Costco: The 'anti-Wal-Mart'

By Barron's

"Membership has its privileges." That slogan belongs to American Express, but it might better apply to Costco Wholesale, the leading warehouse-club operator in the U.S., whose determination to deliver value and innovative products to its 23 million members has made it one of the country's top retailers.

Costco (COST, news, msgs) has succeeded by flouting industry norms. The big-box retailer charges customers a base yearly fee, now $50, to shop in its sprawling stores, which offer quality goods at low markups. Consequently, its margins are among the slimmest in retailing. The privileges also extend to employees, who are paid well and enjoy generous health-care benefits.

This formula has generated fierce loyalty among both shoppers and workers while rewarding long-term investors. Costco shares, which traded Thursday around $58, are up from a split-adjusted price of $1.67 when the company went public in 1985. True, they no longer are dirt-cheap, but in view of the company's superior management and opportunities for growth, neither are they rich.

Small businesses are big customers at Costco, but the company also has managed to make discount shopping fashionable for affluent Americans by offering fine wines, books and big-screen televisions at low prices, and staples such as paper towels and razor blades in bulk.

By offering one-time specials like discounted Prada bags or Callaway golf clubs at individual outlets, Costco has created what it calls a "treasure-hunt" atmosphere in its stores.

Not the Wal-Mart way

Costco is among a handful of retailers that has flourished despite Wal-Mart Stores' (WMT, news, msgs) onslaught; Wal-Mart's more downscale Sam's Club chain runs second to Costco. With its strong labor relations, low employee turnover and liberal benefits, Costco has been called the "anti-Wal-Mart." Its approach has paid dividends because Costco, based in Issaquah, Wash., hasn't encountered the same community resistance as Wal-Mart when it has sought to open stores.

"Retailing isn't rocket science. Costco has figured out the big, simple things and executed with total fanaticism," says Charles Munger, a Costco director for the past 10 years. The outspoken Munger, 82, is better known as Warren Buffett's longtime partner at Berkshire Hathaway (BRK.A, news, msgs), where he serves as vice chairman.

Crucial to the chain's success is CEO Jim Sinegal, who co-founded Costco in 1983 with Jeff Brotman, the company's chairman. "Jim would be on any intelligent list of the top 10 retailers of the past century," Munger says.

Sinegal, 70, also is one of the biggest bargains among big-company CEOs: In an era of seven- and eight-figure pay packages for CEOs, Sinegal earned a salary of $350,000 in Costco's latest fiscal year, which ended in August. He garnered other compensation of about $100,000.

What's more, Sinegal got no bonus last year, after the company determined that it had failed to measure properly the appropriate date for certain option grants from 1996 to 2002, although no evidence of fraud or falsification of records was found.

"Jim wouldn't let the board give him a bonus. His view was that the option glitch happened on his watch," Munger says. "How many people behave like that? No wonder everyone loves him."

Unlike Buffett, who draws a salary of just $100,000 as the CEO of Berkshire, Sinegal isn't a billionaire. He owns Costco stock worth about $135 million and has options on 1.2 million shares.

Sinegal's compensation and demeanor offer a welcome contrast to former Home Depot (HD, news, msgs) CEO Robert Nardelli, who alienated employees with his autocratic style and whose gargantuan exit package of $210 million didn't sit well with shareholders.

• Video: Behind the scenes at Costco

None of this has been lost on the investment community. At nearly $58, Costco trades for 22 times fiscal 2007 projected earnings of $2.58 a share. It has one of the highest price-earnings ratios among major retailers. Target (TGT, news, msgs) shares, at nearly $63, trade for 17 times estimated 2007 earnings, while Wal-Mart, at $48, commands 15 times projected 2007 profits.

Though some retailing analysts deem Costco shares expensive, the company seems to qualify under one of Buffett's investment dictums. Buffett has said he'd rather buy a good business at fair price than a fair business at a good price. Berkshire owned 5 million Costco shares at the end of September.

Growth and more growth

This is a genuine growth story. Earnings per share have increased at a 12% annualized rate in the past five years. Neil Currie, a retailing analyst at UBS Securities, believes the company is capable of generating 13% growth in earnings per share in the next few years and an even higher rate if it gets more aggressive in repurchasing shares. The bullish Currie carries a 12-month price target of $66. With large annual buybacks, Costco could earn more than $4 a share in fiscal 2010, Currie estimates. That could support a stock price of $80.

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