Craig jelinek leadership style

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Costco Wholesale in 2018: Mission, Business Model, and Strategy

Arthur A. Thompson Jr., The University of Alabama

Six years after turning the leadership of Costco Wholesale over to then-president, Craig Jelinek, Jim Sinegal, Costco’s co-founder and chief exec- utive officer (CEO) from 1983 until year-end 2011, had ample reason to be pleased with the company’s ongoing revenue growth and competitive standing as one of the world’s biggest and best consumer goods merchandisers. Sinegal had been the driving force behind Costco’s 35-year evolution from a startup entre- preneurial venture into the third largest retailer in the United States, the seventh largest retailer in the world, and the undisputed leader of the discount warehouse and wholesale club segment of the North American retailing industry. Since January 2012, when Craig Jelinek took the reins as Costco Wholesale’s president and CEO, the company had prospered, growing from annual revenues of $89 billion and 598 membership warehouses at year-end fiscal 2011 to annual revenues of $126.2 billion and 741 membership warehouses at year-end fiscal 2017. Costco’s growth continued in the first nine months of fiscal 2018; 9-month rev- enues were $95.0 billion, up 12.0 percent over the first 9 months of fiscal 2017, and the company had opened four additional warehouses. As of June 2018, Costco ranked as the second largest retailer in both the United States and the world (behind Walmart).

COMPANY BACKGROUND The membership warehouse concept was pioneered by discount merchandising sage Sol Price, who opened the first Price Club in a converted airplane hangar on Morena Boulevard in San Diego in 1976. Price Club lost $750,000 in its first year of opera- tion, but by 1979 it had two stores, 900 employees,

200,000 members, and a $1 million profit. Years ear- lier, Sol Price had experimented with discount retail- ing at a San Diego store called Fed-Mart. Jim Sinegal got his start in retailing at the age of 18, loading mat- tresses for $1.25 an hour at Fed-Mart while attending San Diego Community College. When Sol Price sold Fed-Mart, Sinegal left with Price to help him start the San Diego Price Club store; within a few years, Sol Price’s Price Club emerged as the unchallenged leader in member warehouse retailing, with stores operating primarily on the West Coast.

Although Price originally conceived Price Club as a place where small local businesses could obtain needed merchandise at economical prices, he soon concluded that his fledgling operation could achieve far greater sales volumes and gain buying clout with suppliers by also granting membership to individuals—a conclusion that launched the deep-discount warehouse club industry on a steep growth curve.

When Sinegal was 26, Sol Price made him the manager of the original San Diego store, which had become unprofitable. Price saw that Sinegal had a special knack for discount retailing and for spotting what a store was doing wrong (usually either not being in the right merchandise categories or not sell- ing items at the right price points)—the very things that Sol Price was good at and that were at the root of Price Club’s growing success in the marketplace. Sinegal soon got the San Diego store back into the black. Over the next several years, Sinegal continued to build his prowess and talents for discount merchan- dising. He mirrored Sol Price’s attention to detail and absorbed all the nuances and subtleties of his mentor’s

CASE 4

Copyright ©2019 by Arthur A. Thompson. All rights reserved.

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C-18 PART 2 Cases in Crafting and Executing Strategy

style of operating—constantly improving store opera- tions, keeping operating costs and overhead low, stocking items that moved quickly, and charging ultra- low prices that kept customers coming back to shop. Realizing that he had mastered the tricks of running a successful membership warehouse business from Sol Price, Sinegal decided to leave Price Club and form his own warehouse club operation.

Sinegal and Seattle entrepreneur Jeff Brotman founded Costco, and the first Costco store began operations in Seattle in 1983—the same year that Walmart launched its warehouse membership for- mat, Sam’s Club. By the end of 1984, there were nine Costco stores in five states serving over 200,000 members. In December 1985, Costco became a public company, selling shares to the public and raising addi- tional capital for expansion. Costco became the first ever U.S. company to reach $1 billion in sales in less than six years. In October 1993, Costco merged with Price Club. Jim Sinegal became CEO of the merged company, presiding over 206 PriceCostco locations, with total annual sales of $16 billion. Jeff Brotman, who had functioned as Costco’s chairman since the company’s founding, became vice chairman of PriceCostco in 1993 and was elevated to chairman of the company’s board of directors in December 1994, a position he held until his unexpected death in 2017.

In January 1997, after the spin-off of most of its non- warehouse assets to Price Enterprises Inc., PriceCostco changed its name to Costco Companies Inc. When the company reincorporated from Delaware to Washington in August 1999, the name was changed to Costco Wholesale Corporation. The company’s headquarters was in Issaquah, Washington, not far from Seattle.

Jim Sinegal’s Leadership Style Sinegal was far from the stereotypical CEO. He dressed casually and unpretentiously, often going to the office or touring Costco stores wearing an open-collared cot- ton shirt that came from a Costco bargain rack and sporting a standard employee name tag that said, sim- ply, “Jim.” His informal dress and unimposing appear- ance made it easy for Costco shoppers to mistake him for a store clerk. He answered his own phone, once tell- ing ABC News reporters, “If a customer’s calling and they have a gripe, don’t you think they kind of enjoy the fact that I picked up the phone and talked to them?”1

Sinegal spent considerable time touring Costco stores, using the company plane to fly from location to location and sometimes visiting 8 to 10 stores daily

(the record for a single day was 12). Treated like a celebrity when he appeared at a store (the news “Jim’s in the store” spread quickly), Sinegal made a point of greeting store employees. He observed, “The employ- ees know that I want to say hello to them, because I like them. We have said from the very beginning: ‘We’re going to be a company that’s on a first-name basis with everyone.’”2 Employees genuinely seemed to like Sinegal. He talked quietly, in a commonsensi- cal manner that suggested what he was saying was no big deal.3 He came across as kind yet stern, but he was prone to display irritation when he disagreed sharply with what people were saying to him.

In touring a Costco store with the local store manager, Sinegal was very much the person-in- charge. He functioned as producer, director, and knowledgeable critic. He cut to the chase quickly, exhibiting intense attention to detail and pricing, wandering through store aisles firing a barrage of questions at store managers about sales volumes and stock levels of particular items, critiquing merchan- dising displays or the position of certain products in the stores, commenting on any aspect of store opera- tions that caught his eye, and asking managers to do further research and get back to him with more information whenever he found their answers to his questions less than satisfying. Sinegal had tremen- dous merchandising savvy, demanded much of store managers and employees, and definitely set the tone for how the company operated its discounted retail- ing business. Knowledgeable observers regarded Jim Sinegal’s merchandising expertise as being on a par with Walmart’s legendary founder, Sam Walton.

In September 2011, at the age of 75, Jim Sinegal informed Costco’s Board of Directors of his intention to step down as CEO of the company effective January 2012. The Board elected Craig Jelinek, President and Chief Operating Officer since February 2010, to suc- ceed Sinegal and hold the titles of both President and CEO. Jelinek was a highly experienced retail executive with 37 years in the industry, 28 of them at Costco, where he started as one of the Company’s first ware- house managers in 1984. He had served in every major role related to Costco’s business operations and merchandising activities during his tenure. When he stepped down as CEO, Sinegal retained his position on the company’s Board of Directors and, at the age of 79, was re-elected to another three-year term on Costco’s board in December 2015; he retired from Costco’s Board at the end of his term in January 2018.

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CAse 4 Costco Wholesale in 2018: Mission, Business Model, and Strategy C-19

members per day. Annual sales per store averaged about $170 million ($3.3 million per week) in 2017, over 70 percent higher than the $99.2 million per year and $1.9 million per week averages for Sam’s Club, Costco’s chief competitor. In 2014, 165 of Costco’s warehouses generated sales exceeding $200 million annually, up from 56 in 2010; and 60 warehouses had sales exceeding $250 million, including two that had more than $400 million in sales.4 In 2018, Costco was the only national retailer in the history of the United States that could boast of average annual revenue in excess of $170 million per location.

Exhibit 1 contains a financial and operating summary for Costco for fiscal years 2000, 2005, and from 2014 through 2017.

COsTCO WHOLesALe IN 2018 In June 2018, Costco was operating 750 membership warehouses, including 520 in the United States and Puerto Rico, 98 in Canada, 38 in Mexico, 28 in the United Kingdom, 26 in Japan, 14 in South Korea, 13 in Taiwan, 9 in Australia, 2 in Spain, 1 in France, and 1 in Iceland. Costco also sold merchandise to mem- bers at websites in the United States, Canada, the United Kingdom, Mexico, South Korea, and Taiwan. Over 90 million cardholders were entitled to shop at Costco as of January 2018; in fiscal year 2017, mem- bership fees generated over $2.85 billion in revenues for the company. Headed into 2018, on average, traf- fic at Costco’s warehouse locations averaged 3 million

EXHIBIT 1 selected Financial and Operating Data for Costco Wholesale Corp., Fiscal Years 2000, 2005, and 2014–2017 ($ in millions, except for per share data)

Fiscal years ending on Sunday closest to August 31

Selected Income Statement Data 2017 2016 2015 2014 2005 2000

Net sales $126,172 $116,073 $113,666 $110,212 $51,862 $31,621

Membership fees 2,853 2,646 2,533 2,428 1,073 544

Total revenue 129,025 118,719 116,199 112,640 52,935 32,164

Operating expenses

Merchandise costs 111,882 102,901 101,065 98,458 46,347 28,322

Selling, general and administrative

12,950 12,068 11,445 10,899 5,044 2,755

Preopening expenses 82 78 65 63 53 42

Provision for impaired assets and store closing costs

——— ——— ——— ——— 16 7

Total operating expenses 124,914 115,047 112,575 109,420 51,460 31,126

Operating income 4,111 3,672 3,624 3,220 1,474 1,037

Other income (expense)

Interest expense (134) (133) (124) (113) (34) (39)

Interest income and other, net 62 80 104 90 109 54

Income before income taxes 4,039 3,619 3,604 3,197 1,549 1,052

Provision for income taxes 1,325 1,243 1,195 1,109 486 421

Net income $ 2,714 $ 2,350 $ 2,377 $ 2,058 $ 1,063 $ 631

Diluted net income per share $ 6.08 $5.33 $5.37 $4.65 $2.18 $ 1.35

Dividends per share (not including special dividend of $7.00 in 2017 and $5.00 in 2015)

$ 1.90 $1.70 $1.51 $1.33 0.43 0.00

Millions of shares used in per share calculations

440.9 441.3 442.7 442.5 492.0 475.7

(Continued)

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C-20 PART 2 Cases in Crafting and Executing Strategy

2017 2016 2015 2014 2005 2000

Balance Sheet Data

Cash and cash equivalents $ 4,546 $ 3,379 $ 4,801 $ 5,738 $ 2,063 $ 525

Merchandise inventories 9,834 8,969 8,908 8,456 4,015 2,490

Current assets 17,317 15,218 16,779 17,588 8,238 3,470

Current liabilities 17,485 15,575 16,539 14,412 6,761 3,404

Net property and equipment 18,161 17,043 15,401 14,830 7,790 4,834

Total assets 36,347 33,163 33,017 33,024 16,514 8,634

Long-term debt 6.573 4,061 4,852 5,093 711 790

Stockholders’ equity 10,778 12,079 10,617 12,515 8,881 4,240

Cash Flow Data

Net cash provided by operating activities

$ 6,726 $ 3,292 $ 4,285 $3,984 $ 1,773 $ 1,070

Warehouse Operations

Warehouses in operation at beginning of yeara

715 686 663 634 417 292

New warehouses opened (including relocations)

28 33 26 30 21 25

Existing warehouses closed (including relocations)

(2) (4) (3) (1) (5) (4)

Warehouses at end of year 741 715 686 663 433 313

Net sales per warehouse open at year-end (in millions)

$ 170 $ 162 $ 166 $ 166 $ 120 $ 101

Average annual growth at warehouses open more than a year (excluding the impact of changing gasoline prices and foreign exchange rates)

4% 4% 7% 6% 7% 11%

Members at year-end

Businesses, including add-on members (000s)

10,800 10,800 10,600 10,400 5,000 4,200

Gold Star members (000s) 38,600 36,800 34,000 31,600 16,200 10,500

Total paid members 49,400 47,600 44,600 42,000 21,200 14,700

Household cardholders that both business and Gold Star members were automatically entitled to receive

42,600 42,600 40,200 34,400 n.a. n.a.

Total cardholders 90,300 86,700 81,300 76,400 ——— ———

a At the beginning of Costco’s 2011 fiscal year, the operations of 32 warehouses in Mexico that were part of a 50 percent-owned joint ven- ture were consolidated and reported as part of Costco’s total operations.

Note: Some totals may not add due to rounding and to not including some line items of minor significance in the company’s statement of income.

Sources: Company 10-K reports for fiscal years 2000, 2005, 2015, 2016, and 2017.

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CAse 4 Costco Wholesale in 2018: Mission, Business Model, and Strategy C-21

Big sales volumes and rapid inventory turnover— when combined with the low operating costs achieved by volume purchasing, efficient distribution, and reduced handling of merchandise in no-frills, self- service warehouse facilities—enabled Costco to oper- ate profitably at significantly lower gross margins than traditional wholesalers, mass merchandisers, supermarkets, and supercenters. Membership fees were a critical element of Costco’s business model because they provided sufficient supplemental rev- enues to boost the company’s overall profitability to acceptable levels. Indeed, Costco’s revenues from membership fees typically exceeded 100 percent of the company’s net income, meaning that the rest of Costco’s worldwide business operated on a slightly below breakeven basis (see Exhibit 1)—which trans- lated into Costco’s prices being exceptionally com- petitive when compared to the prices that Costco members paid when shopping elsewhere.

Another important business model element was that Costco’s high sales volume and rapid inventory turnover generally allowed it to sell and receive cash for inventory before it had to pay many of its mer- chandise vendors, even when vendor payments were made in time to take advantage of early payment discounts. Thus, Costco was able to finance a big percentage of its merchandise inventory through the payment terms provided by vendors rather than by having to maintain sizable working capital (defined as current assets minus current liabilities) to enable timely payment of suppliers.

Costco’s Strategy The key elements of Costco’s strategy were ultra- low prices, a limited selection of nationally branded and top-quality Kirkland Signature products cov- ering diverse merchandise categories, a “treasure hunt” shopping environment that stemmed from a constantly-changing inventory of about 900 “while- they-last specials,” strong emphasis on low operating costs, and ongoing expansion of its geographic net- work of store locations.

Pricing Costco’s philosophy was to keep custom- ers coming in to shop by wowing them with low prices and thereby generating big sales volumes. Examples of Costco’s 2015 sales volumes that con- tributed to low prices in particular product cat- egories included 156,000 carats of diamonds, meat sales of $6.4 billion, seafood sales of $1.3 billion,

COsTCO’s MIssION, BUsINess MODeL, AND sTRATeGY Costco’s stated mission in the membership warehouse business was: “To continually provide our members with quality goods and services at the lowest possible prices.”5 However, in a “Letter to Shareholders” in the company’s 2011 Annual Report, Costco’s three top executives—Jeff Brotman, Jim Sinegal, and Craig Jelinek—provided a more expansive view of Costco’s mission, stating:

The company will continue to pursue its mission of bringing the highest quality goods and services to mar- ket at the lowest possible prices while providing excel- lent customer service and adhering to a strict code of ethics that includes taking care of our employees and members, respecting our suppliers, rewarding our share- holders, and seeking to be responsible corporate citizens and environmental stewards in our operations around the world.”6

In the company’s 2017 Annual Report, Craig Jelinek elaborated on how environmental sustainabil- ity fit into Costco’s mission:

Sustainability to us is remaining a profitable business while doing the right thing. We are committed to less- ening our environmental impact, decreasing our carbon footprint, sourcing our products responsibly, and work- ing with our suppliers, manufacturers, and farmers to preserve natural resources. This will remain at the fore- front of our business practices. 7

The centerpiece of Costco’s business model was a powerful value proposition that featured a combi- nation of (1) ultra-low prices on a limited selection of nationally branded and Costco’s private-label Kirkland Signature products in a wide range of mer- chandise categories, (2) very good to excellent prod- uct quality, and (3) intriguing product selection that included both everyday items and ongoing special purchases from a big variety of merchandise suppli- ers that turned shopping at Costco into a money- saving treasure hunt. Ever since the company’s founding, Costco management had strived diligently to ensure that shopping at Costco delivered enough value to keep existing members returning frequently to a nearby warehouse and spur membership growth every year, thereby generating high sales volumes and rapid inventory turnover at each warehouse and cre- ating opportunities to open new warehouses.

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C-22 PART 2 Cases in Crafting and Executing Strategy

compete somewhere else.” Some years ago, we were sell- ing a hot brand of jeans for $29.99. They were $50 in a department store. We got a great deal on them and could have sold them for a higher price but we went down to $29.99. Why? We knew it would create a riot.8

At another time, he said:

We’re very good merchants, and we offer value. The tra- ditional retailer will say: “I’m selling this for $10. I won- der whether we can get $10.50 or $11.” We say: “We’re selling this for $9. How do we get it down to $8?” We understand that our members don’t come and shop with us because of the window displays or the Santa Claus or the piano player. They come and shop with us because we offer great values.9

Indeed, Costco’s markups and prices were so fractionally above the level needed to cover company- wide operating costs and interest expenses that Wall Street analysts had criticized Costco management for going all out to please customers at the expense of increasing profits for shareholders. One retailing analyst said, “They could probably get more money for a lot of the items they sell.”10 During his tenure as CEO, Sinegal had never been impressed with Wall Street calls for Costco to abandon its ultra-low pric- ing strategy, commenting: “Those people are in the business of making money between now and next Tuesday. We’re trying to build an organization that’s going to be here 50 years from now.”11 He went on to explain why Costco’s approach to pricing would remain unaltered during his tenure:

When I started, Sears, Roebuck was the Costco of the country, but they allowed someone else to come in under them. We don’t want to be one of the casualties. We don’t want to turn around and say, “We got so fancy we’ve raised our prices, and all of a sudden a new com- petitor comes in and beats our prices.”12

Product Selection Whereas typical supermar- kets stocked about 40,000 items and a Walmart Supercenter or a SuperTarget might have 125,000 to 150,000 items for shoppers to choose from, Costco’s merchandising strategy was to provide members with a selection of approximately 3,800 active items that could be priced at bargain levels and thus provide members with significant cost savings. Of these, about 75 percent were quality brand-name products and 25 percent carried the company’s private-label Kirkland Signature brand. The Kirkland Signature label appeared on everything from men’s dress shirts to laundry detergent, pet food to toilet paper, canned

television sales of $1.8 billion, fresh produce sales of $5.8 billion (sourced from 44 countries), 83 million rotisserie chickens, 7.9 million tires, 41 million pre- scriptions, 6 million pairs of glasses, and 128 million hot dog/soda pop combinations. Costco was the world’s largest seller of fine wines ($965 million out of total 2015 wine sales of $1.7 billion).

For many years, a key element of Costco’s pric- ing strategy had been to cap its markup on brand-name merchandise at 14 percent (compared to 25 percent and higher markups for other discounters and most supermarkets and 50 percent and higher markups for department stores). Markups on Costco’s private- label Kirkland Signature items were a maximum of 15 percent, but the sometimes fractionally higher mark- ups still resulted in Kirkland Signature items being priced about 20 percent below comparable name-brand items. Except for Walmart, Costco’s prices for fresh foods and grocery items ranged 20 to 30 percent below of the leading supermarket chains. Aside from being lower-priced, Costco’s Kirkland Signature products— which included vitamins, juice, bottled water, coffee, spices, olive oil, canned salmon and tuna, nuts, laundry detergent, baby products, dog food, luggage, cookware, trash bags, batteries, wines and spirits, paper towels and toilet paper, and clothing—were designed to be of equal or better quality than national brands.

As a result of its low markups, Costco’s prices were just fractionally above breakeven levels, produc- ing net sales revenues (not counting membership fees) that exceeded all operating expenses (mer- chandise costs + selling, general and administrative expenses + preopening expenses and store relocation expenses) by only $1.0 billion to $1. 2 billion in fiscal years 2017, 2016, and 2015 and by just $400 million to $800 million dollars in fiscal years 2014, 2005 and 2005. As can be verified from Exhibit 1, Costco’s revenues from membership fees accounted for 69 to 75 percent of the company’s operating profits in fis- cal years 2014 to 2017 and exceeded the company’s net income after taxes in every fiscal year shown in Exhibit 1 except for fiscal year 2000—chiefly because of the company’s ultra-low pricing strategy and prac- tice of capping the margins on branded goods at 14 percent and private-label goods at 15 percent.