Why Costco ($COST) will survive and Walmart ($WMT) will be challenged in Amazon ($AMZN) world…

Is it better to have 25% margins or 15% margins ? The answer is it depends. We cannot answer the question until we have the other half of the equation, which is how many capital dollars support each dollar of margin. A retailer may earn 25% gross margins but turns his investment (in inventory) much slower than his competitor. My point may be clearer when considering profitability and returns in unit terms. Think of terms of price per unit, cost per unit, and invested capital per unit. As your turnover increases, your invested capital per unit goes lower.

ROIC = (Price per unit — Cost per Unit) / (Invested Capital per Unit)

I have seen a lot confusion on the web about AMZN’s disruption of the traditional brick and mortar retail space so I wanted to share my thoughts on what I consider is important to focus on.

WMT and COST are 2 very different retailers as they drive their returns on capital in completely different ways. WMT is a high margin/low turnover business while COST is the exact opposite. WMT carries more than 100,000 SKUs in its Supercenter stores while COST comes in with under 4,000 SKUs. WMT chooses to carry 5 different kinds of tennis raquets and 10 different kinds of office chairs while COST will carry just 1. Outside of the staple categories (mainly food and personal care products), much of those SKUs inside WMT just do not turn very often so the company must earn a higher margin (charge more $) to earn a decent return on its inventory investment/capital. On the other hand, COST can accept lower margin on its business because it can make it up on the inventory turns focusing almost exlcusively on high turnover categories(like recurring revenue food categories).

Each customer may buy a car battery once every couple of years while the same customer may buy a bottle of wine each week. COST chooses to specialize in a select few product categories while WMT rather offer every product in almost every category.

Over the past 4 years, WMT’s gross margin has averaged 24.9% while COST averaged just 12.6%. While EBITDA margins were 7.6% and 3.8%, respectively. At first glance, you would think COST would have much lower returns on capital but this is not the case. 4 year average PT ROIC at WMT and COST was the same at 14%. This is due to the leaner balance sheet that COST operates with. COST generates more money with less capital.

“Your margin is my opportunity” — Jeff Bezos

Amazon was able to kill Borders because they relied on a fat margin to earn their return on capital. This was due to the nature of the book business. The physical store footprint required stocking low turnover books in every store in the country while Amazon just needed to carry a few. For example, let’s say Borders knew it sold 1 Charloette’s Web per month across its network but the problem was it didn’t know which store the sale would come from; as such, it had to stock 1 copy in every store or risk losing the sale. This is capital intensive and requires a higher margin to offset the cost of stocking multiple books in preparation for the 1 unit sale.

Amazon saw their opportunity and seized it. They realized they could undercut on price while making it up on inventory turns and still earn the same return on capital as its competitor. AMZN would only have to stock 1 Charlotte's web copy per month vs. Borders had to stock numerous copies to support that 1 sale. Remember to consider again, how many dollars of capital are needed to support each dollar of margin.

WMT is vulnerable to AMZN’s model as a high margin/low turnover business as it cannot compete with AMZN’s model. COST on the other hand runs a low margin/high turnover business and should be well insulated from AMZN’s threats.

Bottomline, Amazon should dominate the low turnover categories in traditional retail and I expect to see WMT exit certain areas and reduce SKU count as it realizes its efforts to compete in car parts, toys, clothes, electronics, home decor, etc. is hopeless given Amazon’s leaner model and ability to profitably undercut on price.

A couple of qualifiers:

WMT may choose to transition to a COST model in certain categories which could work.

AMZN may not be able to contain “last-mile” charges and may struggle to compete.

Inventory turns defined here as Sales/Inventory