Morningstar's 2011 CEO of the Year Redefined Retail

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.

Member renewal and retention rates have not suffered much when Costco has raised membership fees in the past (which typically occurs every five years or so), suggesting that Costco also wields a fair amount of pricing power over its customers. So far, we've seen relatively strong member retention rates following the 10% increase in annual membership fees that went into effect on Nov. 1 (taking Gold Star, business, business add-on, and Canada business membership fees to $55 from $50 per year and executive membership annual fees to $110 from $100). Taken in combination, we are confident that Costco can preserve a significant portion of the market share it has already captured from other discounters and other specialty retail channels.

It also is clear that Costco's Kirkland Signature brand has become more than a private label that complements other national brands, evidenced by the number of other convenience stores and specialty retailers that purchase Kirkland products for resale. We estimate that Kirkland accounted for more than a fourth of sales in fiscal 2011, and the brand's customer satisfaction and value scores remain very impressive relative to those of branded substitutes.

Costco's low-price strategy inherently leads to thin profitability. However, the company overcomes low margins with massive sales volume and rapid inventory turnover. In fact, Costco converts its inventory into cash before payments are due to its suppliers, leading to negative working capital (excluding excess cash). This efficiency lends itself to exceptionally high productivity levels, not only for a warehouse club chain but also among all retail competitors. In fiscal 2011, Costco generated about $154 million per club, almost 90% higher than the next highest grossing retail concept in Morningstar's coverage universe (Sam's Club, with about $80 million per unit in its most recent fiscal year). This translates into more than $1,000 per square foot, an echelon traditionally reserved for high-end jewelers and fashion apparel retailers.

Exceptional productivity also leads to strong returns on invested capital, which have consistently been in the low-teens to midteens range the past five years and comfortably ahead of our 9.6% weighted average cost of capital assumption. Because we believe Costco's competitive advantages should hold under any economic environment, we expect the firm to continue generating positive economic returns over an extended horizon, implying an economic moat that is only getting stronger.

Still the Early Inning of a Compelling Growth Story
Sinegal's achievements have cleared the way for a significant runway of growth. Given the heavy capital requirements involved (we estimate that each new club requires a capital outlay between $25 million and $30 million), we have been encouraged by the firm's steady mid-single-digit square footage growth over the past several years. Still, with just 600 clubs across the globe and the early success of warehouse clubs in overseas markets, Costco has attractive global growth opportunities. We believe there may be an opportunity to approach 1,000 warehouse clubs by the end of the decade, with international expansion being an increasingly critical growth engine going forward.

Warehouse clubs have started to gain acceptance among international consumers, and we believe Costco can be just as disruptive to retailers overseas as it has been in the United States. This is particularly true in Taiwan, Japan, and Australia, where the company boasts some of the strongest productivity rates in its entire system. We expect 100-125 new international Costco units over the next decade (including another 30 or so in Canada), with even greater potential over a longer horizon.

Domestic growth opportunities are also abundant through real estate creativity. Considering the real estate constraints of some of Costco's more recent market entries, including the opening of its first warehouse club in Manhattan in late 2009, we have found ourselves incrementally more confident in management's ability to find suitable sites to build additional 140,000-square-foot warehouse clubs in the United States (including two-story locations). Under Sinegal's watch, the company has also built a handful of locations in mall parking lots, which could present additional domestic real estate opportunities over the long run. We believe the firm has a clear runway to add another 150 domestic warehouse clubs over the next decade.

A Model of Corporate Stewardship
Costco's corporate stewardship is excellent, with one of the best management teams in retail. As discussed earlier, Costco's management compensation levels compare very favorably with industry standards. Sinegal's base salary is just $350,000--it has not changed in at least five years--and his overall compensation was just $2.2 million in 2011 (including a $200,000 performance bonus and equity awards of $1.5 million), which is in line with many of the small-cap names in our consumer coverage universe. Sinegal had been employed via one-year contracts (an arrangement that will continue under Jelinek), giving the board the opportunity to evaluate him annually. To our knowledge, Sinegal operated under one of the few (if not the only) CEO contracts among companies in the S&P 500 that allowed for "termination for cause," which should come as a breath of fresh air for investors.

Sinegal's ethical approach has been rewarded with a fiercely loyal workforce. Costco has the lowest employee turnover rate in retailing--turnover is approximately one fifth what it is at Wal-Mart, according to our estimates. Costco also pays higher than average wages, close to $20 an hour or 40% more than Sam's Club. Moreover, Costco management is a big believer in promoting from within, with almost 100% of upward appointments going to someone within the organization. The company also offers an exceptional benefits package, including full-time health-care coverage to more than 90% of its workforce. Although this is costly on the surface, the firm is reimbursed handsomely with greater workforce productivity. In fact, Costco generates more than $530,000 in sales per employee.

Watching Sinegal interact with his employees is a sight that is all too rare in the business world. We had the opportunity to attend Costco's analyst and investor event in New York City in November 2009, which was held in conjunction with the opening of the firm's first warehouse club in Manhattan. As we toured the floor of the new location, instead of interacting with sell-side analysts or investment bankers, we saw Sinegal more often than not speaking with the club's employees (even going as far as putting together an impromptu office pool taking employees' guesses as to the opening weekend sales volume for the new club). As we followed up with employees throughout the event, the loyalty for Sinegal was more than apparent with many aspiring to remain with Costco their entire careers. Fostering this level of employee loyalty, in addition to Costco's operational excellence, makes Jim Sinegal an easy choice for our CEO of the Year award in 2011.