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Morningstar's 2011 CEO of the Year Redefined Retail

A record of fostering employee loyalty and driving operational excellence made 2011's winner an easy choice.

R.J. Hottovy,Paul Larson, 01/04/2012

Retailing is not an easy business. It begins with attracting customers, which won't happen until you've identified a suitable location for your store, made your brand recognizable, and carefully selected merchandise to carry from a wide array of vendors. Once you've got consumers through the door, keeping them is an entirely different matter, as switching costs are nonexistent, price competition is intense, and there are few barriers to prevent rivals from replicating what made your store successful. On top of that, you must deal with economic cycles, which can trigger volatile swings in consumer demand and often leave retailers with excess costs and capacity. Not surprisingly, it takes exceptional leadership to succeed in retail, especially compared with other industries with stronger business models.

Morningstar's 2011 CEO of the Year, Costco's COST Jim Sinegal, has not only guided his company through the challenging macro environment of the past few years, but also built the retailer from the ground floor over the past 30 years and redefined how retailers operate in the process. In fact, outside of Amazon.com AMZN (headed by one of the other finalists for this year's award, Jeff Bezos), we struggle to think of a more disruptive force in the retail industry over the past two decades.

Following executive vice president roles at Fed-Mart and Price Club (where he learned the warehouse club concept from Sol Price), Sinegal went on to found Costco in 1983 with current chairman Jeff Brotman and eventually merged the company with Price Club in 1993. Since that time, Costco has not only outperformed its closest peers--Wal-Mart's WMT Sam's Club and BJ's Wholesale Club--but also taken considerable market share from other specialty retail channels. Although Costco's membership base (which has grown at a CAGR of approximately 7% over the past five years) has partly expanded as a result of consumers looking to stretch their budgets in a time of economic hardship, we believe the company is well-positioned to remain a relevant shopping destination under a "new normal" scenario for consumer spending.

With Sinegal retiring as CEO earlier this week and handing the reins over to COO Craig Jelinek (Sinegal will stay on in a supervisory role in 2012 and remain on the board), this year's award may feel as though it is based on a lifetime of achievements rather than recognizing Sinegal for his performance in 2011. However, Costco's performance this past year has been impressive, with fiscal 2011 comparable-club sales of 10% (6% excluding gasoline price inflation and the impact of foreign currency translation), 10 basis points of operating margin expansion to 2.8% (the highest level since 2006 despite inflationary gas and food headwinds), a 14.2% return on invested capital, and over $1 billion returned to shareholders through share repurchases and dividends.

In addition to operational excellence, we've been impressed by Sinegal's ethical approach. At a time when a weakened economy has forced many retailers to aggressively eliminate jobs and shed store locations, Costco has kept the layoffs to a bare minimum. Sinegal also maintained health benefits for all employees this past year (even though it came at the expense of profitability) helping to maintain one of the highest employee retention rates in the retail industry. Additionally, Sinegal's base salary of $350,000 is one of the lowest among our consumer coverage universe and actually below several of Costco's vice presidents.

Pioneering a New Retail Business Model
Costco, with Sinegal at the helm since its genesis, was one of the pioneers in developing the warehouse club retail model, which relies on tremendous bargaining power, a no-frills shopping environment, supply-chain efficiencies, and a customer-friendly average markup on branded products in the low-double-digit range (compared with average markups in the high teens at Wal-Mart and in the mid-20% range at most grocery stores).

With an average of 3,800 active SKUs per club (which constantly change depending on consumer demand) versus more than 60,000 at most mass merchant superstores, Costco wields almost as much bargaining power with its suppliers as industry behemoths like Wal-Mart and Kroger KR. While this approach puts additional pressure on Sinegal and his merchant team when selecting their merchandise assortment, Costco has established a well-deserved reputation for putting only the most sought-after products in front of its members. The firm also reduces handling costs by purchasing full truckloads of merchandise from manufacturers and storing merchandise on sales floors rather than in central warehouses. Self-service store formats and modest marketing requirements (a result of word-of-mouth advertising) help to minimize operating costs, allowing Costco to pass the savings to consumers in the form of lower prices.

By offering a high-quality assortment at rock-bottom prices, Costco has become a relevant shopping destination for consumers across all income levels as well as small businesses. Costco's commitment to price leadership is fierce, evidenced by management's decision to pull Coca-Cola KO products off its shelves at the end of 2009. Although details were sparse, we believe that Costco pulled Coke products off its shelves to procure more favorable nationwide pricing terms. While large consumer packaged food companies have historically had the upper hand in pricing disputes, we believe Costco's role as a vital distribution outlet won out in the end--it is the third largest retailer in the United States with $65 billion in domestic sales--and Coke granted the retailer more favorable pricing terms. In our view, this outcome suggests that Costco's influence over suppliers may be increasing, which should ensure the lowest possible prices for consumers during a post-recessionary environment.

R. J. Hottovy, CFA, is a director of equity analysis with Morningstar.
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