The CFO lessons behind Costco’s long-term strategy

Richard Galanti:
Isn't a special dividend a little quirky? Not a lot of people do it. And again, Charlie piped up and said, "We're quirky. Let's do it."

Ky Chow:
Our guest today is a speaker at this year's CPA Congress. He joined Costco in 1984 after helping them raise their external capital as a banker. And for the next 40 years, he was their CFO. He fronted 150 earnings calls. And not once during that time did the price of the $1.50 hotdog combo ever change. Richard Galanti, welcome to How CFOs Think.

Richard Galanti:
Thank you, Ky. It's good to be here.

Ky Chow:
You stock around 3,800 products. Of those, which one's your favourite?

Richard Galanti:
Well, I'll probably give you two answers. My favourite two food items is the Kirkland Signature vanilla ice cream. It's got a high content butterfat, which makes it creamier and tastier, and it's awesome. And secondly, the rotisserie chicken.

I can't tell you how many rotisserie chickens my family and I have eaten over the years, but what a great value, but more importantly, what a great product. And then on the non-food side, I would have to say tools. I say that because I'm the proud owner of many tools that I don't even know how to use completely, but they're such great values, I keep buying them.

Ky Chow:
Now, Costco's operating model is unique, right? For anyone who doesn't know it, how does the company actually make money?

Richard Galanti:
Well, in the simplest terms, it's like a traditional retailer. You have sales, less cost of sales as your gross margin, less expenses as your pre-tax earnings. One big and important difference with Costco is our gross margin is not only the markup on goods, but an annual membership fee.

If you think about it, we mark up our goods 12 or 13%. The membership fee represents us another 2%, and together we work on a 13 or 14% margin, therefore. Now, that's an extra cost to the customer. Yes, it's a very small cost when you think about the fact that our combined gross profit, both the markup and the membership fee, is significantly less than traditional retailers.

Traditional supermarkets, at least in the US, work on 25 to 28% markups, apparel retailers as high as one to 200% markups. And arguably, we have great purchasing power because our huge sales base. So we think that it's a very competitive way to do business. And on top of that, it drives and enhances our membership loyalty and our customer loyalty.

Ky Chow:
And another benefit, you stock 3,800 products. So again, compared to other competitors, that's quite different for you.

Richard Galanti:
It is, and that creates great efficiencies. In other words, you can't come in and find 10 different alternatives of a given product at a supermarket, as an example. You might find just one and you have to buy six or eight cans instead of just one.

By doing that though, we've greatly reduced our operating costs, we've driven more sales, and we pass that all on to the customer in form of lower prices.

Ky Chow:
The hot dog and soda has been a $1.50 since the 1980s. Financially, what has it taken to be able to hold onto that price for so long?

Richard Galanti:
Well, very early in our history, 41 years ago, we offered a great quality all beef hot dog and soda for $1.50. It was a great value then. And over the years, every time we try to figure out is how do we keep the cost down? How do we drive more value? And by having greater purchasing power, that was one way. We improved our buying power.

About 20 years ago, we built the first of two hotdog plants. They make one item each about 200 million times a year. You can imagine the operating efficiency of doing that. The other thing we do, we bid out the soda fountain business. Well, there's two giant world partners in soda business, Coca-Cola and Pepsi-Cola.

Not only do we make tens of millions of dollars from that opportunity per year from them, they provide us one to two billion free cups with their logo on it. And it's worked and it served us well and it's become an icon of what we do. It's taken on a life of its own and it certainly stands for the extreme value that Costco's known for.

Ky Chow:
Something else that Costco's probably also known for is capping the markup at 15%. I mean, you could charge way more than that. Tell me about a time when that cap has cost Costco real money.

Richard Galanti:
35 years ago, while we were a deep discounter, not every national apparel brand would sell us, as you might expect. They didn't want to sell at deep discounters. And one famous item back then was the Calvin Klein women's jeans, and it was only sold at the high-end department stores like Saks Fifth Avenue and Nordstrom's and Bergdorf Goodman's. And it was rarely if ever discounted, and it sold at the time for $54.99 a pair.

Well, we would get our hands, we would be able to legally divert a few hundred pairs or a thousand pairs. And we'd be out there, we might buy them for $25, half the price of retail or a little less than that. And then because of that 15% cap, we'd sell them for let's say 28 or 28.99 and we'd sell them out to the piece very quickly.

A few years later, one of the exporters that we were diverting through was selling his business or going out of business or retiring. And over a six-month period into a bonded warehouse, we bought through him two million pair of this jean. Two million pair, not a hundred pair, not a thousand pair. And the problem is we bought them for about $22 a pair. Well, with our 15% cap, we couldn't go over the 24 or $25.

Now you can imagine at a time, I think I look back at the time, Costco as a company was making less than $100 million. This one item over a few month period, we could sell it out to the piece at that 28 or 29.99 price, still be a great value to the 54.99, and we could have easily made an extra $10 million in gross margin, 10 or 15% of our total bottom line for that year, but we didn't.

And you can feel how that resonates throughout the company understanding that we're going to always do the right thing and we're going to work for the long term, even if it costs us something in the short term.

Ky Chow:
And how did you defend that to the shareholders though?

Richard Galanti:
Well, they didn't know all the detail on that one, but there were a few times, particularly at the annual shareholders meeting when shareholders meetings were in person, not virtual as they are today, many of them, that you would have a customer or a member come up or you'd have an institutional shareholder call us who owned our stock and he says, "You're selling that too cheap. It's a 70% savings to retail. Why not a 50% savings?" And it was because that 15% rule and getting back to reminding them this is what keeps us honest and what keeps us right for the long term.

Ky Chow:
Okay. So tell me about a time when the market really went against Costco and sticking to a particular price cost you real money.

Richard Galanti:
Not like the hot tub, but another very famous food item at Costco is the rotisserie chicken. For years, we and our main competitor were $4.99. There was a year when there was a big drought in the Midwestern United States and all the soy and corn, all the feed for poultry for chickens skyrocketed. And in fact, our competitor went from 4.99 for a brief period from 4.99 to 5.99. We stuck it out at 4.99.

It was that value proposition, that extreme value proposition to say, "Those prices will come down after the drought or next season, let's keep the price at 4.99 and drive more value and more loyal to our customers." Cost us about $32 million that quarter.

And what did we do on the earnings call? We talked about it. We said, "Look, we missed our gross margin a little bit. We missed the bottom line a little bit, but there were some other things that helped the bottom line a little bit." And in some ways I think that our shareholders, our institutional investors and our suppliers all understood this is how we operate and we're going to do things the right way and for the long term.

And like the hotdog example, what did we do? We spent $400 million or about 560 million Australian dollars on a poultry processing facility in the Midwestern United States, which was close to the corn and soy, the feed. And that poultry processing facility with about 120 farmer partners within a 50-mile radius processes 450,000 birds a day, six days a week or over 125 million birds. But again, think of all the operating efficiencies of how we're doing that and providing great quality and value to our customer.

Ky Chow:
Look, I also want to talk about home brands now. Kirkland Signature is Costco's and it sells now somewhere around $90 billion a year, so under a single name. So what did you understand about home brands that other retailers didn't?

Richard Galanti:
I think just like a lot of things at Costco, it's all about value and how do you drive the value up and the prices down. And with our private label under the name Kirkland Signature, Jim said, "Let's do something a little differently. Let's not use it as a brand that's a little less quality than a leading national brand. A good quality, but a little less quality. Let's take our private label and do each private label item with two basic factors.

One, it must be at least as good if not better than a leading national brand. And two, we have to sell it at 20% or more less than we sell the brand for. And so it would be an extreme value. And that's what we did. And as you mentioned, over many years, it's now developed from a few items to begin with to a $90 billion category for us across all categories from diapers to vodka.

Ky Chow:
Okay. Now I want to talk about shareholders and investors again. Now, Costco stopped giving earnings guidances, but it still reports sales every month. So why keep one and drop the other?

Richard Galanti:
Yeah. I think for many years, public companies generally provided earnings guidance. They provided quarterly guidance on sales, on earnings per share, the basics gave a range. And then of course, to the extent halfway through a fiscal quarter, things were going in the wrong direction, they'd have to issue a press release and saying, "We're needing to update our numbers downward or a little bit of everything and the stock would respond to it," perhaps over respond to it. I think it was probably again in the mid to late '90s when some large companies, including Berkshire Hathaway, which was the famed company owned by Warren Buffet. I remember at a board meeting discussing it on the earnings side, and we decided to do that as well.

Now on the sales side, again, I go back 20 years ago, there were probably 10 to 15 public retail companies that were reporting monthly sales. And over the years, all but one have stopped doing it. Now, part of it, in my view, was because sometimes the sales are good and sometimes they're bad and they didn't need the aggravation. We have continued to do it through thick and thin, thank goodness more through good stuff than bad.

And we think it's a good barometer how the company is doing. If you're reporting monthly sales a month into that fiscal quarter, people are getting a sense our sales a little better, a little worse or as we expected and they can adjust accordingly and it served us well. And again, it gets back to being open and transparent in our view.

Ky Chow:
I want to look at where the cash for Costco actually goes, how it gets split up. Can you tell me more about that?

Richard Galanti:
Let's take last year's fiscal operating results for Costco. It made a little over $8 billion after tax. It had non-cash charges or depreciation and amortisation of about 2.4 billion. So call it 10, 10 and a half billion cash flow from operations. First and foremost, we use it to grow our business, and thank goodness there's plenty of more opportunities to continue to grow our business. In fact, on a base of 15 locations in Australia, we've already announced four more locations coming over the next year and a half.

Costco last year spent a little over five billion of that 10, 10 and a half billion on capital expenditures. That's not just opening new locations, but it's all the logistics and supply chain infrastructure. It's e-commerce, it's IT expense to grow and develop the infrastructure of the IT department. But overall, about half of that 10 and a half billion went into CapEx, including about 30 new locations a year.

Second is an annual regular dividend. Costco initiated its dividend, I think in about 2014 or '15. I'm sorry, about 2007 or '08, almost 15 to 20 years ago. And we've grown it on average around 13 plus percent a year. That today is a little over $2 billion a year. And if you can imagine if it's growing, I can't predict what it grows in the future, but history would suggest somewhere around that, that would be another 200 to $300 million a year adding to that. But that's another two billion. So you've got the 10, 10 and a half billion to start with, less 5-ish billion for capital expenditures, less a couple billion for regular dividend.

The next in line would be stock buybacks. Costco, I think it's somewhere in the 500 or $600 million range, maybe up to $800 million that we buy back stock. What we're doing there is about seven or 8,000 of Costco's 350,000 employees as part of their compensation receive RSUs, restricted stock units or equity grants.

What we do is those are granted and invested every year. We then buy back enough stock to offset that so we're not diluting the earnings per share, diluting the number of shares outstanding. Beyond that, we might buy a little extra, but at the end of the day, call that 500 million to a billion dollars.

Now, after you've started with 10 or 10 and a half, subtracted five or five and a half, you get down to 5, subtracted 2 for the dividend, subtracted, let's say up to one for the other one, you still got a couple of billion, two to two and a half billion dollars left. In a way, we put it into the checking account, not a literal checking account. It's still invested safe and short term.

And then every few years, historically over the last 15 years, every two to four years we do what's called a special dividend where we give the money back to the shareholders. If we're generating more cash than we need in our business, let's give it back to the shareholders.

And I think the last one we did was in late 2023, so what? Three, three and a half years ago, we did a $15 share or $6.7 billion special dividend. And again, Wall Street has viewed that positively. I'm sure my successor, Gary Millerchip at Costco is constantly being asked, "When's the next special dividend?" Well, we can't tell you because then it wouldn't be special. But at the end of the day, that has served us well over the years.

And I get back to, again, Charlie Munger, who was on our board for 26 years until he passed. One of the comments at the board meeting was, "Isn't a special dividend a little quirky? Not a lot of people do it." And again, Charlie piped up and said, "We're quirky. Let's do it." And it's worked. And so in very simple terms, that's how we spend our money.

Ky Chow:
Costco has a stated order of priorities, the law, customers, employees, and then suppliers and then shareholders. Tell me about a decision where following that order costs the company real money.

Richard Galanti:
Let me give you a quick example of each of those. Let's start with obey the law. We had a project 20, 25 years ago and we were ready to go. We were waiting for this final certificate of occupancy. All we need is a few more permits that were coming in that week or next. And all of a sudden we get a call saying, "Hey, there's one more thing. We need $200,000 for the water commission."

And our view was, "Is it really for the water commission or is it for the water commissioner?" I don't know if it was for the commissioner or somebody, but in our view it was a bribe. And we basically said, "We're not doing it and we'll shut the project down." And we did. By the way, under Foreign Corrupt Fair Practices Act in the United States, you better obey the law, but we would do it under any circumstance.

Secondly, customers. Membership fee. Historically over 40 years, we've raised the annual price of a membership fee by $5 each time every roughly five years. Well, as we got into COVID, the economy was not doing as great, inflation was rampant, and we decided to wait a couple years. Our renewal rates were at all-time highs. Every barometer showed that we could do it without any issue of losing member loyalty, and we chose to wait.

And the only people that questioned it were the Wall Street investors saying, "Well, it's been five years. It's been five and a half years. It's six years." He says, "We'll get to it. Don't worry." And we waited. It was a little over seven years when we did it next. And again, it was the right thing to do given the environment out there.

Next, employees. During the great recession, which was like '09 to '14, every year we give the top of scale hourly employees, which is over half the employee base, an increase. And of course, they want to see what that's going to be. At that time when the great recession occurred, employees across the industries were not getting increases, people were getting laid off. It was a tough time.

I remember going into the meeting with the senior executives and Jim, and the first thing out of Jim's mouth was says, "This is a time when it's toughest on everybody when they need it more than ever. Let's give them an increase more than we gave them last year." And I'm there with my little calculator saying that's going to cost $47 million, which that year. But we all knew where we were going. We're going to do it and it was the right thing to do. And again, we have the lowest turnover in hourly retail that anybody can think of in the very low double digits, like 12, 13% when many retailers have 30, 40, and 50% annual turnover. So it pays dividends well for the company on top of being the right thing to do.

Lastly, suppliers. COVID is a great example. When COVID hit, many orders were being cancelled. Things were stuck on the ocean. Logistics was a mess everywhere. And many good companies just called vendors and says, "We're not taking it. Take it back. We're not paying for it." We told every vendor we're going to live up to our commitment if it's an existing purchase order there.

Now, if you haven't made the goods, if you're making patio furniture in Asia and you've got the raw materials and you haven't made the good, let us pay you for all the raw materials, but hold off on making it for six months. And that again resonated throughout the vendor world, if you will, that we did the right thing. And there are other companies that did the right thing, but I think we did it to an extreme.

So those virtues and that mission statement, if you do all those things, ultimately you're going to reward the shareholders and they're fine with that as long as they're being rewarded.

Ky Chow:
What would you say to those that would say that this kind of discipline and integrity and I guess almost nobility is only possible when you are the size of Costco and has that kind of power? You can't have that kind of integrity all the time in other organisations. What would you say to someone who says that?

Richard Galanti:
I'd say a word that starts with bull, but I think at the end of the day, it's all about leadership. You can only be as noble as you are successful. We have been very fortunate. We've been able to take that nobleness, if you will, to an extreme and continue it because we have been successful over many years. And then there are the pressures out there. And again, we're not perfect and we learn from mistakes along the way at Costco as well.

But at the end of the day, having that strong leadership from Jim to start with and how we did things and doing things for the right way for the long term, even if it cost you something in the short term, has served us very well. But even with all that, if we are in a tougher environment, things might be different as things went up and down a little bit.

Ky Chow:
I want to talk about the merchants because it seems that they've driven a lot of the big moves, fresh food, pharmacy, e-commerce. So what was your role or job in those decisions?

Richard Galanti:
Well, first of all, I think it was the operators and the merchants that were most involved in those strategic decisions to decide what to sell, how to do it, how do we do logistics, how to do e-commerce. My job as CFO and people in my department was first and foremost to provide them the management tools and information they needed to run their business in a successful way and do it in a timely manner.

Let me speak about timely manner. One of the things that might seem a little old-fashioned, but we've done for Costco since its inception is the monthly budget meeting. Actually, 13 times a year we operate on 13 four-week periods. So a four-week period closes on a Sunday. By Monday afternoon, anybody with profit and loss responsibility, whether it's a merchant, an operator, a manufacturing business, gets their results for that prior month.

By Tuesday, there are any corrections or adjustments are made. By Thursday, they update their upcoming projections for the upcoming three, four-week periods. And then the following Tuesday and Wednesday, there's a day and a half long budget meeting with today about 160 people in the room from all over the world. So pity the Australian country manager that every four weeks comes to Seattle for two to three days or from Spain or from wherever.

But you know what? We're all on the same page. We're learning from each of them, not just the numbers and how do they do, that's a small piece of each person's presentation. What they're talking about is how they tried some things and from a merchandising standpoint or presentation standpoint in their country, what worked and didn't work. It's a great cross-fertilisation of those ideas and everybody's on the same page. And I think that's something that has been very strong for us. And again, it's led by merchants and operators. Of course, as CFO and people in my areas, we're providing the updates and providing them information and talking about things that we can do to help them.

Ky Chow:
Because I was going to say, fronting up to like 150 earnings calls, people saw you as the voice of Costco, but that's not the same, is it, as being the author of the strategy?

Richard Galanti:
Absolutely. And I recognise that. The ability to run a business with three or 400 employees each location and three or 4,000 people coming in every day and all the regulations from health and safety and everything else, it's a mammoth job and it's all about teaching and developing the people that are under you. And I think we always did a great job of that.

A couple of examples where of course the CFO was very involved would be on capital expenditure decisions and on the few times that we actually acquired something. Okay, we're wanting to build a hot dog plant for $400 million. What costs are that going to save? What's the cost of doing it? And how does that operate and how do we maximise the success of that? Our founder and his successor, they were out there travelling three weeks a month.

And in part, my job was not just explaining the numbers and those expectations, but sharing a little bit about the company itself, the merchandising, some exciting things we're doing from a merchants and operator side. Our merchants and operators appreciated that to get that message out as well. And so I think it was an all around great thing for Costco, and it's one of the things I miss the most.

Ky Chow:
You talk about giving advice. You see that it's very important. What's the one thing you would tell someone to do in their first 90 days as a CFO?

Richard Galanti:
Well, I think in the first 90 days is knowing and understanding who your stakeholders are, both internal to the company as well as externally. Internal to the company, of course, it's not only the people within your departments of tax, treasury, audit, payroll, accounting, payables, all those things.

It's also understanding who your customers are internal to the company, the merchants, the operators, what are their needs and expectations? One big important thing is understanding the relationship between the outside accounting firm. Again, one of the early things that we always shared with our outside accountants is that we want to be transparent both ways. We want to be transparent and pragmatic.

While accounting's a science, there's still discussions to be had. And when they get comfortable, the outside accountants get comfortable knowing that we're going to bring them things when there's an issue, a negative issue, they feel much better that there's true open and honesty and transparency between both sides.

And then the same thing goes with Wall Street. I think we've shown over time that being direct and transparent and dealing with both good things and bad things head on has worked well for us and created that trust.

Ky Chow:
Richard, 40 years. It's been an incredible 40 years, and thank you so much for the lessons here. I can see, for example, that Costco's finance team, it was never looking for ways of increasing the price of that $1.50 hot dog combo. Instead, it was always looking for the operational supply chain and capital solutions that would let you keep and stick to that promise. That is not just a pricing strategy, that is financial leadership. Thank you so much for your time and insights.

Richard Galanti:
Well, thank you for having me today.

Ky Chow:
You've been listening to How CFOs Think from INTHEBLACK and CPA Australia. For more insights, go to the INTHEBLACK website. And to hear more from Richard, he will be a speaker at CPA Congress. Go to the show notes for details on how you can register.