Coriolis Chart Watch Q2 2004

Chart Watch is an online publication featuring a brief view into our latest thinking on the evolving food and fast moving consumer goods industry. It is sent to subscribers four times per year.

This month's Chart Watch presents highlights from a recent interview with Tim Morris, Managing Director of Coriolis Research, and key author of the report.

Who or what is Costco?

Costco is the eight largest supermarket retailer in the world.

They have global turnover of US$42.5 billion across 430 stores in seven countries around the world. Their average store has sales of US$2 million per week - about $2.9 million Australian - or about eight times the average Australian supermarket. Their stores are massive boxes, averaging about 11,000 square metres, located in secondary sites or industrial areas.

Costco carries a limited range of around 4,000 lines, including supermarket-type goods and general merchandise, like television sets. Like Aldi, it only offers a limited selection in any one category, but unlike Aldi it only offers products in very large pack sizes.

In addition, customers have to pay for the privilege of shopping at Costco. In the US membership costs $45 per year (about $65 Australian). When it was launched in the US a lot of people said it would never work - no one would pay to shop. I imagine people will say the same thing here. In return you get very low prices.

So why do you think Costco is going to come to Australia and New Zealand?

Four reasons:

First, Price Club, a competitor Costco merged with in 1993, looked at the Australian market in the late 1980's and actually went as far as looking at the concept of a joint-venture with Foodland Associated, then under Managing Director David Fawcett.

Second, when PriceSmart was spun off from Costco in the early 1990's, that company was specifically given the right to develop the Australian and New Zealand markets - something that it didn't do. Those development rights then lapsed in August 1999 and reverted to Costco, renewing the interest of the parent company in the market.

Third, three Costco executives, including Chairman and Founder Jeffrey Brotman, visited Australian and New Zealand in February of last year.

Finally, I’m told by numerous people in the industry that Costco have appointed an Australian management team, set up an office, and begun bidding on sites around Sydney and Melbourne.

So who shops at Costco?

The concept was originally targeted at wholesale customers - small businesses, restaurants, motels, day care centres, things like that - people who wanted to buy food and related general merchandise items at wholesale prices but couldn't buy at a low enough price through any local wholesalers.

Beyond that, households join the "club" to take advantage of the low prices. Costco is a classic stock-up shop. US data shows that the average Costco consumer goes there once a month and spends almost $100, and then top-up shop during the intervening period at the local supermarket. Business members go twice a month and spend over $200.

Interestingly, the typical household customer for Costco is actually the upper income groups - 85% of heavy Costco shoppers are in the upper income groups. We would expect a similar pattern here. This is unlike Aldi, whose shoppers are much more likely to be lower income.

However, it takes a while for the consumer side of their business to develop because consumers have to learn to change their behaviour. Costco only sells its products in large pack sizes and people have to learn to buy more, less often rather than less more often. It definitely requires a shift in behaviour. That's going to present a challenge in Australia.

So does Costco sell large boxes or six normal sized items wrapped together?

They do both - categories where the manufacturer can pack a larger box, they will just take a large box at a higher price point. Although with cereal, for example, inside that big box they might have two regular sized cereal bags, so you can open one and the other one stays fresh.

Where they can't get large quantities produced, they will just get the manufacturer to over wrap a larger quantity for them. For example, you can't just buy one can of coffee, but there will be three cans of 'normal-sized' coffee in a plastic sleeve for nine dollars or whatever.

The mix of products they sell in the US has changed over the years. When they first opened up it was a lot of foodservice packs, a lot of monstrous sizes. What we've seen since then is the pack sizes actually getting somewhat smaller and more multi-packs where you must buy four, but the four are somewhat normal quantities. I could see a similar evolution occurring in Australasia.

America is very bigger is better, and while Australia follows America, it isn't quite the same - do consumers here have space for all this stuff? Aren't there smaller houses, smaller kitchens here than in America?

Sure, kitchens and freezers in other countires aren't as big as in the United States, though having said that the newer houses being built in Australia and New Zealand are much larger than they used to be. So there is an element of that, but I think it's overplayed. Poor people may live in small houses with little pokey kitchens, but remember Costco targets small business owners and the top twenty percent, and these people are more likely to be living in a new house with a large kitchen and lots of space. And they're the ones that have the disposable income to "invest" in a three months supply of toilet paper.

Besides, many of the largest volume Costco outlets in the world are the ones in the United Kingdom. Now if there's any truth to what you say about Australia or New Zealand, its got to be doubly true in the UK and they've been hugely successful in that market. The biggest thing that has constrained them in the UK market hasn't been their ability to sell; it’s been their ability to get sites. They've been caught up in planning permissions. They've been caught up in the courts. They've had to jump through hoops just to get fifteen outlets open. If it was up to them they would have fifty outlets open in that market.

Getting store sites has been an issue in England. Will they have the same problems here?

Sites will be a problem if they don’t convince the authorities they are a wholesaler not a retailer. They will probably go for the same classification as Bunnings, rather than as a retail supermarket. They often get in under a different zoning because they're classed as a wholesaler not a retailer, not open to the public, only members.

Where do they typically locate their stores?

They locate in industrial areas. They don't go for prime sites or prime real estate - they're not in malls or on the main street or in suburbs - they're in out-of-town, out-of-the-way industrial areas. They like to own their own property and build their own sites. Globally they own about 80% of their sites. They often buy more land than they need and sub-lease the excess to other big-box retailers who are attracted by the traffic volume created by Costco.

What do you think will be the impact on Australia and New Zealand? How many stores do you anticipate there being in Australasia in ten years?

In the US and Canada - the markets where they've been the longest - wholesale club stores have managed to achieve one store for every 350,000 people. Based on this, we believe Australasia can ultimately support around sixty stores - fifty in Australia and ten in New Zealand. But in the medium term we expect around thirty stores. So, for example, you might see four to six stores in and around Sydney.

One model would be that they focus initially on Australia - that they build up their business in Australia before coming to New Zealand. Another potential model would be that they expand into New Zealand quite quickly, within the next two or three years. I’m told the current Countdown Westgate site in Auckland was considered way back in the early 1990’s - so that would be the kind of site they would look at. Over the past decade they've entered a country about every two years – so we could see Australia in 2005 and New Zealand in 2007.

Unlike other retail concepts, they can achieve some economies of scale with one or two outlets. Costco's outlets can operate as independent entities, as the outlets are very self contained. The warehouse club format appears to be able to breakeven with just two or three stores. Contrast this with Aldi where a distribution centre and thirty stores is the minimum to get to scale and they really need seventy stores to breakeven.

You believe they can breakeven with just two stores?

They've got three stores in Taiwan. No one is saying they're losing bucket loads of money - of course no one is saying they're making bucket loads either. But it's no Wal-Mart Germany where Wal-Mart is losing US$150 million per year. Maybe it would be better to say they wouldn't lose a lot of money.

Do you think Costco will be successful in Australia and New Zealand?

Yes. I think Aldi provides a good parallel. Before Aldi came to Australia there was a lot of talk about how competitive the Australian market was and how low the prices here were already. That Aldi would struggle to get sites. That they wouldn’t be able to compete with the scale of Coles or Woolworths. That the Australian consumer was different from consumers overseas and what they wanted was a traditional supermarket. But Aldi currently has 70 stores and continues to grow rapidly.

Unlike the existing supermarket groups in Australia and New Zealand, who all try to cluster around a middle point with very similar stores, Costco is a very different concept. It's bold, it's brash, it targets a narrow segment of the market but serves that segment very well, rather than trying to be all things to all people. There is an underserved and available base of small businesses and upper income households ready and waiting for Costco to open. So I think they'll succeed.

I think they will have thirty stores in the medium term, with stores in Australia and New Zealand.

What impact will Costco have in Australia and New Zealand? Who do you think should be worried?

First, I think retailers who are good at what they do, who have a defined target market, who execute on a clear strategy, will be successful. If you're good at what you do, you have a niche. If you have quality perishables or good service or a convenient location with plenty of parking - you will continue to attract customers to you. It's like the black plague – if it doesn’t kill you, it just makes you stronger.

Even in our best scenarios we only see Costco getting to eight to ten percent market share in supermarkets. So even in the very best case there is another ninety percent of the market left for everyone else.

The second winner will be manufacturers that make the effort early on to build their business with Costco, - who go out of their way to give them the products they want, in the form that they want, in the pack sizes that they want - will be able to grow with Costco. If you can get in there first, there may be a kind of natural monopoly because there is some effort involved in the pack sizes, in terms of their shipping requirements. It may be difficult for your competition to get in there at some future point.

I think another winner will be manufacturers that can get in and build the relationship with Costco and then use that as a springboard to get into Costco's global operations.

Is there much profit for manufacturers in dealing with Costco?

You've got to remember that Costco drives huge volumes through a narrow range, which makes production very efficient. In addition, they don't have expectations in terms of merchandising support, advertising support, or cooperative spending. They're a good customer to get along with, they buy in big volumes and pay on excellent terms. You might not get as much money, but you get it right away from a relatively low-stress customer.

Who do you think will be most impacted by the arrival of Costco?

Today about 25% of the average Costco's units members are businesses, but these business members account for 60% of sales

So I think the first impact that Costco is going to have is on cash and carry wholesalers - specifically Metcash's Campbell's Cash & Carry. Campbell's has 41 outlets across Eastern Australia generating sales of about A$950 million in 2003. In the first instance, Costco will have a major impact on them.

Campbell’s offer and concept seems to me to be about twenty years out of date. There's a great saying that goes: "Do you have loyal customers or resentful captives?" My reading of Campbell's is that they have a lot of resentful captives, who if they were offered the supplies they need for their small business or restaurant or daycare centre, they would jump at the chance to shop at Costco.

Similarly in New Zealand I think the impact will be felt by the Foodstuffs Group's cash and carry arm - Gilmours, Trents and Toops - they've got a combined total of 24 outlets across the country. I think a lot of their cash and carry customers will end up going to Costco.

When Costco first open it's primarily traditional cash and carry customers. As the concept develops and as people learn to change their behaviour, the consumer element grows. The average Costco doubles in sales over the first eight years its open. In the United States it may do US$50 million in its first year - that scales up to about US$105 million by year eight, as that learning process goes on and sales build.

So one implication of this would be that supermarkets located in middle-to-upper income neighbourhoods will feel an impact, not those in lower income areas. So a Woolworths or Coles in an upper income area in the catchment of a Costco will feel the impact.

It's said by retailers in the US market that when a Costco opens, the conventional supermarket closest to it actually gets a sales lift - because of the draw effect - people driving for long distances to get to the Costco then stopping at the supermarket to get things they couldn't get a Costco. But at the same time, all the other supermarkets in the area lose one or two percent of their sales. So its a small effect spread across a wide area, because they have a much larger catchment than a normal supermarket.

Only sixty percent of Costco's sales are supermarket-type products. So there will also be an impact across a wide range of general merchandise retailers - department stores, office products stores, sporting goods stores, etc.

So Costco isn't going to put anyone out of business. They may be the straw that breaks the camels back when it comes to some of the more marginal operators - I would expect some of the marginal cash and carry sites might close.

The additional impact that Costco will have is not only the impact they have from attracting customers with their low prices, but, as with Aldi, the reaction of retailer A to that price, and then the reaction of retailer B to Retailer A's reaction. So they will have a knock-on effect.

Having said that, warehouse club stores are true everyday low price operators. They don't use the word sale, they never have specials, the never overtly discount products.

Costco doesn't have specials or discounts?

No, they just have a product at a price and that's the price. If they negotiate better buying terms they'll lower the price, if prices go up, they'll just raise prices. Obviously if they bring these items in as one-time-buys, Sony plasma television screens, they'll have that until it sells out and they may need to mark it down to move the last of the quantity. But that's certainly not something they advertise, not something that's a focus of their business.

So the industry really doesn't have price wars. In the US where you might have a Sam's Club up against a Costco, they don't go out all of a sudden and say we're going to drop the price of our milk to draw customers into our store, rather what they're doing is competing on a basket of goods. They just put the price out and that's the price and the other retailers will have to choose how they react to that. Is it important to match that specific item or not?

How do you think the failure of Cost-U-Less in New Zealand is viewed by Costco?

I think that Costco's management would look at Cost-U-Less as a bunch of cowboys with no track record and no money.

Costco has global sales of of US$42.5 billion across 430 stores, with each unit averaging $107 million per year. Cost-U-Less has global sales of $177 million, or 1.6 time one Costco unit, spread across 11 units, with each unit averaging $16 million per year. So they're in a different league.

Cost-U-Less was a different concept than Costco. The Costco concept is based on a very limited range of 4,000 items across food and general merchandise categories in a massive box, where as Cost-U-Less, with closer to 12,000 items in a much smaller box, was much closer to a traditional supermarket - more closely resembling the Pak'N Save concept in New Zealand.

In fact, Cost-U-Less buys some of its products from Costco as a regular customer, loads these into containers, and ships them around the world. So they were essentially buying at Costco's retail price and adding their own shipping costs and margins on top of that. In addition, they were very poorly capitalised and their strategy, as far as I can tell was to operate on islands around the world: Guam, the U.S. Virgin Islands, American Samoa, Fiji.

Costco is a completely different entity. It's the eight largest supermarket retailer in the world with a huge wealth of knowledge and experience in developing new markets. They've successfully entered seven countries in addition to the United States: Canada, the United Kingdom, Mexico, Puerto Rico, Japan, South Korea and Taiwan.

How can Australasian retailers and manufacturers get more information on Costco?

We’re selling a comprehensive board level, three part, 314 page report on Costco. This report provides Australian and New Zealand retailers and manufacturers with all the information they need to plan a response to the arrival of Costco.

All the details can be found here.

Do you have something to say? Do you have an opinion about an important industry issue?  We want to know!  Please call or email us your comments, questions, gripes and suggestions.  Share the wealth!  If you know someone who would be interested in Chart Watch, please forward this message to them.