It was classic Wall Street logic. In August 2003, the financial community decided it was fed up with Costco, the Issaquah-based discount warehouse chain and, at least until the recently announced Sears/Kmart merger, sixth largest retailer in the country on the basis of revenue. Costco was experiencing flat earnings growth for the year, and Wall Street thought it knew just what to blame. The company, proclaimed analysts, treated its employees too well. Costco's average U.S. hourly wage of approximately $16 an hour is widely considered to be the best in the retail business. And its approach to health care, as noted in a report at the time by the financial research and investment firm Sanford C. Bernstein & Co., "has been to provide employees with the best plan at the least expense to the employee." On Wall Street, this is not seen in a positive light. "Whatever goes to employees comes out of the pocket of shareholders," says Bernstein analyst Ian Gordon.
The financial guys noted another sin: Costco also treats its customers too well. Its bargain prices are legendary and, at the time analysts were tsk tsking, Costco was planning to add staff at checkouts in order to shorten lines. You might think that caring for customer is the No. 1 principle of business success. But again, Wall Street views the matter in terms of its slice of the pie. "It was spending what could have been shareholders' profit on making a better experience for customers," Gordon says. Or, as Deutsche Bank analyst Bill Dreher famously told BusinessWeek, "At Costco, it's better to be an employee or a customer than a shareholder."
The company's CEO and patriarch, Jim Sinegal.
(Kevin P. Casey)
Wall Street exacted its punishment: Costco's stock price plunged 19 percent in one day. Afterward, Gordon remembers, Costco's chief financial officer "dragged [co-founder and CEO] Jim Sinegal around to investors. He got beaten up a little." Regardless, Sinegal appeared unwilling to kowtow to the people who control his company's stock price, a highly unusual quality for a CEO, especially one who owns a lot of company stock. "He basically told them, 'I don't care,'" recalls Teamster Rome Aloise, the lead representative of Costco's unionized employees who make up one-fifth of its U.S. workforce.
"Why shouldn't employees have the right to good wages and the right to good careers?" asks Sinegal one day last month, sitting in his strikingly unpretentious office, more like an alcove really, devoid even of a door separating him from his employees. Costco has told Wall Street again and again that it believes the key to its success rests with taking care of employees and customers. Analysts "may not like it," Sinegal says, but "it's not a secret." It's also not a secret how he feels about the denizens of the Street. "Those people are in the business of making money between now and next Tuesday," he says. "We're trying to build an organization that's going to be here 50 years from now."
The dustup with Wall Street has given the 21-year-old Costco a new kind of prominence. At once, the company has become an icon of what are known around business schools as "high-road" values. Forget Ben & Jerry's, now under new management that's not quite as progressive as its hippie founders. Costco is a retailer of ever-growing size with, according to the latest figures, $47 billion in annual revenue, 113,000 employees, and 449 warehouses internationally in locations including the United Kingdom, Japan, and Mexico. It walks the walk on a whole different scale. Costco's values stand out all the more because they contrast dramatically with those of its main competitor, Wal-Mart, which operates the 550-store warehouse chain Sam's Club.
As many have recently noted, Wal-Mart's business model relies on relentless cost-cutting. According to Wal-Mart, its 1.2 million U.S. employees earn an average of $9.99 an hour, less than two thirds of Costco's average. Only 42 percent of Wal-Mart's workers have health care coverage through the company, compared with more than 83 percent at Costco.
The flagship Issaquah warehouse has even sold diamonds for $250,000 a pop.
(Kevin P. Casey)
Given the overpowering influence of Wal-Mart, the nation's largest private employer and the world's largest retailer, at times there has seemed no way out from the downward competitive pressure it exerts. Which is why Costco's defiantly different approach has grabbed the attention of the folks who study these things. Annette Bernhardt, a policy analyst at New York University's Brennan Center for Justice, says she and her colleagues frequently bring up the Costco/Wal-Mart dichotomy in order to illustrate high- and low-wage business models. "It has really given researchers and activists a language to talk to the American public about these issues," she says. Peter Cappelli, a professor of management at the Wharton School, plans to analyze the differences between the two companies for an upcoming study. Rutgers University labor economist Eileen Appelbaum pronounces Costco a company that "shows that you can compete without having to drive down the wages of employees."
Not entirely coincidentally, this debate over business values has been playing out amidst a highly charged battle of political values. The economic race to the bottom, particularly as it relates to outsourcing, figured in John Kerry's campaign against George W. Bush. Unsurprisingly, Costco and Wal-Mart are polar opposites in this arena as well. Sinegal and fellow Costco founder Jeffrey Brotman endorsed Kerry and made large financial contributions to Democratic campaigns. Wal-Mart's political action committee donated overwhelmingly to Republican campaigns, a pattern mirrored by the company's executives.
In politics, of course, Wal-Mart's team trumped Costco's. But in business, well, that's another story.
The Costco Way: Strategy or Values?
The company sets a cap on its profit margins on merchandise.
(Kevin P. Casey)
For years, Jeffrey Pfeffer, a professor of organizational behavior at Stanford University, has been telling the world of business that the race to the bottom makes no sense, not only ethically but also economically. "The idea that the only way you can succeed is to pay the lowest wages is empirically wrong," he practically shouts. Look at companies like IKEA and Toyota and the Italian shoe producer Ferragamo, he says, all of which have sent their products around the world without outsourcing their labor to Bangladesh. They do so because they offer coveted products. And he and numerous other business academics maintain that decent wages motivate employees to work more productively and produce a higher-quality product. "Lots and lots of books" have laid out the case, Pfeffer says, including his 1998 tome, The Human Equation: Building Profits by Putting People First. A whole school of thinkers at the Harvard Business School once preached the philosophy. Nevertheless, Pfeffer says, "It's been ignored—absolutely."
That's because the picture is not so simple, counters Wharton's Cappelli, who specializes in studying business practices. "It is absolutely not true that all those companies that are not being nice to their employees are simply stupid," he says. Nor, he says, is it just about good guys and bad guys. "There are systematic reasons people adopt the practices they do." For some companies that trade on premium quality and service—say the Ritz-Carlton hotel chain—treating employees well pays off in their bottom line. "But it's not true that if the Holiday Inn Express treated its employees in the same way, it would pay off for the Holiday Inn Express." Companies that compete primarily on price don't necessarily need the same level of skills in their workers as do their higher-end counterparts, he maintains.
Cappelli suspects that when you probe the differences between Costco and Wal-Mart, as he plans to do, you will find that their opposing business practices stem from differences in their respective businesses. Costco charges a membership fee to shop there ($45 a year); Wal-Mart doesn't. Costco, fittingly clustered largely along the blue-state coasts, caters to an affluent urbanite crowd. Wal-Mart, a red-state company in every way, canvases small towns and rural areas across the heartland of America, attracting shoppers who are often literally desperate for low prices. Even Sam's Club, which like Costco, charges an annual membership fee ($35), sticks close to Wal-Mart's geographic base. Wal-Mart agrees with Cappelli that such differences make a wage comparison between it and Costco misleading.
I ask Cappelli if he's found any companies that take the high road for reasons beyond their bottom line. Some, he responds. "The interesting thing about them is that they almost all tend to be privately held." After all, recent case law demands that publicly held companies put shareholders before anything else. When Cappelli started teaching 20 years ago, he recalls, companies talked about balancing "stakeholders," including employees, the community, and shareholders. Thanks to a slew of shareholder lawsuits, he says, "nobody talks about that now."
Except Costco. Wall Street has not failed to notice that Costco's numbered code of ethics puts taking care of customers and employees at No. 2 and No. 3, respectively. Rewarding shareholders, albeit Costco's stated ultimate goal, is No. 5.
In 29 years of union work, the Teamsters' Aloise has observed that employers do not treat workers well "out of the goodness of their hearts." Costco, he says, "might be the exception to that." He calls Jim Sinegal "a very decent person," true to his word. Aloise recalls that during the long, drawn-out grocery strike last fall and winter in California, where he is based, Sinegal called him a number of times wanting to know if he might be able to help settle it. "It might have been naive," Aloise says. Given that the grocery chains were pointing to competition from Costco as one reason they had to cut costs, they weren't about to look to Sinegal as a mediator. But Aloise appreciated the gesture, as he did the fact that the strike's final settlement had zero impact on the deal Costco negotiated with the union shortly afterward.
As I drive out to Issaquah to meet Sinegal on a sunny November day, I'm interested in finding out whether Cappelli or Aloise is right when it comes to Costco, whether the company's humanism is about strategy or values.
There are still fall leaves about, giving a pleasant feeling to Costco's low-rise campus, which encircles a pond and is up the road from picturesque Pickering Barn. Inside is a lobby that resembles a hotel's: an atrium with towering ferns and water streaming over a frieze of salmon (a consumer rather than an environmental statement, a nearby placard reveals, signifying the fillets Costco sells). Sinegal himself comes down to greet me. He's an unimposing figure, a gray-haired 68-year-old with a mustache, wearing bifocals and an open-collared blue-and-white checked shirt.
He is the man employees see as setting the tone of the company. Co-founder Jeff Brotman, chairman of the board, maintains a day-to-day involvement in the business, too, but from behind the scenes, managing its real estate. Sinegal tours the stores continually. He has just returned from a weeklong trip to Florida, New York, and Puerto Rico.
Like his appearance, Sinegal's air is more grandfather than business tycoon. He talks quietly, as if shrugging his shoulders, like what he's saying is commonsensical, no big deal. Employees, however, say he's demanding to work for, and he has a way of getting to the point, quickly. "Have you shopped at Costco?" he asks me, when we're settled into his office, which is enlivened with a wall of pictures, including one of George W. and Laura Bush that someone gave him as a joke. "I have," I tell him. "A lot or just a little?" he prods. "A little," I confess. He nods noncommittally and allows me to go on.
When I ask him about the way Costco treats workers, he says, "It absolutely makes good business sense. Most people agree that we're the lowest-cost provider. Yet we pay the highest wages. So it must mean we get better productivity. It's axiomatic in our business—you get what you pay for."
The wage at Costco starts at $10 an hour and, as of next March, rises to $18.32— excluding twice a year bonuses of between $2,000 and $3,000 for those at the top wage for more than a year. In comparison, unionized grocery clerks around Puget Sound, very good jobs as retail goes, start at $7.73 an hour and top out at $18. (Wal-Mart does not share its wage scale.)
Costco's wages help keep turnover unusually low, just 6 percent after the first year. "We're trying to turn our inventory faster than our people," Sinegal says. "Obviously," he adds, "it's not just wages that motivate people." How much they're respected, and whether they feel they can have a career at a company, are also important, he says. To that end, Costco has some rules about how it treats workers. An employee of over two years cannot be fired without the approval of a senior company officer. (It used to be that only Sinegal and Brotman could issue approval.) The company also requires itself to promote internally for 86 percent of its openings in top positions. "In truth, it turns out to be 98 percent," Sinegal says.
"If somebody came to us and said he just got a master's in business at Harvard, we would say fine, would you like to start pushing carts?" Employees at Costco often start working part time while they're in high school or college and grow within the company. "That's how I started in this business—tying mattresses on tops of cars," Sinegal says. He was in San Diego then, an 18-year-old student in junior college. He worked part time at Fed-Mart, a discount store run by the man who would turn out to be his mentor and source of inspiration, Sol Price.
Sinegal doesn't like to talk much about his personal history and doesn't cooperate with media outlets wanting to do personal profiles. He seems temperamentally averse to self-glorification, one of his more appealing qualities. In the course of conversation, though, Sinegal reveals that his father was a laborer, working in coal mines and steel mills around Pittsburgh, until he broke his back and started a small business. It's a significant fact about how Sinegal sees the world. At one point, when I ask him about his politics, he says simply, "As you can imagine, that's part of my DNA."
Sinegal acknowledges that there's a relationship between his political and business values, then immediately veers away from the implication that only Democrats are good employers. "That's not fair," he says.
Still, his politics, his family background, and the way he talks without a lot of fanfare about workers' rights and the need for respect make me think that there's something more going on at Costco than bottom-line tactics. So, too, does his attitude toward his own remuneration, which he has kept for the last three years at $350,000 excluding stock options, very low for a CEO at his level. "Listen," he says, "I'm one of the founders of this business. I've been very well rewarded. I don't require a salary that's 100 times more than the people who work on the sales floor."
Sinegal's executives speak a similar language. "One of the things Wall Street chided us on is that we're too good to our employees," says CFO Richard Galanti, as effusive as Sinegal is reticent. "We don't think that's possible." In his office, he reaches up behind his desk to take a memo off his bulletin board. It's from Sol Price, the founder of first Fed-Mart, then Price Club, which merged with Costco in 1993. Dated Aug. 8, 1967, it reads: "Although we are all interested in margin, it must never be done at the expense of our philosophy." Specifically, the memo propounds the importance of keeping prices low, rather than grasping for "how much the traffic will bear." But Galanti says there's an object lesson in that approach as it relates to employee relations. Costco, he says, is not going to make money "at the expense of what's right."
So, he says, when Wall Street urged that Costco raise employees' 5 percent contribution toward health care premiums, the company refrained from asking for the 20 percent or 30 percent that is typical. "What we looked at is how much can the employee afford." The employee share will rise to 8 percent by 2007.
Now, not to exaggerate Costco's munificence, 8 percent translates, for a family of four, to $1,200 a year, which is no small change for clerks making between $20,000 and $40,000 a year. And it's still hard to support a family on those wages, even if they are the best in retail.
The Upside and Downside of Paternalism
Costco's strategy for success: Wow the consumer.
(Kevin P. Casey)
Although partly unionized, Costco seems at heart a paternalistic company, revolving around the goodwill of Sinegal, an archetypal father figure: kind but stern, aiming to do the right thing but prone to irritation if someone suggests otherwise. As it happens, there is someone suggesting otherwise. Last August, a Costco assistant store manager in Colorado named Shirley "Rae" Ellis filed a class-action suit for sex discrimination. She had spent the last six years trying in vain to be promoted to manager. In October, a second woman joined the suit: Leah Horstman, who finally gave up on her hopes of being promoted to assistant manager and left Costco after 23 years with the company.
By phone, Ellis talks about her case. She recounts that before she came to Costco, she worked for eight years for rival Sam's Club, most of those years as a store manager specializing in turning around troubled sites. Though it was a top position, Ellis says she wanted a new challenge at a company where she could stay for the rest of her career. She was in her mid-40s. She says she was recruited heavily; Target offered her a position in charge of a district. Instead, she took a $50,000 pay cut to work as assistant manager for Costco. Why? She says the Costco vice president who recruited her assured her that she wouldn't have to wait longer than a year to be promoted to warehouse manager. That was an extremely lucrative position, offering a salary of $100,000-plus, a $40,000 bonus if your store made profitability targets, and stock options worth, she was told, $1 million. But despite repeated requests for a promotion and meetings with various executives including Sinegal, it never came. "It appeared to me you needed to know somebody," she says.
Like many employment cases, which rely upon subjective judgments of behavior, Ellis' is not clear-cut. Since she charged the company with discrimination, Costco has accused her of insensitive behavior, including using racial epithets, which she denies. The company also moved her to a store an hour-and-a-half drive from her home, according to Ellis.
Whatever the merits of her specific case, though, her suit raises some provocative points. "It's like there's a blind side to the employment system," says her attorney, Brad Seligman. He is executive director of the Impact Fund, a public- interest foundation in Berkeley, Calif., and is also handling a massive class-action sex discrimination suit against Wal-Mart. For the top warehouse positions of manager and assistant manager, Costco doesn't post job openings. Instead, it taps people on the shoulder. And the people doing the tapping, Seligman notes, "are uniformly male." Of 33 executive and senior officers, only two are women. The result: According to Costco's latest figures, 16 percent of store mangers and 17 percent of assistant managers are women.
"That's bullshit," Sinegal snaps when I ask him about the lack of job postings. "You post for jobs like cashiers and stockers. You don't post for jobs running a $120 million store. The people who are getting those jobs are people who have proven themselves." More calmly, he contends that women do not tend to seek out store manager jobs. More typically, he says, they go for merchandise-buying jobs, which have more regular hours and are better suited to family life. He won't comment on any further specifics of the suit.
It's worth noting that the type of discrimination alleged is on a whole different level from that charged in the Wal-Mart suit. In the three years since it was filed, 115 women have come forward to tell stories of often blatant sexism. Wal-Mart managers allegedly held meetings at Hooters and told employees things like they need to be home raising their kids and that "retail is for housewives who just need to earn extra money." There's nothing like that in the Costco suit, which attorney Seligman allows is much narrower. Whereas the Wal-Mart cases accuse the company of discrimination across the board, the Costco one is focused only on access to the two top warehouse positions.
It's also true that many Costco employees express the kind of unqualified good feeling about their employer that is rare. "They take care of us, they really do," says Sigrid Windham, a serene 57-year-old who works in the Issaquah warehouse, receiving the huge pallets of goods trucked in by vendors. Her last job at a small natural foods store didn't include benefits. Friends at Costco urged her to apply, telling her, "you need to do this." Now, she marvels at the company's comprehensive health care plan, which includes prescriptions.
Chris Wolf, a warehouse floor supervisor at a Costco in Redwood City, Calif., recalls a recent prolonged period of illness. While in the hospital, he received a call from his warehouse manager, wanting to know whether he would be able to cope financially and if he needed to borrow money against next year's vacation pay. "I don't think a lot of other companies would care," he says.
Ceasar Martinez, a 27-year-old forklift driver also in the Redwood City store, came to the U.S. from El Salvador to live with relatives when he was a teenager. After high school, he wanted to go to community college but, without family financial support, felt he couldn't swing it. So he looked for a "good company," where he could make a livable wage with only a high-school diploma. Costco, paying several dollars an hour more than the other jobs he found, was the logical choice. He's been there ever since, drawing upon what he considers a "really good, fair salary" to invest in property in El Salvador, where he plans to retire one day.
Radical Ideas about Pricing
Costco's cavernous Issaquah warehouse lies across the road from its headquarters. Walking in, Sinegal surveys its beamed, open ceiling and the piles of goods devoid of niceties like fancy signs and clothes hangers. He recalls a joke he tells shareholders, who sometimes complain about the money Costco spends on real estate: "It costs us a lot of money to make these places look cheap." He explains, "The image of being a working warehouse is very important to us." The no-frills environment makes Costco even more of a hard-core consumer experience—it's all about the goods and the price. And there's some serious money being spent in Costco's showcase store. Last year, the Issaquah warehouse alone racked up $224 million in revenues, roughly double the company average that is, in itself, astonishing. Sam's Club, in contrast, averages $65 million in revenue per store, according to a Sanford C. Bernstein report.
Sinegal walks over to a stack of men's all-cotton button-down shirts bearing Costco's signature brand name, Kirkland. They sell for $12.99 each. A few years ago, they sold for $17.99, a bargain even then. Costco had committed to the manufacturer that it would buy at least 100,000 a year. But two years ago, it was selling a million per year. So it negotiated a better price with the manufacturer. As a result, Costco dropped the price it charges customers by $5 a shirt.
Brad Seligman has brought suits against both Wal-Mart and Costco.
(Kevin P. Casey)
That sums up much of Costco's business strategy. Wow the consumer with unbelievably low prices so they keep coming in. "Who the hell's going to notice if you charge $14.99?" instead of $12, Sinegal asks, acknowledging the temptation to charge a little more. "Well, we're going to know. It's an attitudinal thing—you always give the customer the best deal."
Costco, in fact, sets itself a strict cap on its profit margin per item: 14 percent for all goods except its Kirkland brand items, which have a 15 percent cap. Department stores typically mark up items by 30 percent or more. "That 14 or 15 percent markup basically covers the cost of doing business," says Bernstein's Ian Gordon. The lion's share of Costco's profits come, not from anything it sells, but from membership fees.
Listen to Tim Rose, a Costco senior vice president in charge of buying food and sundries, and you get the impression that the company's attitude toward pricing is every bit as radical as its attitude toward workers. Recently Rose's team convinced the high-priced California wine label Opus One to sell in Costco; a number of prestigious manufacturers shun the chain because they don't want their merchandise known as discount products. Depending on the vintage, Opus One typically sells for anywhere between $130 and $300. Costco sells it for $90 to $110. Rose says he'd like to sell it for $60. "I know it doesn't cost $60 to produce Opus One," he says. The prices of prestige items like Opus One are "inflated," he says, because of marketing spin and the law of supply and demand.
In effect, Costco is tossing out that law. The company's cap on markup stays the same no matter how great the demand or limited the supply. Indeed, as with Kirkland brand shirts, the more people want an item, the cheaper it becomes. Costco gets away with this because of volume, No. 1; 43 million people carry membership cards around the world. No. 2, Costco caters to prosperous consumers with an ever-changing array of high-end products. Sure, there are cheap—and like all Costco goods, incredibly large—cans of corn. But there are also fine wines, state-of-the-art electronics, and Tiffany-style jewelry. The Issaquah warehouse has sold diamonds for more than $250,000 each. Even with the 14 percent cap, that's a net of $35,000. There's a class element to the company's success and thus, ultimately, its largesse.
In the Issaquah store, I watch a customer eye a display of men's cashmere sport coats selling for $299.99. He fingers the material, then tries one on.
"These really are an incredibly good buy," the customer, a trim, 40ish man with an authoritative air, tells a clerk who's standing nearby.
She murmurs assent. "They sell for $500 at Nordstrom."
"Are you kidding?" he replies, perhaps more acquainted with cashmere than the clerk, who couldn't afford a Costco card of her own until she got one free by working there. "They start in the 800s."
Ten minutes after walking up to the display, he's got a $300 item slung over his shoulder.
Kicking Sam's Butt
Sam's Club has a different feel. In January, it opened a store in Renton, on the same street, South Grady Way, as a regular Wal-Mart. The Renton store is the newest of three Sam's Clubs in the Seattle area, all on the not-so-tony fringes. There are certainly bargains to be found. An Oscar de la Renta pullover, with the manufacturer's price tag of $50 still attached, sells for $15.86. A 3-pound, 7-ounce pumpkin pie goes for $5.86. And gas, at $1.86 a gallon, is cheaper than it was at Costco's Issaquah store a couple days earlier.
There are fewer upper-end items, though. There are no coats over $100, no jewelry over $3,000. Gourmet cheeses and other staples of la dolce vita are hard to find. There appears to be simply less stuff in general, and it's amazing how much you can overhear snippets about Costco in the aisles of Sam's. "I'm going to Costco on Saturday," a woman in the cheese aisle says into her cell phone, apparently not finding what she wants. Nearby, a freelance baker, preparing a big order for Boeing employees, voices his disappointment at not finding the right cheesecake crusts and toppings.
"That's what Costco's got on you," he jests to a couple of bakery clerks.
"The only thing!" one replies. But the truth is the parking lot is half full.
After switching CEOs and strategies for years, Sam's Club presents more of a threat to Costco than it ever has. Current CEO Kevin Turner has zoomed in on a strategy of attracting small-business owners—a large part of Costco's base. Last year, he ignited speculation of a price war with Costco, one that never materialized as it turned out, by announcing that Sam's would not be undercut. Sam's is also encroaching on Costco terrain by opening new stores in areas like the Puget Sound region. Costco is returning the favor in places like Texas.
Still, at least for the time being, Costco is whipping Sam's in the marketplace. For a recent comparable 52-week period, Costco's net sales were 28 percent higher even though it has one-third fewer stores. Says Phil Bonanno, a retail analyst for the Massachusetts research firm Management Ventures, "Costco outperforms Sam's Club on almost every product measure you can think of: sales per building, sales per item, inventory turns [how quickly merchandise moves], sales per square foot."
Last week, Costco announced an impressive 21 percent earnings increase for the first quarter of its 2005 fiscal year—about the same level the company achieved for the entire previous fiscal year. Despite a slight dip in the past few days because the company didn't beat analysts' expectations, as usual of late, its stock price has rebounded from last year's slump and climbed far above where it stood before Wall Street started griping.
One person well aware of Costco's stock price is D.J. Brooks, the customer who bought the cashmere coat. As it happens, he's a financial guy who traded equity derivatives in London and Japan before moving here to start his own hedge fund. Brooks admires the way Costco treats its employees and feels it pays off when he interacts with clerks who appear to have a brain. As for the criticism from his financial brethren, Brooks notes the stock trajectory and breaks into a sly smile. "So maybe Wall Street was wrong."