this is where you can see that what Sol said about being really great creatively in business at the prices in Price Club, but not great at execution... Why was Price Club not in Northern California, [chuckles] given that they started in Southern California? These are the kind of mistakes that they made. So this new Costco under Jim hits a billion dollars in revenue in less than three years after getting started. [chuckles] This is in the eighties!
- BGBen Gilbert
And three billion in less than six years, which is the first company ever to hit that milestone, too.
- DRDavid Rosenthal
It's wild. They go public in, what, two-plus years after founding?
- BGBen Gilbert
Yeah, 1985, they go public.
- DRDavid Rosenthal
Crazy. Once this plays out, and of course, Sam's Club is also becoming a juggernaut at this point in time, Price Club is doing fine. Again, capital is not the competitive vector here, but they're not being as aggressive, they're not expanding as fast as Costco and Sam's Club. What happens with Price Club is, in some ways, sort of the same as what happened with FedMart. You know, as Sol readily admits, he and Robert are great at creative ideas in retail. They're not so great at scale execution. Now, it's different in that capital is not a competitive vector here. Back in the FedMart days, FedMart was constrained. You know, the whole reason they went looking for a capital partner was they needed more capital in order to be able to grow stores and compete with Walmart and Kmart.... These Price Club warehouses were paying back their capital investment quite quickly, especially relative to FedMart, because of the cash flow dynamics that we were talking about. So Price Club was certainly doing fine. It wasn't declining, but Jim and Jeff at Costco, and certainly Sam at Walmart and Sam's Club, they are pedal to the metal, aggressively expanding, and that's not really Sol and Robert's MO.
- BGBen Gilbert
No, and it does- if you kind of read between the lines in some of this stuff, it does kind of seem like Costco wasn't poaching people from Price Club, but a lot of really good people sort of found their way and went and got jobs at Costco. So Costco definitely had, at this point, the base of the sort of most aggressive, talented wholesalers of the West Coast.
- 1:14:22 – 1:18:48
Reuniting the family: the 1993 Price Club–Costco merger + Sol’s later life
- DRDavid Rosenthal
Yep, totally. And Sol, at this point in his life, he's sort of proved himself again. He's made his point after his terrible exit out of FedMart. He steps back from the day-to-day of the business. He hands that over to Robert. He gets really into real estate. He's not as aggressive as he once was. So in June nineteen ninety-three, Costco and Price Club merged together to form the united Price Costco, and as we've talked about, this really is a reuniting of them.
- BGBen Gilbert
And at the end of the day, Price Club was either gonna land with Walmart or with Costco, and Sol Price didn't want it to be Walmart, and very, very much wanted to join forces with Jim Sinegal, and so they sort of made that happen. This was the natural successor for this combined business in Jim Sinegal.
- DRDavid Rosenthal
Now, interestingly, the transaction really is about as close to a merger of equals as I think we've ever seen on the show, with the caveat that Jim is clearly gonna be the CEO that's gonna run the combined company. At the transaction, fifty-two percent of the equity in the combined company goes to Costco shareholders, forty-eight percent to Price Club shareholders. They're about the same size, about a hundred stores each at the time of the transaction, but Costco is growing way faster. So had they just waited a couple years, the balance of favor would've been way far in the Costco side of things.
- BGBen Gilbert
Yeah, and you sort of get the sense that the Costco folks were being very respectful of the Price Club folks because I believe it was something like a thirty-plus percent premium paid for Price Club stock, and so I think it was everyone sort of looking at each other and Costco sort of knowing that they could really buy Price Club for a much smaller relative percentage in the future, but why don't we just do this today? I know it's a good deal for Price Club folks, and let's just say pseudo-merger of equals. Let's call it, and let's be one team from now on.
- DRDavid Rosenthal
Yep, and there was a forcing function to this. It wasn't just that Jim had a soft spot for his mentor, Sol, and for Price Club. Sam's Club and Walmart was aggressively expanding at this point in time, and so if they had waited too much longer, Sam's Club would've just gotten huge and potentially run away with the market. So after the merger happens, even the newly combined Price Costco is still only a hair bigger than Sam's Club in terms of number of stores and revenue, so they kinda needed to do it pretty quickly, or Sam's was gonna run away with it.
- BGBen Gilbert
Fascinating, which is so funny because it's a much less disciplined business. Every bit of DNA in Costco and Price Club is just so unbelievably disciplined and an admirable way to run a business, and Sam's Club strikes me as a bunch of cowboys who are changing strategies all the time.
- DRDavid Rosenthal
Well, you know, it's a second business line under Walmart, of which the main Walmart Supercenter business line is one of, if not the greatest retail business of all time. [chuckles] It's certainly the biggest still to this day.
- BGBen Gilbert
Yep.
- DRDavid Rosenthal
Sol, kind of amazingly, lives to be ninety-three years old. He passes away in two thousand and nine. After the merger, he really devotes the rest of his life, the next fifteen plus years, to philanthropy and politics. So he does a ton of charitable development in San Diego. He gives back to USC. USC's public policy school is the Price School of Public Policy because he also becomes super involved in Democratic politics, and actually, when Obama is running for president in his first campaign in two thousand and eight, he comes through San Diego and meets with Sol Price. You know-
- BGBen Gilbert
Wow!
- DRDavid Rosenthal
... Ninety-two-year-old Sol Price. That's how influential he is, how much money he's giving to the Democratic Party in this kinda last chapter of his life.
- BGBen Gilbert
Do you know who speaks at the twenty twelve DNC when Obama is getting reelected?
- DRDavid Rosenthal
I do, Jim Sinegal. [chuckles]
- BGBen Gilbert
Yep. So they really are... When I say ideologically similar or the natural successor or almost like another son of Sol Price, Jim Sinegal and Sol Price really are of one mind in many ways.
- DRDavid Rosenthal
Except Jim is a way better executor. [laughing]
- BGBen Gilbert
[laughing]
- 1:18:48 – 1:33:23
How Costco actually makes it work: membership psychology, margin caps, and ethics
- BGBen Gilbert
All right, so let's talk about the execution of this business a little bit, and there's some concepts that I think we've talked about at a high level, but we haven't really drilled into why they work so well, and honestly, I have, like, ten or twelve of these, David. So we're gonna talk about two important ones now, and then we'll get into more as we sort of make our way to modern day a little bit.
- DRDavid Rosenthal
Yeah, let's do it.
- BGBen Gilbert
So one that we haven't talked about is the economics of membership, and there's the obvious ones that everyone sort of realizes. Today, the base level membership is sixty dollars, and as a consumer, I assume I'm getting some kinda good deal by paying sixty dollars, and that even before learning too much about Costco, I'm aware that that sixty dollars is something I'm paying up front to get the benefit of some low prices later. But let's analyze some of the second-order effects of membership, which I think are potentially even more interesting than the obvious ones.
- DRDavid Rosenthal
There's a lot of psychology happening here.
- BGBen Gilbert
Yes.... The first one is that it actually selects for wealthy customers.
- DRDavid Rosenthal
Yes! This is amazing.
- BGBen Gilbert
As does buying in bulk. So the items that you're buying are literally cheaper per unit, so you're saving money, but you need to buy a lot of it upfront, just like you need to pay a membership fee upfront, which means that they tend to get members who are not sensitive to cash flow, and they also tend to get members who have space to store stuff at home. And so I looked into some of the data on this to try and put some numbers to it. There was an independent research firm that found that the typical Costco consumer makes about $125,000 a year in household income and has a four-year degree. Walmart, by comparison, has a median income of about $80,000. And keep in mind, the median US income is $71,000, so Costco shoppers have a seventy percent higher income than the US median.
- DRDavid Rosenthal
Yeah, this is one of the most surprising things about Costco. They have the lowest prices, but they have the wealthiest consumers of any major retailer. [chuckles]
- BGBen Gilbert
Yes, it's totally fascinating, and very smart consumers, people who can kinda look at the deal and go, "Actually, I know I'm coming out ahead on this." Another interesting psychology around this is when you pay sixty dollars upfront, it encourages you to come and use the membership. You are more likely to shop because you've prepaid some of your margin dollars.
- DRDavid Rosenthal
I think this is called the endowment effect, if I remember back to my psychology classes.
- BGBen Gilbert
Yes. You just sort of assume that you're getting some kinda good deal by prepaying for a membership upfront, so you wanna go maximize the margin dollars that you're able to get on their discounts, which is totally fascinating. Another one is that membership further decreases shrinkage. We already talked about the fact that employee retention is great for making sure people don't steal things, so this membership makes it so members don't wanna lose their membership. You sorta feel like you're part of some sort of club. On top of that, these items are huge. They're hard to steal. How do you steal a TV? How do you steal a two-and-a-half-pound thing of nuts? And so there's, like, all these factors, membership is one of them, that really contribute to low shrinkage.
- DRDavid Rosenthal
Yes. Now, you mentioned getting a good deal. We talked earlier, back in the FedMart days, about how loss leaders and sales was kind of an anathema to Sol Price. How does that play into this?
- BGBen Gilbert
Yes, this is super interesting. So Costco basically wants to provide insane value to consumers. They want you to get a better deal as a member than you could possibly get by shopping anywhere else. And so how do they go about doing this? They have enforced a strict cap on the margin that they are willing to make on any product. So they have decided internally that they are not allowed to mark up anything more than fourteen percent above what the suppliers sell it to them for. And I'll tell you, they are tough but fair with their suppliers in making sure that they get a great price for their members. And so Costco decides, "We will only mark up anything a maximum of fourteen percent." They actually do mark other things up less than that, because things like electronics, they actually can only mark up six, seven, eight percent, so maximum fourteen percent. The only exception to this is Kirkland Signature, where they cheat a little bit and let themselves go up to fifteen percent. Quite indulgent. So how does this compare? I think that's the interesting thing here. A common practice at department stores is literally one hundred percent markup. Someone gets a good for fifty bucks, they sell it for a hundred bucks. I mean, even at Walmart, a discounter, quote-unquote, "marks up twenty-five percent," which is almost twice as much as Costco's margin. And so Jim Sinegal has a great quote on this. He was asked about it, and his response was, "You could raise the price of a bottle of ketchup to a dollar and three cents instead of one dollar, and no one would know. Raising prices just three percent would add fifty percent to our pre-tax income. Why not do it? It's like heroin. You do it a little bit, and you want a little more. Raising prices is the easy way."
- DRDavid Rosenthal
Well, and I think also, back to the membership, it all comes back to member trust. The members have to trust that they are gonna get the absolute best price on everything, and that Costco isn't gonna be playing these games, otherwise, they would just go shop at Amazon or Walmart or wherever.
- BGBen Gilbert
You're exactly right. The value proposition forty years ago was, "You are going to get the very best deal possible on the goods that you're buying here." "Extreme value proposition" is what they like to say, and the fact that they've just made that true every year for forty years is something that really does stick in people's psyche. And I totally get the heroin line. I think it's so easy to decide to cheat one year, and then in all the future years, you're gonna cheat, 'cause you've broken expectations with customers, with shareholders. There's something kind of magical, even in the relationship between Costco and a supplier, where a supplier knows that when Costco is being really tough on them to give the lowest price, Costco is not gonna turn around and then mark it up fifty percent and make a bunch of money. Costco is going to make the same margin that they've always made on that good.
- DRDavid Rosenthal
Totally. It's worth double-clicking on the supplier relationship for a sec. Costco's relationship with their suppliers is worlds apart from Walmart's relationship with their suppliers. You go to Bentonville as a supplier, and you are getting put through the gauntlet. It is designed to squeeze you [chuckles] as much as possible. That is not how the supplier relationships work with Costco. They'll work with their suppliers. They'll understand your business. They'll come see you.
- BGBen Gilbert
Yep. Okay, I was gonna save this for later, but we gotta do it now. The Costco code of ethics, as it exists today, largely inspired by the FedMart values from forty, fifty years before, are, in order: Obey the law. Number one, first and foremost, obey the law, and we will save that for a moment. I've got a fun story of how that came to be. Number two, take care of our members.... And listeners, when you're listening through these, the order is important, the subject of each statement is important, and the phrasing of each statement is important. So one, obey the law. Two, take care of our members. Three, take care of our employees. Four, respect our suppliers. And I find it fascinating that they use the word respect because they have a posture of tough but fair. And so there's this great anecdote, and, I mean, I heard one, but there's fifty examples of this that you can find in various Tegas calls or talking with people who are suppliers to the company, where Costco buyers always ask, "Why?" when a supplier tries to increase the price. And that part's not that novel. I imagine a Walmart buyer also tries to ask why. The buyers are very deep, so they actually know the commodity prices of ingredients from suppliers. So let's take, like, a chocolate company, for example, that sells a chocolate product. If the chocolate company said, "Hey, the chocolate costs more now," the Costco buyer would say, "Well, I know the price of cocoa. I've been watching the commodities market. I understand milk, sugar, butter. Why is it more expensive? Just give me feedback on that." And a lot of the times, it is like a commodity price has gone up, or they use labor in a certain area that's gone up, or maybe they have a long-dated contract with a supplier of their own that, you know, has an artificially high price for some reason until the contract expires. And so the Costco buyers will write all of this down. Will keep track of it, and because they manage so few accounts, they actually can keep track of it. Like, each buyer is only really adding three, five, ten, maybe fifteen new SKUs a year, but you manage a very tight set of relationships. So they'll just call the supplier back and say, "Hey, last time we talked, you'd mentioned that cocoa prices were high. I've noticed they've gone down. Are you lowering the prices so that we can lower it for our members?" It's like this really amazing side benefit of having the low SKU count is that they can be tough, but fair with suppliers and really stick to it.
- DRDavid Rosenthal
So awesome.
- BGBen Gilbert
And because of Costco's gross margins always being targeted at eleven percent, capped at fourteen percent, this means that for every dollar that Costco gets a supplier to reduce the price on something, again, tough but fair, the customer actually sees most, you know, eighty-nine percent of the benefit. And so Costco really does just get to pass... Whenever they get a benefit, eighty-nine percent of that benefit goes to the member. So the way I look at this is some companies always look for ways to make more margin. Costco specifically does the opposite. They look for ways to provide more value to members and retain them for members as longer and get them to get their friends to be members. And they try hard across the board to get lower overhead costs through cleverness and efficiency, not through squeezing or underpaying or anything like that.
- DRDavid Rosenthal
[chuckles] So there's a really fun acquired canon, acquired cinematic universe story related to this, which is the famous, as chronicled by Brad Stone in The Everything Store, coffee date between Jim Sinegal and Jeff Bezos in two thousand and one, which occurs at the Starbucks inside of the Bellevue Barnes & Noble, [chuckles] of all places.
- BGBen Gilbert
That's right.
- DRDavid Rosenthal
So perfect. And at the time, this is two thousand and one, Amazon stock was in the dumps. They were under pressure from Wall Street. Jeff and the organization were embarking on a campaign of raising prices on amazon.com to get profitable. And they had just started this rolling out. It was super important. Jeff has this coffee with Jim, and Jim explains this philosophy to Jeff. Jeff comes back to Amazon HQ the next day and is like: "I'm reversing the policy," and says exactly what you just said. There are two types of companies in this world, companies that work hard to charge their customers more and companies that work hard to charge their customers less. Henceforth, as of today, Amazon is a company that works hard to charge its customers less, [chuckles] and that is directly from Jim Sinegal.
- BGBen Gilbert
Wow, that's awesome. So on this point number four of suppliers, here's some quick math that illustrates why they do have to be so careful and why they do wield such an enormously large stick. So Walmart's revenue today is about three times Costco in the US, but since Costco sells so few items, they are a massive customer for any given supplier. They always have this super lopsided relationship. The average revenue per product, because of the SKU count at Costco, is about ten times Walmart.
- DRDavid Rosenthal
Wow!
- BGBen Gilbert
So anytime they're in a negotiation, I mean, like, almost every time, the person sitting across the table is looking at Costco like, "You are my largest customer."
- DRDavid Rosenthal
You're, like, fifty percent of my business.
- BGBen Gilbert
I think they try not to have that be the case, but it's very easy for it to become that. So it is really important that they have it as one of their sort of four main tenets, respect our suppliers. Now, notoriously missing from these four is the notion of a shareholder, and Jim Sinegal articulates: "If we do these four things throughout our organization," and again, those four things are, obey the law, take care of our members, take care of our employees, respect our suppliers, in that order, "then we will achieve our ultimate goal, which is to reward our shareholders."
- DRDavid Rosenthal
It's so funny, going back to our previous episode and Rob Strasser's ten principles at Nike, and, like, on the one hand, the Nike principles and the Costco principles are about as far apart as you could imagine. On the other hand, Rob Strasser, Nike Principle number ten, is, "If we do the right things, we'll make money damn near automatic."
- BGBen Gilbert
Right.
- DRDavid Rosenthal
And that really is the same thing at Costco.
- 1:33:23 – 1:45:45
Kirkland Signature and global expansion: private label as quality + value engine
- DRDavid Rosenthal
Yeah, a combined two hundred stores, so pretty large footprint. They're in Canada, they're in Mexico. They've already started international expansion, which then is gonna become huge throughout the two thousands, as we'll see for Costco. But right around the time of the merger, Costco takes a pretty important step that unlocks a huge part of the next chapter for the company, and that is the creation of the famous Kirkland Signature house brand. And there's a fun story around this. When they were talking about creating their house brand, the company's corporate headquarters was in Kirkland, Washington, right near Bellevue, right across the lake from Seattle, and so that's where the Kirkland Signature name came from. I think by the time they actually launched it, they had relocated to Issaquah, [chuckles] a little farther south, and they were like, "We can't call this Issaquah Signature." [chuckles]
- BGBen Gilbert
No. Kirkland Signature is good.
- DRDavid Rosenthal
But it was tied in with international expansion because they needed a brand name and a trademark that they could clear across all the countries that they were operating in and planning to operate in, and so Kirkland Signature, like, that works in Japan, that works in Korea, that works in Taiwan.
- BGBen Gilbert
It sounds so generic. Like, I didn't even put it together when I first moved to Seattle twelve years ago, that the Kirkland over there was of Kirkland Signature, 'cause Kirkland kind of just meant nothing to me. It meant, you know, what's the, um, Whole Foods version, the three sixty-five?
- DRDavid Rosenthal
Yeah.
- BGBen Gilbert
Interestingly, over time, Kirkland Signature has come to mean something, and that is a certain level of quality. Nobody is attesting that this Kirkland Signature sweatshirt is a Lululemon sweatshirt that has fancy materials and the most cutting-edge technology in it, but it is of a certain bar of quality that is sufficient for Costco members. And that is sort of the ethos that Costco has around Kirkland Signature, that we're only going to put something out there if we feel that we can create value for you, that it's gonna be a lower price than what you could get otherwise, or the flip side of that, that we can make a better product than you could get from any of these branded products that we were either previously stocking or evaluating stocking.
- DRDavid Rosenthal
And, uh, maybe the most obviously and, uh, perhaps most famously, where this comes to bear is in wine and liquor [chuckles] sales. The Kirkland Signature wine, you know, you'll get people who are wine snobs that'll drink Kirkland Signature wine, and they're like, "Yeah, yeah, yeah, it's, you know, Costco, but, like, this is actually good stuff." And tequila and vodka, it's the same thing.
- BGBen Gilbert
Oh, and especially for these things that are very clearly difficult to make, and therefore, it's made by one of a few people, like made by a real winemaker, or, like, the battery's definitely made by a company that makes other batteries. It's not like they're low-quality batteries. So I do think, much like their eleven percent target gross margin on everything, Costco looks at their house brand as an opportunity to provide value to members, not an opportunity to capture more margin for themselves.
- DRDavid Rosenthal
Yep. Now, they also have a pretty unique opportunity they realize with their house brand. Because of the very small number of SKUs that they're putting in the warehouse, there's much less competition on the shelves for any given product category for the house brand. So like, yeah, you mentioned, you know, Whole Foods has the three sixty-five house brand, Walmart has their house brand, you know, blah, blah, blah. All these big retailers do. Safeway certainly does. But in a standard retail environment, the house brand is gonna be one of, like, five or six or ten different brands of a given product category on the shelves. At Costco, it's one of two, three?
- BGBen Gilbert
Or one of one. I mean, if you go buy the mixed nuts, the mixed nuts are Kirkland Signature mixed nuts. The jumbo cashews are Kirkland Signature jumbo cashews, and in part, because the buyers were evaluating the whole landscape, and they determined, "We can do something better for less." I think the Costco fancy mixed nuts is the best mixed nut blend. But I think that that was an enterprising buyer who was being creative and working with suppliers and thought, like, "I actually think we can provide a better product for a lower price than what exists on the market." And I don't know. I think there's a lot of scenarios where they have. Certainly, [chuckles] consumers agree. Fifty-two billion dollars of Kirkland Signature sales were done last year. That does not include the Kirkland Signature gas. So out of Costco's two hundred and thirty billion top line, a little under a quarter of it was Kirkland Signature sales, and closer to a third, if you include the gas.
- DRDavid Rosenthal
Wow!... That's incredible.
- BGBen Gilbert
It's America's largest consumer package brand.
- DRDavid Rosenthal
So at the same time, too, as they're spinning up Kirkland Signature in the kinda mid to late '90s, they also start expanding internationally. So first, they go to the UK, then they go to Korea, to Taiwan, to Japan, ultimately China, which is now a big initiative for them. What's interesting is, I think at the time, I suspect there were very few other Western-style global or globally aspiring retailers that were entering Asian markets. Because it's not exactly obvious that a huge warehouse with bulk packaging would work in cultures like, say, Japan, where people live in tightly packed, dense, urban environments, much smaller houses and apartments than in America. This is not the land of SUVs and suburbs.
- BGBen Gilbert
Right.
- DRDavid Rosenthal
But it works great.
- BGBen Gilbert
Yeah. I mean, at the end of the day, people really like value. High-quality products at a great value is a super compelling value proposition for anyone in the entire world.
- DRDavid Rosenthal
Totally.
- BGBen Gilbert
I wanna go back to something that we've been wading into in the discussion of Kirkland Signature, which is: Why is it okay that at Costco, they can only have thirty-eight hundred SKUs? Like, why are people okay with this deal where I don't need selection when I shop here? And I think there's a few illustrative examples of the story from here that get into that. But first, this is a great time to thank our final sponsor of this episode, Crusoe, which is honestly one of the coolest companies [chuckles] in the world right now. Crusoe is a cloud infrastructure provider, just like AWS and Azure, that is one hundred percent purpose-built for AI training and inference.
- DRDavid Rosenthal
Yep, just like Costco warehouses are purpose-built to drive down their costs and sell high-quality products at the absolute lowest prices, Crusoe does the same thing with their data centers. So for many AI workloads, you'll get significantly better performance for your costs from Crusoe than any traditional cloud provider, and with a really cool environmental benefit.
- BGBen Gilbert
Yeah, the way they do this is nuts. First, on the quality front, they're specifically for AI. Literally, their data centers are nothing but rows and rows of the latest NVIDIA A100s and H100s, so they have the benefit of focus and specialization. Crusoe was also among the first to deploy cutting-edge networking fabrics like InfiniBand, which accelerates performance of large AI training clusters dramatically. Think two hundred movies per second between servers, crazy fast stuff. And two, this is what is very special about Crusoe, they use energy that would otherwise be wasted or stranded to power the data centers.
- DRDavid Rosenthal
Here's what Crusoe does. They've gone out to energy sites, think like Texas, Montana, Argentina, and more, and built their data centers right on top of oil and gas flares, [chuckles] which, before Crusoe, uh, was just an enormous waste of energy that generated tons of unnecessary greenhouse gas emissions. It takes some crazy ingenuity to pull this off, true vertical integration. Crusoe manufactures their own designs of modular data centers, like building data centers out in the oil fields. They own the servers, the networking, the software stack, even trenching last-mile fiber to get connectivity out to these sites. And bonus, they also improve rural connectivity for the communities that they work in. They do all the work to build the data centers, build the on-site infrastructure, and then ultimately power Crusoe Cloud, all in-house.
- BGBen Gilbert
Crazy. We discussed all of this in depth over on ACQ2 with Crusoe's CEO, Chase Lochmiller. Funny, we had reached out to Chase two years ago to have him on, uh, ACQ2, and it took us this long to actually get it scheduled. So go give that a listen. We've been fascinated by this company for a long time. We will link to it in the show notes. His and Crusoe's story is totally amazing. And if you or your company or any investments you've made have AI workloads that could use lower cost and more performant infrastructure, which is all of you, go to crusoecloud.com/acquired. That's C-R-U-S-O-E cloud.com/acquired, or click the link in the show notes. So David, let's talk about low selection and how that's okay. So Walmart and other retailers operate it under the assumption that shoppers require selection. It seems like a reasonable assumption, unless you started your life as a B2B wholesaler that then fell backwards into consumer and then realized it was fine for consumers, too. So obviously, if you have selection, it makes the life of a retailer very difficult in a lot of ways, but it was just assumed that you had to. But Costco makes the opposite bet. They bet that you don't need selection as long as you ensure that everything you can buy is high quality, and that is the crazy thing that has worked. Costco essentially has its entire buying team's ethos sort of shopping for you. They're pre-selecting the best one or two items in every category, and consumers, because they do all that work ahead of time, are basically just okay sacrificing selection entirely and saying: "Yeah, as long as you give us good value on great stuff, we're totally okay with that." That's an important unlock. You can't just have low selection and be like, "Well, it's all cheap stuff." It has to be, like, high quality in its category and the best deal on the market in order for people to be okay with low selection, which drives low SKU count, which drives all the amazing things we've talked about so far.
- DRDavid Rosenthal
Yep. It comes back to trust. And part of this, too, also hearkens back to Sol and the FedMart days. Sol developed this kinda principle back in FedMart that he called the intelligent loss of sales.
- BGBen Gilbert
Yes, I was waiting for you to bring this up.
- DRDavid Rosenthal
Yeah. So this isn't necessarily the number of brands in terms of the selection out there. This is about product sizes. So today, Costco has taken this to the extreme of, like, you can only buy the two-and-a-half-pound jar of nuts. There's no, like, eight-ounce jar of nuts.
- BGBen Gilbert
Well, you could buy a whole bunch of little packs of... afternoon packs of nuts.
- DRDavid Rosenthal
... Either way, you're walking out with a lot of nuts. [chuckles]
- BGBen Gilbert
Yes.
- DRDavid Rosenthal
But other retailers, and everybody back in the FedMart days, had all sorts of different sizes of products, and the idea was that by having different sizes, you would maximize the surface area of customers in market that you could reach. Like, Sol uses the example in the book of household lubricating oil, like kind of WD-40 type stuff. He's like, "We only carried the eight-ounce can, even though there was, like, a three-ounce can out there. We lost some sales from customers that only needed one or two ounces, and thus, would only buy a three-ounce can, and they just didn't buy the eight-ounce can. But it was worth it to us to forego that, because by only having the eight-ounce can, we could reduce the number of SKUs that we had and get all these benefits" that you're talking about, Ben.
- BGBen Gilbert
I mean, yes. You and I have been trying to do this without having a name for it for years. People sponsor Acquired seasons. There are lots of other podcasts that let you do all kinds of crazy stuff, and we're just like, "Look, we have a SKU. It's called 'The Season.' We would love to work with you on that." And it makes our lives so much better, and we can run our business in a completely different way by having a low SKU count.
- 1:45:45 – 2:03:05
Modern operations: cross-dock logistics, two businesses under one roof, and Executive membership
- BGBen Gilbert
Honestly, it's, like, maybe my favorite business that we've studied. Let's wait till the end to talk about that. But there's a few more things along the way that happened in the '90s and 2000s before we get to today that I think are important to touch on. We've mentioned logistics a few times, and that the low SKU count means that they can meaningfully simplify their logistics. And to put a point on that, they only have so many suppliers who are bringing goods to Costco. The fact that they sell in bulk means that they can bring a whole pallet into a warehouse, and consumers just sort of come and pluck it off the pallet. It's wholesale. It's a wholesale club. But there's something we haven't talked about, which is Costco's distribution centers. So they use something called a cross-dock system for their distribution centers. Now, remember I mentioned back in the Price Club days, it's a little bit more complicated today. Not all the suppliers just show up to the one store, the one warehouse with all the goods. They actually do need some system to receive things from suppliers and bring them to stores.
- DRDavid Rosenthal
Yeah, back in the Price Club days, there were no distribution centers. [chuckles]
- BGBen Gilbert
Exactly, but here's how the distribution centers work. Trucks pull up on one side and unload pallets, and that's where the suppliers' trucks are. On the other side of the warehouse, there are Costco trucks, and so what happens is, since they move stuff entirely by the pallet, no partial pallets, no, "These few things go to this store, these few things go to that store," the supplier trucks unload the pallets. They just get scooted across the dock to go directly to a Costco warehouse, and then within minutes to hours, that truck leaves, and there's no unwrapping of individual boxes. There's nothing sitting overnight in the facility. This is so much simpler, and it really plays into that cash flow dynamic, where things can be available for sale so fast. And just to underscore how differentiated the system is, ninety-two percent of Costco's merchandise is cross-docked. Only ten percent of Walmart has cross-docked merchandise on a pallet system like this.
- DRDavid Rosenthal
And it's not like Walmart hasn't invested many tens of billions in their distribution and logistics systems. [chuckles]
- BGBen Gilbert
Totally, it's just that Costco has made a trade-off that makes it so that they just have a much simpler operation, and they've got all the downsides that come with the trade-off, no selection, but they get all the upside that comes from it, too. And so this also plays into this labor thing. You can totally pay your employees more when you need less people to generate the same amount of sales. You don't have wasted manpower unwrapping items from pallets, no one turning the labels out to look pretty. The customers do all of this. So it legitimately means they just need less people, and this is why they generate over seven hundred and thirty thousand dollars of revenue per employee. They're just efficient at aligning their trade-offs.
- DRDavid Rosenthal
I love it. This is the bricks-and-mortar retail version of the SaaS business fallacy, which we fall prey to all the time on the show, which is, if you invest in or build around SaaS companies and SaaS company margins, you can fall into the trap of thinking, "Well, why would I ever wanna be involved in a business that doesn't have ninety percent margins?" [chuckles] But actually, what you should really care about, especially as an investor, is not your margin percentage, but your absolute margin dollars. [chuckles] And so, yes, Costco has much lower margins than their competitors, but the volume that they drive and the actual dollars end up being worth it.
- BGBen Gilbert
Yeah. Even though Costco is only an eleven percent gross margin business and only ever will be an eleven percent gross margin business, it's still a pretty amazing business to own.
- DRDavid Rosenthal
Yeah, I mean, it's... What did you say? Two hundred and thirty-plus billion dollars of revenue? [chuckles]
- BGBen Gilbert
And, uh, seven and a half billion dollars of operating income off that. So again, tiny little sliver margins, but seven and a half billion dollars of operating income falling out the bottom is pretty awesome.
- DRDavid Rosenthal
Yep, especially seven and a half billion dollars of highly defensible operating income. [chuckles]
- BGBen Gilbert
Yeah, seriously, and as you've been talking about, because of the way that their inventory is financed, a reasonably capital-light business, all things considered. I mean, they're building these warehouses on huge pieces of real estate, you know, with gigantic shelving and all this headcount, and it's an amazingly capital-efficient business. It's weird.
- DRDavid Rosenthal
Yeah. Okay, I think it's time to talk about Investing Nerds' favorite aspect of the Costco story, which is that there really are-... two different businesses here under one roof. There is the retailer, and then there is the membership business. It's almost like way back, Sol and Robert sitting in the office after FedMart thinking, "You know what? We actually had two different businesses at FedMart." Costco is also two different businesses. There is the operations of the retailer, and then there is the membership business. [chuckles]
- BGBen Gilbert
Right. And psychologically, they're one thing. It's one experience for the customer, but financially, it's two entirely different things.
- DRDavid Rosenthal
Yeah.
- BGBen Gilbert
So a lot of people like to make a lot of hay about the idea that Costco generates all their profit on memberships, and that retail is just a break-even business. And this has been popular to say because they run the retail business at such thin margins, and memberships are nearly a one hundred percent margin business. I mean, really, what does it take to run a membership business? [chuckles]
- DRDavid Rosenthal
Yeah, with, like, a, what, ninety percent renewal rate?
- BGBen Gilbert
Something crazy high like that.
- DRDavid Rosenthal
Talk about a SaaS company.
- BGBen Gilbert
Yeah, but it's not quite true. It is accurate to say that membership fees represent about seventy percent of the company's operating income, with the other thirty percent of the profit margins coming from retail. It's been a little bit more than thirty percent in recent years, but that's sort of the historical split. Think about it as sort of a seventy-thirty thing. It really is staggering that a business that does two hundred and thirty billion dollars top line, seventy percent of the profits can come from the four billion dollars of revenue they generate from memberships. That tells you how razor-thin the margins are on their retail business, almost to the point where you're like: Why do they care about growing sales at all? All they should care about is increasing retention of members. The split is just significant enough for the retail business where you're like, "Okay, yeah, we should care about growing sales in the retail business." But if it wasn't seventy-thirty, if it was ninety-ten or ninety-five-five, you'd kind of be like, "Well, I'm actually not sure why we care about making a single another sale of toilet paper, because unless it is increasing the likelihood someone retains, I don't care about it." And they're not quite there, but they're almost there.
- DRDavid Rosenthal
Well, except though, the way that you grow memberships is you grow retail sales. [chuckles]
- BGBen Gilbert
Right. But for the last several years, they have totally been growing retail sales per member, and if it was like a ninety-five-five split, you sort of could make the argument of, like, why do they care about growing the retail sales per member? But at this sort of more seventy-thirty-ish split, there's just enough profit dollars coming from the retail side of the house where you care about that, too.
- DRDavid Rosenthal
I love it. It's like Amazon and AWS versus Amazon retail. [chuckles]
- BGBen Gilbert
Yes. In the last twenty-five years, membership has grown from nearly nothing, if you look at what the numbers were in the early nineties, compared to today, four and a half billion dollars.
- DRDavid Rosenthal
Yeah. I mean, when we were talking about the FedMart days, like, it was two dollars for a lifetime membership.
- BGBen Gilbert
Crazy! And again, David, this membership business takes almost no investment.
- DRDavid Rosenthal
They don't do any advertising. [chuckles]
- BGBen Gilbert
Right. To quote our friend Andrew Marks: "I basically think that Costco has decided to only be a decent return on invested capital retailer, which allows them to have an insane return on invested capital membership club business."
- DRDavid Rosenthal
Yep.
- BGBen Gilbert
It's so true. Again, to quote Andrew, "Insanely stable growth on a huge capital-light fee stream."
- DRDavid Rosenthal
I mean, that sounds like a venture capital management company.
- 2:03:05 – 2:50:28
Costco today and what defends it: treasure hunt, scale economies shared, and selective vertical integration
- BGBen Gilbert
So I don't think people realize, maybe by this point of the episode they do, but certainly not before, how big Costco is. It's sort of a sleepy story since it's tucked away in a Seattle suburb. They don't do a lot of chest-pounding. They just are quiet, and they do two hundred and thirty billion in revenue. They're the third-largest retailer in the US. They have one hundred and twenty-four million members worldwide. One-third of US shoppers are Costco customers. They have a little over three hundred thousand employees at eight hundred and sixty stores. We talked about this. They do seven hundred and fifty-ish thousand dollars of revenue per employee.
- DRDavid Rosenthal
Yeah, that's wild. If I remember from our Walmart episode, Walmart, I think, has over two million employees. I believe Amazon has well over a million.
- BGBen Gilbert
Yeah, so Costco is doing somewhere between a third and a half the total revenue of Walmart, but they're doing it with, what? Almost an order of magnitude fewer people.
- DRDavid Rosenthal
Yeah.
- BGBen Gilbert
It's crazy. They have the highest revenue dollars per square foot of any wholesaler or discount store. Target's about four hundred and fifty dollars per square foot of revenue. Walmart's about six hundred dollars. Costco is eighteen hundred dollars per square foot of revenue.
- DRDavid Rosenthal
Wow! Is that a Costco or an Apple store?
- BGBen Gilbert
And they have a lot of square feet.
- DRDavid Rosenthal
Yeah. [chuckles]
- BGBen Gilbert
And this is up from... Let me look at this graph. In nineteen ninety-eight, they had six hundred dollars a foot, and now they're at eighteen hundred dollars a foot, so meaningfully grown it. It's important to point out, you made the comment about Apple, Costco's margins are a lot lower than Apple. So they're generating a huge amount of revenue dollars, not so much on the margin dollars, but as we've been talking about, that's the point.
- DRDavid Rosenthal
Yep. The individual warehouses these days, you may have these stats exactly, but I think an average Costco warehouse generates over two hundred million dollars in revenue, and the top ones generate three, four hundred million dollars of revenue for a single store. Single Costcos could be scaled public companies on their own. [chuckles]
- BGBen Gilbert
Yeah, two hundred and sixty-nine million dollars of sales per store on average per year.
- DRDavid Rosenthal
Wow!
- BGBen Gilbert
Nuts. So just for fun, let's go north of eighteen hundred just to see who else is out there. Tiffany is three thousand, so kind of within spitting distance, like it's only two X, or it's less than two X, and they sell diamonds. [chuckles]
- DRDavid Rosenthal
[chuckles] Well, so does Costco.
- BGBen Gilbert
Yeah, it's true. Apple, of course, is the GOAT at fifty-five hundred dollars a square foot with high margins. I mean, Apple is just a nuts business. But, uh, it's worth pointing out, Lululemon is approaching Costco level, too. They're around sixteen hundred dollars a foot, but of course, much smaller stores than Costco. Costco is just unbelievably efficient. We talked earlier about how that's illustrated in the head count efficiency, but now we see it in the real estate efficiency, too.
- DRDavid Rosenthal
Yep.
- BGBen Gilbert
This point on growing revenue per foot is interesting, you know, I mentioned it went from six hundred to eighteen hundred over the last twenty-five years, because it reminds us to look at an important similar metric in retail, which is same-store sales. So Costco grew this by fourteen percent last year.
- DRDavid Rosenthal
Wow!
- BGBen Gilbert
Same-store sales, fourteen percent, which is how you get to that two hundred and sixty-nine million dollars of revenue per store. They are so good at this that they actually publish their stores by cohort year in their annual report, which almost no other company, and certainly no other retailer, does. And they clearly illustrate that not only does the average store increase meaningfully over the previous year in most years, but new stores also inherit a lot of the learnings. So the first year of a new store is dramatically better than what first years of stores were years ago. And to illustrate this, year one of a store opened last year was better than year five of a store opened in twenty fourteen.
- DRDavid Rosenthal
Wow!
- BGBen Gilbert
It's crazy.
- DRDavid Rosenthal
It's also wild that these stores are still growing at those rates year over year, given that many Costco stores have been open for, like, thirty-plus years at this point. [chuckles]
- BGBen Gilbert
Right? It's crazy. I mean, part of it is the addition of gas and the other big ancillary items they're selling, but part of it also is just being really good merchants and finding these little things that members love and find value in and doing little optimizations everywhere.
- DRDavid Rosenthal
Yeah, and exactly to that point, you know, one of the sort of famous aspects today of the Costco shopping experience is the treasure hunt nature of it, and this is something that they've learned over time. You know, the original Sol Price Price Club business plan was just the three thousand core SKUs for businesses and then opening that up to consumers. Along the way, they kinda realized that, hey, if in addition to the core staples we have, which pretty much don't change, we could change the brands, we could change the exact details of what they are, but we're always gonna have nuts. You know, we're always gonna have chicken, stuff like that. If we have a small number of additional ooh and ahh, wow, one-time items, such that every time as a member you come into the store, there's something new and different for you to find and buy at a really low price, that would drive repeat traffic and make coming to Costco more of a novelty, more of an entertainment event. And so today, I think about twenty-five percent of their SKUs are these treasure hunt items.
- BGBen Gilbert
... Huh, I did not realize that. I mean, I know they've sort of learned a bunch of things over the years, like when they brought in fresh food for the first time, they didn't optimize the place in the store where they put that, but they still saw a huge spike because it drove repeat. When you have fresh food, people come in, they wanna buy that, they add some other stuff. But they've been very clever in figuring out where to put it in the store to make sure that you have to walk by a bunch of other stuff to get-- I mean, the fresh food is in the back, right? It's like, if you're coming in for fresh food, congratulations, you get to see all these other cool things that our buyers have managed to find out in the world for you, and of course, you get some of those, too.
- DRDavid Rosenthal
Yep. And I think for the items, again, the non-staples, the treasure hunt-type items, they intentionally wanna run out so that they're not gonna be there next time you come.
- BGBen Gilbert
Yes, that's a good point. Okay, analysis time?
- DRDavid Rosenthal
Analysis, let's do it.
- BGBen Gilbert
'Cause we haven't been [chuckles] analyzing this business yet.
- DRDavid Rosenthal
[laughing]
Episode duration: 3:01:33
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Transcript of episode 9PxxtJVWRrg
