How Costco’s Memberships Generate Float
One of Costco Wholesale’s (NASDAQ: COST) best attributes from a value investor’s standpoint is its ability to generate float with its memberships.
The best way to think of float is as revenue that a company does not have to spend on merchandise or operations. Instead, the company puts the money in the bank to hold as a reserve, borrow against it, bankroll expansions without issuing debt, cover unforeseen expenditures, cover operational costs, or pay out in dividends.
Knowledgeable investors know that Warren Buffett loves float because float equals cash. On some level, float can even be thought of as additional free cashflow. Some forms of float are obviously better than others because traditional float, such as an insurance company’s premiums, may come with some commitments. An insurer can borrow against its premiums, but it cannot use most of that money for operations or expansions.
Costco, on the other hand, can use the float from its memberships for almost anything it wants to. That’s good news for investors because Costco generated $768 million in membership fee revenue in the fourth quarter of 2014, according to The Wall Street Journal. Costco’s float is growing too – its membership fee revenue grew by 7% during the fourth quarter.
Even though they generate float, membership fees still make up a small percentage of Costco’s revenues. The company still makes most of its money the old fashioned way – by selling stuff to customers. Costco’s merchandise revenues in the fourth quarter were $31.04 billion and they increased by 9%, according to our friends at the Journal.
Costco’s Membership Revenue Explains Amazon Prime
Costco’s membership fee revenue explains why Amazon.com (NASDAQ: AMZN) has devoted so much time and effort to promote its Amazon Prime membership scheme. Amazon CEO Jeff Bezos is trying to generate a lot of float by mimicking Costco’s membership program.
Brad Stone’s excellent book, The Everything Store: Jeff Bezos and the Age of Amazon, revealed that Bezos is a huge fan of Costco and its founder, Jim Sinegal. In Chapter 4, Stone explained how Bezos picked Sinegal’s mind in 2001. One of the lessons Bezos clearly learned from Sinegal was the way the membership fee worked. Here is how Sinegal explained the membership fee, according to Stone:
“The membership fee is a one-time pain, but it’s reinforced every time customers walk in and see 47-inch televisions that are $200 less than anyplace else. It reinforces the value of the concept.”
What the book didn’t mention, but value investors like Charlie Munger clearly understand, is that the membership fee also generates float. In addition to buying customer loyalty, it provides an additional revenue stream.
A good way to think of the membership fee is as an investment that a customer makes in Costco. The fee provides a strong incentive to shop at Costco, and the customer wants to recover his or her investment. Costco then tries to reward the member with really low prices.
This strategy has certainly paid off. Executive members who pay $110 for their annual membership generate two-thirds of Costco’s revenues, according to Forbes. Around 300,000 new executive members joined Costco in the second quarter of 2014. Obligating customers to your organization by selling memberships is an effective business plan.
This business plan works outside the United States; Costco has around 10 million members in Canada alone. As I noted elsewhere, one out of three Canadians is a Costco member. The total number of Costco memberships worldwide was around 71 million in February 2013.
It also does buy a lot of loyalty. Forbes reported that 94.4% of Costco’s business members and 89.7% of its Gold Star cardholders renewed their memberships in the second quarter of 2014. Around 1.2 million new members joined Costco in 2013, according to Forbes.
If Bezos could duplicate Costco’s membership fee success with Amazon Prime, he could generate a lot of float. He could also turn his company into a true value investment, much like Costco is.