The ‘perfect’ company, according to Buffett’s partner
GUEST EXPERT. Does the “perfect” company exist? For Charlie Munger, one of the greatest living sages of business and investment, Costco Wholesale (COST, US$491.80) rises to the podium of perfection.
“It’s a perfect company,” the 99-year-old partner of Warren Buffett said at the recent annual meeting of his company, Daily Journal (DJCO, US$277.78).
“It has a wonderful future, it has a wonderful culture and it is run by wonderful people,” says Charlie Munger bluntly, adding that he will never sell a share of the operator of 850 warehouse stores.
It must be said that the legendary investor is not entirely objective, he who has acted as administrator of the retailer for more than 25 years. The billionaire would directly hold 167,000 shares of the chain, a stake whose value amounts to 93 million US dollars (M$US).
Outstanding financial performance
Like Charlie Munger, we are big fans of the American channel. We have followed it for many years and have great esteem for its exemplary business model, characterized by a low cost of capital and considerable competitive advantages.
It would take too long to describe all the assets that make Costco an exceptional company. However, among its main advantages, it should be noted that it reaps more than half of its operating profit a year ahead of most of its competitors, thanks to the annual subscription that customers agree to pay to enter its stores. The subscription formula erects exit barriers for its customers. Indeed, once subscribed, the customer has every interest in shopping there often to amortize his membership cost.
The annual growth in the number of subscribers, which fluctuates between 5% and 7%, has proven to be fairly stable over time. The subscription renewal rate has long exceeded the 90% threshold in North America – it was 93% in 2022!
At a time when high inflation is suffocating consumers, Costco continues to offer a strong value proposition: it leverages its immense buying power to return the maximum savings to its customers. Its model focuses on inventory turnover and growing sales volume, rather than increasing profit margins.
Indeed, gross profit margins are capped at 15%, unlike 25% or even 50% at some specialty retailers. Any realizable surplus in profit margin is passed on to customers in the form of lower prices.
This business model, coupled with brilliant execution, results in outstanding long-term financial performance.
Since 1997, when Charlie Munger became a Costco board member, the company has grown its revenue at a compound annual rate of around 10%. Earnings per share grew from US$0.73 per share to US$13.14 per share at the end of fiscal 2022, representing compound annual growth of 12.3%. The stock has had an equally stellar run, rising 15% a year over that time. A US$10,000 investment in the stock in August 1997 would be worth US$346,000 today, excluding dividends paid.
Even Amazon hasn’t come to the end of it
This financial and stock market performance is all the more exceptional as it was achieved despite the incessant onslaught of formidable rivals, including Amazon (AMZN, US$101.87) and Walmart (WMT, US$145.43).
When Amazon announced the acquisition of organic supermarket chain Whole Foods Market in June 2017, Costco’s stock plummeted as investors feared the e-commerce giant’s foray into the grocery business would come shake its competitive stronghold. We then seized a rare opportunity to buy the stock at a reasonable price.
Almost six years later, it is clear that the market’s initial fears were unfounded. Between 2017 and 2022, Costco’s revenue grew by 12% per year, and its earnings per share by 16%. The number of total members increased from 90,300 to 118,900, representing an annual growth of 5.7%.
Costco’s fiscal year 2022 was marked by strong same-store sales growth of 14%. This key retail trade indicator measures the increase in sales of establishments that have been open for a year. Inflation has contributed to inflating growth. Even if the pace has since slowed, the love rating of Costco customers seems far from crumbling.
Costco’s big flaw
However, as Charlie Munger points out so well, such an exceptional company comes with a big imperfection: its title is anything but a bargain on the stock market.
It was for valuation reasons that we sold our stake in Costco a few years ago. Not without regret, because we remain convinced that the company holds great potential for long-term growth. The chain is notably extending its presence internationally, with the forthcoming opening of stores in Sweden and New Zealand.
The stock is currently trading at 34 times earnings per share over the past 12 months, excluding cash on the balance sheet. Even though Costco deserves to trade at a premium, its valuation largely reflects how exceptional this company is.
Disclosure: Medici customers and employees own a stake in Amazon.