Warren Buffett is famous for his investing concepts, though few are as long-lasting as his economic moats, or enduring competitive advantages. The idea is that certain businesses can use their competitive advantages as defensive weapons, protecting profits and keeping competitors at bay.
Buffett's idea is simple, yet powerful. Moats, whether real or economic, are used as barriers. In feudal Europe, moats kept invading armies away from keeps and city centers. A good moat could keep away competitive forces; a moat with alligators could actually harm them. Similarly, the right kind of business advantages can deter most competitors from the arena or even harm (financially) those who try to take away customers.
Costco Wholesale Corporation (NASDAQ: COST) has some decided advantages over most grocers and warehouses. Costco spends less and charges less than just about everybody else. Shelves in Costco's minimalist warehouses are packed with bulk items, which means more product is moved per purchase, and at a lower cost, than in competitors' stores. It's an eminently scalable business model.
The second, and perhaps more significant, advantage is that Costco has developed a large, dedicated paid membership base, along with a loyal workforce. Costco shoppers are so convinced they are made better off by its services that they are willing to pay for the privilege of entering the store.
Low Cost Structure and Economies of Scale
In a way, Costco is the logical conclusion of supply chain economies of scale. Costco's stores are designed and built with maximum cost efficiency in mind. The floors are concrete, and the ceilings aren't tiled. Products are lined up simply on row after row after row of skeletal, metallic shelves. If a product can be packaged in bulk, it is.
As a result, Costco has lower gross margins than its competitors but higher returns on invested capital. Net profitability margins are also small, since Costco uses its lower operating costs to suppress prices rather than inflate margins. This leaves very little room for competing stores to undercut it.
Even the product offerings are unique. Most of Costco's select range of brand products are aimed at maximizing bulk value, but there is still an emphasis on quality. The inventory is narrow compared to other stores; Wal-Mart Stores, Inc. (NYSE: WMT) carries nearly 20 times as many stock-keeping units per superstore.
Low markups and simple, consistent, valuable products allow Costco to speed huge volume through each store, leveraging the fixed store base. Through the years, Costco has added auto services, along with pharmacy, optometry, jewelry, insurance, photo center, gas and liquor products. It's more efficient for customers to shop in one trip, and Costco caters to that.
Brand Equity and Corporate Culture
As important as cost efficiency is, Costco's economic moat is mostly built on its brand and corporate culture. Costco deploys a subtle yet effective marketing strategy, emphasizing value for customers, shareholders and employees. This means low costs, high pay, plenty of rewards, donations to local charities and so on. This model creates devotion and buy-in from all parties, and it helps Costco further insulate itself from competition.
Ultra-low prices certainly help, but they aren't the only reason customers choose Costco. By requiring a membership to enter, Costco shoppers may feel as though they are part of a more exclusive club of customers. Many customers probably feel compelled to shop at Costco more frequently to justify a paid membership. As much as 75% of Costco's gross profits are earned through membership dues.
Costco workers receive strong salaries and good benefits compared to the employees of competitor companies. As of 2015, the average American Costco employee earned $20.89 per hour, or nearly double the $11.83 figure for an average Wal-Mart employee. This also correlates with sales figures; the average sales per worker for Costco were twice as high as Wal-Mart's, too.
While it's likely that Costco's workers are well paid because of this fact (and not the other way around), most experts believe Costco realizes lower turnover and better employee satisfaction because of high wages. This certainly helps maintain an economic moat.
No moat is unassailable, but Costco is better prepared to weather downturns and changes in consumer tastes than most. This is good news for paying members, employees and investors.