The fortunes behind Costco

The grand opening of the first Australian store of US discount retailer Costco in Melbourne’s Dockland precinct was greeted excitedly by bargain hunters all over the country. In Melbourne, there were long queues at Costco’s registration desk (you have to pay a membership fee to shop there: $55 for businesses, $60 for individuals) and at the checkouts, where tyres, toilet paper and designer handbags were among the hot items.

Across the rest of the country, shoppers scoured the internet for information about prices and hoped that the chain will meet its stated goal of having 20 to 30 stores around Australia sooner rather than later.

Despite the hype surrounding the store opening, Costco remains a rather faceless US retail giant to most local shoppers.

But behind the giant stores and cut-price goods is the story of two very clever mature-aged entrepreneurs who have managed to secure the backing of some of the world’s richest entrepreneurs, including Warren Buffett and Bill Gates.

Despite the size of Costco – 556 locations in nine different countries – it is actually a relatively young business, having been founded in the US city of Seattle in 1983 by two entrepreneurs named Jim Sinegal and Jeffrey Brotman.

Sinegal already had a great shop-floor-to-head-office story. He started as a “bagger” at US grocery chain FedMart in 1954, and worked his way up to executive level. He would later become executive vice president for Price Company and a protégée of the company’s leader Sol Price, who had pioneered the model of a warehouse store that sells high volumes of relatively cheap goods to a band of loyal members.

His business partner, Jeffrey Brotman, had a rather different background. He was a lawyer, although his family had been in retail and he was a keen student of shopping trends. Prior to teaming up with Sinegal, Brotman had been in Europe, where he had noticed a concept he thought could work in the US.

“I had visited Europe and seen what the French called “hypermarkets”, a combination of discount supermarket and department store,” Brotman told CNNMoney recently. “I thought the concept would work well in the US, so I called around to retail contacts and asked them to list executives who could run such a business. Jim was on most lists. I cold-called him one day and flew to California to meet him.”

In the beginning, the pair used their credit cards to fund the business, until the cards were cancelled by the bank. Eventually they raised $7.5 million to establish three stores in Seattle, and the empire was under way.

The model is very different to anything currently in Australia. The key feature is the membership fee, which accounts for around three quarters of the company’s profit and essentially underwrites the entire business. (The renewal rate, by the way, is 85%).

The other key plank is that big is better. By using its bulk buying power and demanding that manufacturers supply goods in bulk packs (for example, washing powder comes in a 10 kilogram pack) Costco can pass on savings to customers. The company also keeps its margins very low – never more than 14% – to keep prices down.

And that’s pretty much all there is to it: stack ‘em high, sell ‘em cheap and make sure the shoppers keep coughing up their membership fee each year.

“Retailing isn’t rocket science. Costco has figured out the big, simple things and executed with total fanaticism,” Charlie Munger, a Costco director since 1997, said in an interview a few years ago.

Munger, of course, is better known as the right-hand-man of investment guru, Warren Buffett. The Oracle of Omaha is apparently a Costco member and has praised the company as a low-cost business which has built high barriers to entry. Buffett has even lamented the fact that his investment company Berkshire Hathaway hasn’t bought more shares in Costco, although it still owns around 5.3 million shares worth around $305 million.

Another high-profiled name on the Costco share register is Bill Gates. His charitable organisation, the Bill & Melinda Gates Foundation, owns just over six million shares, worth $352 million.

Despite the fact Costco has attracted such big names, investors haven’t always been thrilled with company’s performance. In 2004, one Wall Street analyst attacked the company’s generous pay rates, suggesting it was better to be a Costco employee or a Costco customer than it was to be a Costco shareholder.

Sinegal and Brotman have made no excuses for their willingness to reward staff. “Our attitude has always been that if you hire good people and provide good wages and good jobs and more than that – if you provide careers – then good things will happen to your company,” Sinegal told The Motley Fool in 2006.

The pair are rich, but not obscenely so. Sinegal’s stake is worth about $120 million, while Brotman’s shares are valued at $62 million. That’s pretty unimpressive compared to Gerry Harvey’s $1 billion stake in Harvey Norman.

Yet Brotman and Sinegal appear to have few complaints. Even at the age of 73, Sinegal travels the world visiting Costco stores – he was in Melbourne for the opening – and has set no retirement date.

“It is never drudgery to come to work,” he told The Motley Fool. “I love the business. I don’t know what I would do with myself if I couldn’t go in and visit the warehouses. It is incredibly exciting and I love the people aspect of it, both from the standpoint of the people that I work with as well as our customers and our suppliers, and I just love every bit of the job.”