What Makes Costco's business superior to Fred Meyer?
Updated: Jul 20, 2021
The business begins where the profits (or opportunities for profit) begin. Everything else is just a collection of commodity assets. Property & equipment, inventory, time and materials...these are all just things that are worth roughly the same to most buyers. There is not yet a true profit. Even you, the owner, for all your talent and hard work, are only capturing a basic wage for your skills until you have a structure built that can scale beyond you to put resources to higher and better use. That is the beginning of a differentiated competitive advantage.
Anywhere you look, whether at small businesses or giant corporations, you see massive differences in profitability (and valuation) between otherwise similar companies. All because one company has figured out how to create and capture more value from the same set of available resources.
As an example, look at the difference in productivity between an employee at Kroger (parent company of Fred Meyer, QFC, King Super's) and an employee at Costco. Kroger generates about $335k of revenue per employee, whereas Costco generates about $683k. Similar job, same humans doing said job. But one of them is plugged into a system that brings in about $683k with that time, and the other works in a system that brings in $335k.
The same story plays out with the physical assets used in the business. Kroger has a return on invested capital of roughly 10%, vs Costco's 17%.
Sometimes the explanation lies in a brand premium which customers are willing to pay for higher quality. Is that the case here? Actually no. Costco's gross margins are 13% vs Kroger's 23%. Yet Costco winds up with the higher operating profit margin (3.26% vs 2.10%).
Costco's superior profitability comes not from high priced products, but from low-cost operations. This is what makes their assets and their employee's time more valuable, such that they can afford to pay more generous compensation, charge less for their products, and still make more money than Kroger.
This is reflected in the valuations of these two companies. Again, despite nearly identical functional value for the consumer, you see wildly different stories. Costco trades at a forward price-to-earnings of 35 and a price to sales of 0.94 (adjusted for debt). In non-investor-speak, for every dollar of earnings Costco reports, they are worth $35 as a business entity. Likewise, for every dollar of revenue they pull in, they are worth roughly $0.95 as a business. Which, given the sheer volume of business they do, isn't at all trivial. These same figures for Kroger are 13.5 for the forward price-to-earnings ratio, and 0.35 for the price to sales (adjusted for debt). This isn't an accounting fluke either. Even their total valuation, including debt, relative to their EBITDA (approximating free cash flow), tells the same story. 21.5 for Costco, and just 7.87 for Kroger.
This isn't meant to be a retail case study, so much as to illustrate how two very similar businesses can have wildly different profitability and wildly different valuations. Costco is earning a true profit, well above their cost of capital. Kroger, meanwhile, while not a bad business, is a little mediocre by comparison. They aren't elevating the usefulness of their assets the way Costco is.
Costco's value is in its system of operations that elevate the usefulness of all its inputs (the warehouses, the logistics, the labor, the products themselves...). Kroger's trying to do the same thing, but it's doing it less well.
I know I'm crapping a bit on Kroger here. The next ten years might tell a different story for these two companies, so it isn't over yet. And their stocks might perform very differently, given the wildly different valuations they have been given. But for you, in your business, you've got to ask, "On the day that I sell my business (or decide to stay with it), do I want my business to be a Kroger or a Costco?"
Of course, the biggest opportunity here is to take a business that is currently providing a commodity service at commodity levels of profit (Kroger), and transform it into a highly resourceful, highly productive, highly valuable enterprise (Costco). Just by improving the productivity and efficiency of your company, you can potentially double or triple the value of your business without needing to double or triple your revenue.
This is far from unusual. In fact, this is literally the private equity business model. They buy a cheap, under-performing business, then make a series of operational improvements, and sell it at a higher price. They massively improve the value of the resources involved, and pocket the difference. What I offer through exit planning, is the chance to do that process yourself, so that you capture the full value of your business, instead of someone else.