Costco

Introduction

0:00Hey, Acquired listeners, we've placed this episode on Costco toward the top of the podcast feed since people frequently say it is one of their favorite episodes and a great place to start listening. It was released on August 20th, 2023. I don't think I have ever been more in love with a company and a business model. What are you, Charlie Munger? It's just the deeper you dig, the more good things you find. And usually it's the exact opposite of that. It's like the opposite of being an early-stage venture capitalist.

Welcome to Acquired

0:43Welcome to Season 13, Episode 2 of Acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert. I'm David Rosenthal. And we are your hosts. What if I told you that there was one place where you could get all these things under one roof? A two-and-a-half-pound container of cashews, prescription eyeglasses, a tank of gas, new

1:14tires for your car, 96 rolls of toilet paper, a new refrigerator, an outdoor shed, a 10-carat diamond ring, some fresh prepared sushi, fine wine at a great price, and you could even grab a hot dog with a soda and a free refill on your way out for just $1.50. Ben, I don't believe you. Hey, it has been the same price for 40 years now? 47 years. Yes. Most of you are very familiar with this Disneyland of consumer value that I'm referring to.

Costco History

1:47It is Costco. This company seems very simple on the face of it. If you sell in bulk, you have the opportunity to offer great deals to your customers. But what really makes it work are the 50 clever innovations that they've refined over the years that all work together like an orchestra that's been rehearsing for decades. Nothing about Costco is an accident, from the extra-wide parking spaces to the whole rotisserie chickens. And if your goal is to offer extremely great value to your customers on high-quality products

2:20at the lowest possible prices, there are a lot of ways that you could go about doing that. And today, we will walk through the very specific path of decisions and trade-offs that Costco has chosen to accomplish just this. So listeners, remember that. Extreme value, high-quality products, lowest possible prices. And David, my God, does this method work well. There is a reason Charlie Munker loves this business. Oh, does he ever. You know the great Warren Buffett joke about Costco, right? Ooh, no.

2:50Okay, so here it goes. Warren and Charlie are flying on a plane that gets hijacked. It's kind of macabre. The hijackers each grant one of them one last wish. And they ask Charlie first. And Charlie says, I would like to give my speech on the virtues of Costco one more time before I die.

3:08And then the hijackers turn to Warren and he says, shoot me first.

3:15It's so great. This actually happened at a Berkshire annual meeting.

Warren Buffett Joke

3:18It's on YouTube. We'll link to it in the show notes. Oh, that is awesome. I mean, Charlie Munker, of course, on the board of Costco and longtime fan of the bottle, as you should be too. So here are some insane stats. Costco has grown revenue right about 10% for over 30 years in a row. Their revenue per square foot of their warehouses belongs more in a conversation with Tiffany than Walmart. They seem to have incredible running room ahead of them to expand internationally and here in North America. And David, here's one that is just for you.

3:49Their store brand, Kirkland Signature, does more revenue alone, not including anything else in the store, than all of Nike. I know. It's so great. I think I found that Kirkland Signature, as a unified brand, I think might be the largest brand in the world by revenue. It's the largest consumer package brand in the world. Yes, which is a misnomer because, like, they sell everything. You know, most other brands only sell, like, shoes. But their $52 billion a year that they sell, which inches by Nike by just about a billion

4:22dollars, doesn't even include the Kirkland Signature gas. All right, listeners, if you want to know every single time a new episode drops, you can sign up for email updates, acquired.fm slash email, and two brand new things. We will be including little hints at what the next episode will be to the email list now. And two, we'll be including follow-ups from episodes when listeners share things with us after release, be it little corrections or just additional insights. So sign up, acquired.fm slash email. Come talk about this episode with us at acquired.fm slash Slack and learn from other listeners

4:57who may be closer to these topics than even David and I are. If you want more from David and I, check out our second show, ACQ2, available in any podcast player. Just search ACQ2. And our next few episodes are about AI with CEOs who are leading the way as the world very rapidly changes in front of us. So without further ado, this show is not investment advice. David and I may have investments in the companies we discuss, and this show is for informational and entertainment purposes only.

David Rosenthal Introduction

5:24David Rosenthal, what are the history and facts? So Costco was founded, as many people know, in Seattle, lovely city of Seattle, in 1983 by retail veterans Jim Senegal and Jeffrey Brotman. Now, Jeff came from a long line of Seattle retailers. His dad was a retailer. His brother is a retailer. Jeff was one of the first investors and board members of Starbucks.

5:54Super cool. And Jim, well, we'll talk about Jim as we go here.

Saul Price Early Life

5:59But if you were around in kind of of shopping age, shall we say, in 1983, you know that the true history of Costco dates way further back than that, to someone that we talked a lot about on our Walmart episode, the legendary Saul Price and his two companies, FedMart and Price Club. And although Costco, quote unquote, was founded in 1983, the organization that we know and

6:30love today is actually the result of a merger between Costco and its predecessor company, Price Club. And Price Club is really, of course, the actual result of Saul's previous company, FedMart, which FedMart itself really came out of, FedCo, in the 1940s. In some ways, we sort of have to tell a whole industry history here.

Industry History

6:54But in other ways, these kind of are all the same company because they're all stacked learnings from Saul Price and his various brain children over the years to create the Costco that it is today. Totally. We start History and Facts in January 1916 in New York City in the Bronx, where one Solomon, Saul Price is born. Now, Saul's parents were Jewish immigrants from Belarus.

7:24They'd arrived just a couple of years before at Ellis Island as teenagers. They had absolutely nothing. They spoke no English. They had no money. Nothing. So Saul's parents, like many Jewish immigrants around then in New York, ended up getting jobs in the garment factories in the Lower East Side. And the conditions in these factories were like terrible, just absolutely terrible. If you went to school here in the U.S., you might remember learning in American history class

7:55about the Triangle Shirtwaist Factory Fire in 1911. This is like the start of the American labor movement and the Communist Party and the Socialist Party emerged as a reaction to this in America because it's a terrible disaster. Literally, the factory owners had locked the doors to keep the workers in the building so they wouldn't steal. And then a fire breaks out. 146 people are killed, mostly women and young girls. Like, this is terrible.

8:27So Saul's parents didn't work at Triangle, but they worked at other factories just like this. Crazy. And you can't make this up. Saul, maybe the most influential American retail capitalist in history, comes out of the Triangle Shirtwaist Factory movement and communism and socialism and everything that's happening in New York and the Jewish community at this time. Wow. And you say one of the most influential. I do think he's top two, top three with Sam Walton, of course.

8:57Sam Walton actually wrote in Made in America that he stole more ideas from Saul than anyone else in his business career. All right. So very credible argument that he is the most important American retail capitalist. Jim Senegal, of course, co-founder, CEO of Costco. Jim tells the story that a reporter once asked him if he learned a lot from Saul. And Jim replied, no, that's inaccurate. I didn't learn a lot. I learned everything. Absolutely everything I know I learned from Saul.

9:29So we found this awesome biography of Saul that's like really rare. It's out of print. It was written by his son, Robert. And if you are a fan of Costco or want to learn about retailing or just like all these business practices, you absolutely should try to get your hands on this thing. It's self-published, too. It's self-published. I don't think there's anywhere else in the world that lays out in detail exactly how Costco works and its predecessor companies. It's amazing. Also super fun, Blinkist, sponsor of the show, made a summary for us.

10:04Yes. I was texting David before this, listeners, and I was like, I don't think a lot of people are going to be able to like get this book if they want it. And Blinkist agreed to order a copy and then turn it into a Blinkist. So you can get the Blinkist summary. We'll link to the show notes on how to do that. But David, the other crazy thing is I think Robert may have signed every copy of this book because he signed yours and he signed the one that I got. Oh, amazing. That's how rare this thing is.

Saul Price and Fedco

10:27So back to Saul's growing up years. He says in the book, there's a quote from him, in the New York Jewish community at the time, there was no such thing as Republicans. The socialists were the conservatives and the communists were the radicals. So it really illustrates where Saul's political ideology comes from. Absolutely. So as a young child, he develops an eye defect that causes his left eye to droop. He's really self-conscious about this, as you can imagine. But as a result, he channels all of this insecurity into being like a massive overachiever in school.

11:03So he skips two grades in school growing up. And then in the middle of his high school years, his parents moved the family from New York City to San Diego, California. Now, San Diego, it's a town of like 150,000 people. This is not the San Diego we know today. There's no Qualcomm. There's no Illumina. There's only like just the beginnings of the U.S. Navy and the defense industry there.

11:33But it's a small town. When Saul gets out there to San Diego in a parallel moment to Sam Walton's early life, Saul meets his future wife while he's in high school. And it turns out that Saul's future wife's first name is Helen, just like Sam's wife name is also Helen. And Sam's wife would be very influential on him, along with her family. Same thing with Saul. So just like Helen Walton, Helen Moskowitz's soon-to-be Price comes from one of the wealthiest

12:06families in San Diego. This is literally just like San Diego Walmart. Literally, that's what's about to happen here, just like 10 years before Sam and Walmart. Wow. So Helen's family owns and operates a scrap metal business. A scrap metal business in the 1930s in San Diego is about as well positioned as you can possibly be because San Diego is about to go through a huge transformation during World

12:37War II. It's going to become the principal port of the U.S. Navy's Pacific Fleet, which is going to be the main naval operations of World War II. The city is going to absolutely boom, and it's going to be shipbuilding. It's going to be Navy. It's going to be metal. David, you and I were just down in San Diego doing our episode with Doug DeMuro, and I went and stopped by the Midway Museum because we had just done our Lockheed Martin episode. And you can feel the history dripping off that thing on all the old airplanes and everything. San Diego has been obviously a huge Navy culture for 75 years now.

13:08During and after the war, all these sailors and GIs come through the city. And then when the war is over and they come back home, wherever they lived in the country before, they're like, wait, why am I living in Kansas? I should be living in San Diego. San Diego is pretty great. It's really nice there. So from 150,000 people when Saul moves there, after the war, San Diego is on a path to becoming today it's the eighth largest city in America. It's larger than Seattle. It's larger than San Francisco.

13:39Oh, I wouldn't have guessed that. Yep. So this is going to become quite the fertile market, shall we say, for a new retail enterprise in post-war America. But before then, Saul goes to USC and gets his law degree. They come back to San Diego and he starts practicing as a lawyer. Now, Saul's timing is just, I mean, you could not script this any better. He becomes a lawyer right before this boom. When you're a lawyer in a small town, I mean, my parents were lawyers in a small town growing

14:13up. You're a lawyer for your clients, but you're kind of also consigliere. You're advising on business, real estate, negotiations, divorces, trusts, estates. You're like super deep with your clients. So after the war, Saul starts counseling all these entrepreneurs with these new retail concept startups that are emerging in San Diego. One of these startups is called the Seven Seas Locker Club, which ostensibly the premise for this business is literally a club of lockers where Navy sailors can store their uniforms

14:48when they're on leave and wearing their civilian clothes. And then when they go out to sea, they can store their like personal clothes and effects while they're away on the ships. Yep. But actually, that's just a Trojan horse to get all of these consumers into the door. Oh, it's foot traffic. And then they offer all kinds of goods and services to them within the locker club. So there's laundry, there's dry cleaning, there's clothing, there's jewelry, there's food, there's haircuts. This might start to sound a little familiar here.

15:19Another client is a jewelry store called Four Star Jewelers. Now, in addition to operating their own jewelry store, these guys also sell jewelry wholesale to other retailers. And it turns out that there's one account in particular that accounts for like the vast majority of their outside wholesale business. And it's this odd retail concept operating out of Los Angeles called Fedco.

15:55And you're like, Fedco? What is a Fedco? What is happening here? It's also like, okay, how are they doing so much volume? You should go check it out and see what's going on. Yeah, exactly. Well, Fedco, it turns out, was a non-profit membership club. It was a customer collective, and it was called Fedco because it was only open to federal employees, primarily postal workers. After the war, about 800 postal workers in the Los Angeles area decided somehow that they

16:28wanted to pool their buying power together and their federal employees. And so they start this club so that they can pool the buying power and get better prices on goods that they can all participate in together. Well, it turns out there are a lot of federal employees out there, especially in San Diego. They charged a membership fee. They charged dues to join. But unlike Costco today, they didn't really make any money on the memberships. Remember, they're a non-profit. So the cost was $5 one time for a lifetime Fedco membership.

17:04Yeah, hard to see that working. But actually, it's not so different inflation-adjusted from REI's membership today. Very clearly, REI is not interested in making money off the membership program. I pay, what is it, $85 or something once just to grant me sort of a higher affinity to the store, and the money's not really relevant. That is the perfect analogy. That's exactly what Fedco is. Yep. So, as you can imagine, Fedco becomes quite popular amongst government employees in the

17:36LA area. And then, not just the LA area, people start driving from all over Southern California, including San Diego, sometimes up to like hundreds of miles round trip to do the majority of their shopping at Fedco. It was time to expand, yeah. But Fedco's a non-profit. They're not looking to like expand and build this huge empire. Exactly. So Saul and the jewelry guys, they see what's happening with all of the wholesale business

18:08that they're sending to Fedco up in LA. And they're like, man, we got to find a way to open a Fedco here in San Diego. And Saul's like, actually, I might have just the location. It turns out that Helen's family owned a 21,000-square-foot warehouse in San Diego's industrial district that's currently sitting empty. So the three of them go over, they check it out, and they're like, oh, yeah, we could totally recreate Fedco in this building right here in San Diego.

18:40So if Saul were Sam Walton, that would be the end of the story right there. He'd just be like, great, I'm going to clone Fedco. No, this is how Saul is different than Sam. And I think probably harkens back to his upbringing in New York and everything that was happening. He calls up the Fedco board of directors in LA and he says, hey, we want to partner with you guys. We think that a Fedco would do great in San Diego. Can we create a joint venture together?

19:12We've got the building. We'll operate the store. Let's go into business together and be partners. Fedco, though, like you said, they're a nonprofit. They're not interested in expansion. So they turn him down. And Saul, God bless him, he calls them back and he's like, no, no, no, guys. We really want to do this. How about this? You can own the whole business. We'll just be a franchise down in San Diego. You get all the upside. You get all the enterprise value. Like, we don't care. We just want to bring this to San Diego.

19:42And they say no again because, you know, it's like a nonprofit board of directors. Yeah, on the one hand, you might think Saul Price, not a very savvy business person, just take the gift and go with it. On the other hand, ridiculously principled guy. There's a really funny Saul quote from later in his life. He's asked about how he feels about essentially being the father of modern American retailing. And he thinks about it and he sort of laughs and says, you know, maybe I should have worn a condom.

20:13Oh, Saul. Oh, Saul. But it's not that he's a rube. He's a really good businessman. He's just also incredibly principled. Yep. And this is going to flow through directly into Costco, as we'll see. Okay, back to Fedco. So after this second rejection, Saul and the guys are like, I guess we now can go do it ourselves. So in November 1954, they open the store in this warehouse location and they had to think

20:45about what to call it. And they're like, well, basically, this is a clone of Fedco, but we can't use that name and it's kind of a bad name anyway. What if we draft off the same brand recognition, though, and call it FedMart? An equally bad name.

21:02An equally bad name that would have historic impact. So why do you think Walmart is called Walmart? Why do you think Kmart was called Kmart? Oh, it was the first Mart? It's because of this. Yes, literally. I mean, Sam Walton talks about this in Made in America. By the time Walmart was starting, people knew what Fedmarts were. They were expanding across the country. And he was like, oh, great. We're going to draft off the Fedmart brand. And it was the same thing with Kmart. Fedmart becomes the first scaled quasi-national discounter.

21:37And people are like, what are discounters? Discounters are Walmart's, Kmart's, Target's. That is the industry that Saul births here. And so very specifically, we are not talking about what Costco is today as a wholesaler. Fedmart is not big pallets with enormous quantities of things. It is much more like a Walmart. You want to go grab a can of beans off the shelf, you grab a can of beans off the shelf. And importantly, it is both packaged food and sundries or general merchandise under one roof.

22:09Yes, correct. And on the one hand, Fedmart is obviously a clone of FedCo. On the other hand, the huge single key difference that makes all the difference, it's a for-profit company. It's not a nonprofit. And so just like all capitalist for-profit companies, Saul and the jewelry guys and Fedmart have the impetus to expand. That makes sense. And so just to put some other fine points around what it is and what it isn't, it is still only for federal employees, right?

22:42Yes, at this time. Okay. And it's not a membership club. Well, so it is still a membership club. You do still have to be a federal employee. You do still have to buy a membership. I think they maybe took the lifetime membership price down to $2, so they undercut FedCo or something like that. But obviously, it's not about the membership. The reason they did this and the reason that no other discounters had really scaled before, this is crazy.

23:12There were actually laws on the books in the U.S. at the time that manufacturers of goods could set a minimum selling price for retail. And it was actually illegal for retailers to offer products below that price to the general public. Whoa. So the term discounters, discounting, meant selling below the manufacturer's minimum price. How did you get around this? Well, Saul kind of stumbles into figuring out that if you are a membership club,

23:49you're not open to the general public. So you can skirt these laws and sell below the manufacturer's minimum price. Interesting. Huh. So this is crazy. And this is why I think there's a strong argument that Saul really is the goat among American capitalist retailers. We haven't even gotten to price club and wholesaling and Costco yet. He also invents that later. First, he invents the discounter, which then Sam Walton, Kresge with Kmart, Dayton with Target,

24:21copy, and becomes the dominant retail form of America. Two totally separate things. He invents both of them. Crazy. So when Saul and the guys opened the first FedMart in 1954 in San Diego, it is a huge and immediate success. Their sort of wildest dreams expectations are that they do a million dollars in sales in the first year. The store does three million dollars in sales in 1954 in one year. Wow. And why do you get the sense that it worked?

24:51It worked because it was already working. This was a no risk bet. Clearly, FedCo had proved the model in L.A. They just did the same thing as a for-profit company. Makes sense. So a year after San Diego, they opened the second FedMart in Phoenix, Arizona, right off the bat, going multi-state. They want to go big here. It's another absolute banger. Literally, when they open it, there are lines half a mile long to go get into the parking lot of the store, like going out in every direction from the store.

25:23They take it to Texas. They go to San Antonio. They go to Houston. They go to Dallas. All of these stores are huge successes. So, at this point, two things happen that are going to prove very fateful both for FedMart and for Costco. One, Saul fully stops practicing law and goes full-time with FedMart. He becomes the president of FedMart. Two, he hires a young college student from San Diego City College as a part-time bagger in the San Diego store.

25:55One, Jim, Senegal. And Jim would end up working for the next 22 years at FedMart directly for Saul. Eventually, Jim ends up running FedMart's entire distribution and centralized warehousing operations. Warehouses. You can see the Costco picture coming together here. Put a pin in that. So, FedMart goes public in 1959.

26:25They raised $2 million. They plowed that money into both expanding the number of stores across the country, but also, remember back to Seven Seas Locker Clubs, the suite of goods and services that they're offering under the roof, or in some cases, not under the roof. This is when they add gasoline to FedMart. So, the Costco gas lines, like this started with FedMart. They would intentionally price a few cents lower than whatever the other gas stations were charging in the area.

26:57And a few cents at that time was a lot because gas was like 25 cents. And unlike gas stations, FedMart is making money on consumers shopping in the store as well. So, they can price at cost on the gasoline, get all the traffic coming to the store, and then monetize through the store. They add a pharmacy to FedMart, Costco pharmacy today. People are religious about it. So, there's a crazy story. The guy who sets up the pharmacy division for FedMart starts getting death threats from people in the industry.

27:33He has a rock thrown through his window. It's literal mafia stuff because they're undercutting the fat margins in these pharmacy counters so much. That guy's protege, who then takes over the pharmacy division for FedMart when he retires, that guy goes on to start Costco's pharmacy division and run it. Amazing. Most importantly for the Costco story here, after they go public, FedMart uses part of this capital to develop their own house brand for some of the popular products that they're selling on the shelves.

28:11It's like the FM brand, is that right? The FM brand, yep. If you ever see FM branded old photos and stuff of like newspaper articles referring to FM, Cola, FM, whatever, that's what it is. It's FedMart. And then one more piece of FedMart playbook, shall we say, that clearly makes its way over. However, as Saul is running the company during these first few years, he starts to codify some retail management philosophies.

28:44And he famously sort of canonizes these as FedMart's four priority order principles. And he teaches every new employee throughout the whole company about this. Number one, first priority, provide the best possible value to customers. Number two, second priority, pay good wages to employees and provide good benefits, including health insurance. This is in the 50s. Like this is progressive stuff. Number three, maintain honest business practices. And then number four, the last one, make money for investors.

29:18So if you're a Costco nerd out there, and there are probably many Costco investor nerds listening right now, those all probably sound very familiar to Costco's priority order values. Right. Not the same, but kind of rhymes. Put a pin in it. When it comes to Costco, we'll bring those up and go into each of them in depth. So you might be listening and saying like, yeah, yeah, yeah, that sounds good. But I'm thinking about, you know, I don't know, maybe I go to Walmart today or I walk into Target and I see some similar things written on the walls there. Isn't this kind of all the same?

29:50If you really mean them, no. There are some very, very clear tradeoffs that Saul is going to make with FedMart that Costco makes today that are very different from what their competitors do. Like, one, do you sell loss leaders in the store? Loss leaders being when you mark down items below your cost in order to attract people into the store with sales. If you're those other retailers, yeah, of course, this is like a time-honored tactic in retailing.

30:21Of course, you're going to use this. Sam Walton bragged about it in Made in America about we could get this, you know, incredible number of, I don't even remember what the thing was, but build a pyramid of them in the parking lot and blow them out to get people to come and participate in the spectacle. Right. If you're Saul and Costco today, you're absolutely not going to do this stuff. No, they won't sell something unless they can make money on it. Because the flip side of doing loss leaders is that you got to make up for it somewhere. You got to mark up other goods in the store to fat margins to make it worth doing the loss leader for you.

30:55Well, basically, it means you're treating your customers like they're stupid. Totally. That's exactly my read on this, too. I feel like, David, acquired number one tenant, treat the audience like they're smart. If you're going to ever do loss leaders, you're sort of violating that tenant and saying like, eh, we're going to get one over on our customers. Totally. This is anathema to Saul. He passes that down to Jim Senegal. It's anathema to Jim. Okay, so that's one trade-off. Here's another really big one. What do you pay your employees?

31:27So in 2006, Harvard Business Review published a really great piece called The High Cost of Low Wages, where they very directly compare Costco and Walmart employee salaries and benefits. Which, for listeners, if you want those numbers today, Costco's average hourly wage is $26 and Walmart's is $19.50. So huge, huge difference if you are going to go get an equivalent job at one or the other. On top of that, at Costco today, you also are eligible for a 401k with a match and very, very good health care.

32:05Shockingly good health care, even for hourly workers. So if you're going to go work at one or the other today, you'd be very lucky to go work at Costco. So, obviously, the trade-off of this is for FedMart at the time and straight through to Costco today. This creates meaningfully higher per-employee labor costs for the company. Yep, totally. But what are the benefits? And this is where we get this beautifully interlinked set of trade-offs that play well together. So what do you get? Well, you get low employee turnover.

32:36And when I say low, I mean very low. After the first year, Costco today has only a 7% attrition rate among their workforce. This is wow. This is for hourly labor. Yes. Typical retail is 20%. So it is a meaningfully lower cost to onboard and train new employees. Like, you normally have to spend a lot of your money ramping people to get them up to speed. Costco, Price Club, FedMart doesn't have to do any of that because they're really rewarding their employees. Employee loyalty also reinforces the idea that people shouldn't steal.

33:11They feel grateful for this job. They're excited to be in it. The shrinkage or the unaccounted for merchandise at Costco today is astonishingly low. It is 0.15% of sales. That's crazy. So merchandise does not walk out the door. Their strong bias also is to promote internally. So if you look at Costco today, 36% of U.S. employees have over 10 years of service. And this is truly unique, I think, about Costco among major American, at least, corporations, and was true at Price Club and FedMart before it.

33:48The senior, senior management, this is the same story. I mean, Jim started as a grocery bagger in the 50s at FedMart. Craig Jelinek started his career as an hourly employee at FedMart. This is how long the tenure is of these people and how linked these stories are. If you look at their executive team at Costco today, basically all of them have been there for over 25 years. The only vice presidents at the company who have not are the digital e-commerce people that they had to bring in to address some issues.

34:23Decades ago. It's crazy. So what happens? FedMart truly was the first discounter that scaled nationally. All of these innovations, even though Sol came up with them, as these other companies are scaling, and I think particularly Kmart, they don't really have the large-scale operational expertise nor the access to capital to really fend off the competition.

34:53Kmart, if you remember back to our Walmart episode, came out of the Kresge department store chain, which was huge. So they had so much more access to capital, certainly than FedMart, and even than Sam Walton and Walmart. You know, Sam had to fight bitterly, last mile by last mile, building out his distribution network to beat Kmart. Sol and FedMart, they don't really have the firepower to compete. So they need capital, or they need to sell the business, one or the other. And it seems like what they kind of did was accidentally both.

35:25Yeah. In the biography, Sol comments to his son Robert, who had also joined the company, joined FedMart at this time. He says, quote, All right, listeners, this is a great time to thank one of our favorite companies here at Acquired, Sentry. That's S-E-N-T-R-Y, like someone standing guard. Yes. Sentry helps developers debug errors and latency issues pretty much any software problem and fix them before users get mad.

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37:31you can check out sentry.io slash acquired. That's S-E-N-T-R-Y dot I-O slash acquired. And just tell them that Ben and David sent you. Yes, and they are offering two months free to all acquired listeners. Yes. Thank you, Sentry. All right, David. So, what happens with FedMart? So, like you say, by the time we get to the end of the 60s, early 70s, Saul's burned out. He and Robert, they don't want to be running this business at scale. First, he brings in, quote-unquote, professional management and moves up to chairman of the board.

38:03Second, he starts looking around for a capital partner to help the business compete on a more level playing field with the other discounters. They end up going to Europe. And this is super important, both for the drama that happens, but also leading into Price Club and Costco. At the time, in the 70s, this new retail concept in Europe was getting going, actually pioneered by the French company Carrefour, which is still a huge global retailer today. And that concept is the hypermarket.

38:36So, what are hypermarkets? Hypermarkets are smashing together everything we were just talking about with the discounters, the general goods retailing, with a full-scale grocery store supermarket. So, fresh food, everything. This is what almost every Walmart is today, the super centers. It's grocery and hard goods in one huge, enormous warehouse, you might say. Which is funny. You would have assumed that the Americans would pioneer that.

39:06It's hilarious that the French did. It was the French, of all people. So, this concept didn't exist yet, and it wasn't until the late 80s that Walmart would really embrace it and roll it out across America. So, as Saul and Robert are looking for partners to take FedMart to the next level and going across Europe, they're meeting with all these hypermarket operators. So, they end up getting into bed with one of the German clones run by a retail entrepreneur named Hugo Mann. The idea was that Mann was going to help Saul and FedMart take this hypermarket concept and morph the existing FedMart stores into hypermarkets,

39:48which Walmart would do to great success, but like 15 years later. Had this happened, we would be telling a very different story today. And we might all be shopping at FedMart's. Totally. In practice, what ended up happening is this weird thing where Saul Price was an innovator and a great merchant, but not a deal guy. And so, it seems like there's two cardinal sins that get committed. One, not really asking Hugo Mann, why do you want to do this deal?

40:19And what is interesting about this to you? And what do you want to do with the combined company? And then, two, selling the majority of it and treating them like a minority investor. Yeah, Saul is looking for a growth investor, and he ends up getting a buyout. Yeah, one with misaligned interests. So, within a few months of when the deal actually closes, perhaps predictably, Saul and Hugo get in a huge fight. At the very first board meeting. The very first board meeting, they're like yelling at each other, this is not going well.

40:51So, man fires Saul, literally fires Saul, I think, and Robert, too, and changes the locks on their office doors. Oh. Literally boots Saul out of his own company. It's super ugly. And then, the person at FedMart, of the remaining executives, who they task with, you think, like doing an all-hands or the equivalent of, and, you know, inform the rest of the company what's just happened. You know who that was? No. Jim Senegal. No way!

41:22Yes!

41:24Wow. Isn't that hilarious? Oh, my gosh. Oh, that is crazy. And I think what was going on here is Hugo Mann just realized that FedMart was sitting on a gold mine of real estate and just wanted the real estate portfolio. And what Saul and Robert wanted was operating capital from the parent company, from Hugo Mann, to invest more in aggressively opening more FedMart stores. And pioneering hypermarkets in America. Yeah, which, of course, Hugo Mann had no interest in. Yep. So, had this not gone down like this, I think Saul probably would have just retired as new management took over at FedMart and all would have been amicable.

42:04He wasn't really interested in continuing his career. But. But, because of how this went down with him getting locked out of his office, he is pissed. He is now 60 years old at this point, and he is a man on a mission. Great time to be a founder. Totally. Amazing. I love that. He's like the Morris Chang of American retail. Yes. Morris Chang, of course, being the founder and CEO of TSMC, who was booted out of Texas Instruments at age 56, I think. Something like that. Yeah.

42:34And then would go on to start TSMC. So, Saul and Robert together, they get a lease on an office literally the next day after they're booted out, and they're like, we're doing it again. We're back in the saddle. Let's go. So, but they know they're not going to compete directly with FedMart because FedMart is failing at that. They're going to get steamrolled by Walmart and Kmart and Target and everybody else. By the way, FedMart within five years was like completely dead after this acquisition. Totally ran into the ground.

43:05And Hugo Mann did make a fortune on the real estate, but yeah, FedMart's dead. Yep. So, Saul and Robert are sitting around in their new office brainstorming what's their angle of attack here. And they keep coming back to one part of the FedMart business that they felt was underappreciated and they didn't really exploit enough while they were at FedMart. And that is the division that Jim Senegal ran, the centralized warehousing operations.

43:40So, the two of them are like, you know, if we zoom out, there really is kind of a different and orthogonal way to think about the FedMart business. You really could say that Jim ran our warehouse operations kind of like its own business. They were supplying the individual FedMart stores, which were sort of smaller businesses. And when you look at it that way, almost all of the margin that we made at the company was at the warehouse level.

44:15The stores themselves were not particularly profitable and pretty hard to compete with the competition out there. I didn't realize that they thought to sort of slice the margin up into those two almost like places in the value chain. Yeah. So, they're like, well, is there a way that we could take Jim's operation, recreate it, and make that the core business instead? And so, the business plan that they come up with is literally that.

44:45Create warehouses for other individual small businesses, other retailers. And they're envisioning, like, gas stations, restaurants, small variety stores in the, like, independent chains that they can come and shop to stock their own shelves at this centralized warehouse that we're going to operate. So, just business owners can be members. Just business owners. And they're like, man, if we did that, I think that would be providing a huge service to these small businesses.

45:18Because one of their big problems that we know from operating the FedMart stores is actually how you manage your inventory, like, physically where you put it. You know, you need a centralized warehouse to hold your inventory. If you're a small gas station, you don't have your own warehouse. We can be your warehouse. Right. And to put a finer point on it, the reason why it's awesome to just run warehouse operations is because the logistics are simple. You are taking pallets of stuff, and you are moving it to a location in a warehouse, and then the customer comes and takes a huge amount of it off your hands.

45:56You don't really have to turn and make sure the labels are facing out, and you don't have to deal with, oh, little one-off. You know, we've only sold 16 units, but there's actually 127 units on this thing. Everything is nice, easy, big quantities, doesn't require a lot of attention from your staff. Being in the wholesale business is good if you can get it, but their inclination at this time is, well, the only people who would be willing to shop and buy in that way are business owners. This would never work as a consumer concept.

46:27Yep. All of that, totally true, and amazing parts of the Costco model. There's one piece in particular that really, really makes this a crown jewel, and it's the reason why they were so enamored of what Jim was doing. If you're operating a wholesale warehouse, you don't have to operate any logistics. The manufacturers deliver the product right into your warehouse. You don't need to run trucks. You don't need to operate other warehouses.

46:57You don't need to move stuff around the country. Right. And the business owners just come to you and pick it up right from the warehouse where it was delivered, right from the manufacturer. Totally. And because of all this, because this new business, this Costco Price Club, going to be called Price Club, is providing such a valuable service to the small businesses that are shopping there in managing all these logistics for them. Or I shouldn't say managing because Price Club doesn't manage it either.

47:28The manufacturers do. They're like, we can actually go back to that original FedCo membership idea, and instead of having it just be like a way to skirt around the law, we can charge real money for this membership because we're providing real value out of this to the businesses. Yep. So, once they hit on this business plan, Saul and Robert poach a few people from FedMard and elsewhere, including they hire this super bright young guy from Harvard Business School named Giles Bateman as their CFO, and then they go get started.

48:06Giles would later go on to become chairman of, do you know this, Ben? No. Comp USA. Really? That's a big part of my childhood and part of the enormous diaspora of retailers that come out of not only FedMart, but Price Club. Jim Senegal, after, I think he was probably locked up at FedMart under new management for a while, after that, he would come over and briefly work at Price Club a couple years later. So, like, the best of the best are coming through this place.

48:36Hmm. So, they decide, as they're getting started, that in order to keep the operations really tight and realize the maximum benefit, Ben, of everything you were describing of how these warehouses operate, they're only going to stock about 3,000 of the highest volume items that they think most other retailers are going to sell to their customers. So, at the time, Walmarts and Kmarts had on the order of about 50,000 SKUs, and even FedMart had probably close to that many at the time.

49:08Going all the way down to 3,000, this is a non-consensus move. Totally. But, if you're only selling to businesses and they have small stores, it's not like we need to stock basically everything under the sun, it just needs to kind of be sufficient. Right. Super important. Remember, they are not thinking about consumers just yet. However, when they launch the first store, when they open the first Price Club in San Diego, unlike FedMart, it's not an initial gangbuster success.

49:40Turns out it's a lot harder to sell and recruit businesses to come be your customers than it is just putting out a shingle and attracting consumers. And there's not like a viral word of mouth necessarily among these business owners. They're not just encountering each other everywhere all the time. Exactly. So, they're worried after a couple months that this thing might not work. They might need to shut it down. And then, they have the greatest stroke of luck. So, they're going around San Diego trying to sell memberships to businesses.

50:15And they get a meeting with the San Diego City Credit Union. And the credit union management are like, we're a credit union. We're not a retailer. We don't really buy much stuff. We're not interested in this. But, you know what? Our members, if we could find a way to get them access to what you're doing here, that might be a really good benefit that we could offer of like, oh, you can get wholesale prices on goods. So, Giles, the wunderkind young CFO, he goes over to the credit union, hammers out a deal whereby any credit union member can qualify for a new quote-unquote group membership plan at Price Club and be allowed to shop there just at slightly higher prices than the business members.

51:00It turns out that this does two things. One, this unlocks the gusher of consumers into Price Club. Which allows for not only volume, but word of mouth. This is the seeds that are sown of, Costco today doesn't really advertise. And this is the first moment that they realize, oh my gosh, consumers are going to tell each other about this thing. Exactly. And it's even better than that. Because not only do consumers tell other consumers, it turns out that a lot of small business owners are also consumers.

51:34So it also drives small business owner membership. And because the business members get slightly better pricing on things, all of a sudden all these consumers are running around being like, oh, hey, I think my aunt owns a nail salon or something like that. Like, let me get her to go sign up and get a membership. And then I can use her card and get better prices. Yep. And David, do you know what I did this week? I suspect that you drove to a Costco. And do you know what now has a business membership to Costco? Oh, hell yeah. Where's my card?

52:06Actually, I think you need to go in and have your picture taken. I was on a personal one before, but while I was there, I was like, you know, it would be appropriate this week. So we now have a business membership. Hey, we are a small business. That's right. I love it. Another fun story. As this unlocks the viral consumer word of mouth channel, of course, traffic at this first San Diego Price Club store starts growing and growing and growing. Saul and Robert start getting calls from local hot dog vendors that want to set up carts at the store's exit.

52:38If you got traffic, you know, you may as well. You're going to attract hot dog vendors. That's right. So at first they ignore them. Eventually, though, they start getting enough calls. They're like, huh, maybe we should do something about this. And maybe rather than letting these guys come set up their carts, what if we do it ourselves? So Saul calls up Hebrew national hot dogs and asks them if they can supply them with hot dogs to sell at the stores. And Hebrew says, not only will we sell you hot dogs to sell, we'll supply the cart too.

53:12And thus, the Costco $1.50 hot dog and soda deal is born. And still, to this day, it's $1.50 47 years later. There's a decent chance this is the one and only loss leader that Costco sells today. Yeah, they're a little cagey about what the actual costs are. I do know that they've gone through many, many iterations in-housing all the operations to try and keep their costs down.

53:43Oh, they actually make the hot dogs now. Yep. They also sell 130 million of them per year. Wow. That's not all in America, but if it were, that's like a third of America going to Costco and getting a hot dog every year. Yeah. So there is this interesting question that has now been answered, which is there's this kind of horrible way of shopping where I need to go buy in bulk directly from the warehouse. No good retail experience. Are consumers actually going to do that?

54:15You know, this whole thing was intended for business owners. And there's all these benefits that come from selling to business owners. Again, you don't need a separate retail area and wholesale area. The logistics are all much easier. You know, you don't have to ever have your own logistics to move stuff from your warehouse to a different store to sell it. But are consumers going to do this? And they learn immediately, yes. It's sort of this shocking thing where it's like, whoa, consumers are willing to just go to a warehouse and buy stuff right off the pallet. That's a pretty unexpected thing that happened.

54:47It turns out that there is really one pretty sure thing, at least in America, probably the whole world, that if you sell something at lower prices than anywhere else, you're going to sell a lot of it, no matter what hoops people have to jump through. Yep. One other fun thing. Do you know what the building that this warehouse was in was previously? I do. And it's super cool. Well, it is, listeners, the airplane hangar of the Howard Hughes Aircraft Corporation.

55:17One of the many, I'm sure, that Howard Hughes had. Yes. But we got to cover Howard Hughes at some point on Acquired. Definitely. So, on the back of this wild success in San Diego, once again, Sol and Price Club quickly expand, just like with FedMart, first to Arizona and then beyond. This time, though, it's way different than FedMart vis-à-vis competition and capital dynamics. So, whereas FedMart was capital-constrained relative to the competitors, because of the genius aspects of this Price Club model, they are cash flow geysers, these stores.

55:58So, the suppliers handle the logistics, deliver directly into the warehouses. So, let's just follow the cash flow cycle. They deliver to the warehouse. The moment they drop off that pallet is when they invoice Price Club. And invoices tend to be about net 30. So, that means the pallet gets dropped off and you have 30 days to pay the supplier. But the minute that the pallet gets dropped off in the warehouse, those goods are for sale. Right. No more internal supply chain, no more unpacking, no more shelving.

56:31It's just available to buy now. So, in many, if not close to all cases with Price Club and then with Costco today, those goods are sold before Price Club has to pay the invoice to the supplier. It's amazing. All right, David. I got a bunch of great stuff for you on this one. So, we're going to flash forward a little bit to today. But I have a huge thank you for Costco Chief Financial Officer Richard Galanti spent an entire afternoon with me walking through a lot of these characteristics that really make Costco work.

57:03So, I got a bunch of great tidbits while I was hanging out in their campus outside Seattle. Where was my invite? I invited you. You could have gotten on a plane. True. All right. So, here's how it all works today. So, Costco actually turns their inventory 12.4 times per year. And just for comparison, Walmart turns their inventory eight times per year. Home Depot is more like five times per year. So, at this number north of 12 times a year, David, exactly what you're saying. It means Costco can sell through its inventory faster and more often than every 30 days.

57:37To be specific, they're on about a 26, 27-day sale. This is amazing. So, with typical payment terms being net 30, it means they literally have zero dollars tied up in inventory. And in fact, they're able, to your point, to make a few bucks on the float. So, this is, of course, an average. There are some things that will sell in a week or two. Other big ticket items might sit for a month or two. Sometimes, Costco can even turn things two or three times before they have to pay a supplier for it. So, this is called a negative cash conversion cycle, where vendors effectively finance Costco's inventory for them.

58:16You know what? I'm in. I capitually, I'm with Charlie on this one. He can come in here and give the speech 10 times in a row about how great Costco is. I will listen to all of it. I am in love with this company. So, there's a couple interesting components here. There are companies that can achieve a negative cash conversion cycle, but the way they do it is by having predatory terms, where they go to their suppliers and say, I'm not going to pay you for, like, three or six months. And that is one way to do it. Costco's using standard payment terms here.

58:46Right. 30 days. And so, there's two unique things that enable them to do it. One is this warehouse model, where things are instantly available for sale. Customers come right to the place where they were dropped off. Not quite anymore, and we'll get to that later. But at Price Club, that's definitely what it was, and grab stuff right off the pellet. The other thing that makes it all work is, to this day, Costco has kept their SKU count very low. SKU, SKU being a unique item that a store has for sale. I think, David, you mentioned before, about $3,000 at Price Club is what they had available for sale.

59:19If you look at a Walmart today, they have something like $100,000 to $150,000 different SKUs that they sell. Super centers, indeed. Costco, in the last 10 years, was around $4,500. And then they sort of looked and said, can we bring it down, and went to $4,000. And today, they're sitting at $3,800. So, this number is still going down, not up. And if you do the math, and you start thinking, well, geez, if you're not selling a lot of SKUs, but you have a lot of customers coming through your stores, what does that mean? It means that any given item is going to turn faster.

59:52It's sort of this magical unlock. In addition to the instantly available for sale in the warehouse thing, it is the low SKU count that directly gives you the ability to turn your inventory over quickly. It's just so awesome. I mean, like, if you look at a price club then, and certainly at Costco today, capital light, quote-unquote, would be the farthest thing from your mind. You're like, these are massive structures. There must be so much money that goes into this. Well, yes, that's true. But it's a capital light business model.

1:00:23It's wild. It's all being financed for you by your suppliers because of these dynamics. And, of course, today, as Costco opens new warehouses, they can very tightly predict how they'll perform because they know how all the other ones perform. And so, sure, there's a lot of upfront money in opening a new store. But once it happens, you sort of know exactly what it's going to mature to and exactly how you're ROI positive on all your fixed costs to invest in that new location. And you have this negative cash conversion cycle with all of your inventory being effectively free, if not profitable, for you while it sits there.

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1:01:28Yep. And it's like 47 pages long with requirements that kind of sound like alphabet soup. Do you support SAML 2.0? Can you integrate with our Okta? Do you have SCIM provisioning, SCIM? What about RBAC? And you're thinking, I have no idea what these acronyms even mean, let alone how to implement them. So, here's the thing. These are not nice-to-haves. These are deal blockers. Without SSO, without SCIM, without RBAC, without audit logs, you simply cannot close enterprise deals, period.

1:02:03But none of these features make your core product better. They don't make your beer taste better, to use our favorite analogy here on Acquired. So, if you're building, like, a design tool, spending six months building SAML authentication doesn't make your design tool more powerful. So, this is where WorkOS comes in. They've built Stripe 4 enterprise features. WorkOS turns enterprise authentication requirements into drop-in APIs, abstracting away as much unnecessary complexity as possible. So, instead of your team spending months reading SAML specs, you can implement enterprise SSO in minutes.

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1:03:09So, on the back of these eighth wonder of the world, like, cash flow dynamics that these Price Club warehouses have, Price Club goes public in 1979, three years after founding. And I say go public, not in an IPO, not in a direct listing. They don't list anywhere. They don't raise any money because they don't need any capital. So, what happens is there's so much buying and selling activity among the original shareholders because this thing has become so valuable that this is the first time I've actually ever heard of this happening.

1:03:43Price Club crosses the 500 shareholder mark that, at the time, the SEC mandated if you had more than 500 separate shareholders of a company, you had to start filing as a public company. So, Price Club's just like, okay, we'll file. We'll be a public company. They don't list on an exchange. They're just like, sure, we don't need the money. That's crazy. So, they're registered with the SEC, but they're not listed on a... Yeah, it's traded over the counter. They're not on the New York Stock Exchange or on the NASDAQ or anything like that.

1:04:14Wow. So, for those first three years, I need to know a Price Club shareholder in order to buy the shares. Yeah, there probably are some market-making systems. I think this is what the over-the-counter market kind of does. But, yeah, you can't just go trade it on an exchange. Wow. Hilarious. So, 1982, they do ultimately list on NASDAQ, probably just to get more liquidity in the trading. Also in 1982, Saul gets a call from his old buddy, Sam Walton. He wants to come out.

1:04:45He wants to see Saul. Wants to have dinner with the two Helens, get the families together. He wants to shop his competitor like he always does. Yeah, you know, and he's like, you're doing so great with these Price Clubs. I love your second act. I want to come see it in action. And Saul is like, sure, come on out. I think he knows what Sam is up to, but he doesn't really care. What's he going to stop him from going into a store, you know? Totally. So, Sam and Helen come out. They all have a nice dinner in La Jolla. Saul tells him all about Price Club, how the model works, the cash flow dynamics, everything.

1:05:17Sam, of course, goes back to Bentonville. And within 12 months, guess what pops up? Sam's Club. Amazing.

1:05:26And this is really the major difference here between Saul and Sam. Saul doesn't care. He's like, sure. You know, again, what am I going to do? Stop you? They stay friends. There's this amazing story that Sam tells in Made in America, where a few years later, Sam is going around again to Price Club, shopping his competitors with his tape recorder, making notes about how they're doing pricing and inventory and stuff, and the security at the store confiscates Sam's tape recorder. Saul ends up just mailing it right back to Sam, and he's like, keep your notes.

1:05:58It's all good.

1:06:01It's so funny. Right around the same time, another person comes out to San Diego to visit Saul and Price Club, a guy named Bernie Marcus. And for some listeners, that is going to ring a lot of bells. Bernie has a story very much like Saul's. He was the president running the Handy Dan hardware store chain, and he had gotten kicked out by the board and was pretty salty about it and was looking for a second act.

1:06:34So Saul has him out to San Diego. He shows him the Price Club warehouse. He gives him the playbook, and he says, look, Bernie, you've got all this hardware expertise. Take the Price Club playbook. Go kick their butt and open the Price Club of hardware stores. Bernie Marcus, of course, then goes home, turns around, and starts Home Depot. Which we have heard from listeners 10 times that we need to do the Home Depot story at some point. I actually did not know Bernie Marcus's name or that he was the founder of Home Depot,

1:07:06so I think now we have to. Now we have to. So this now brings us, finally, to one more call that Saul gets also in 1982. There are these years in retailing, 1962 when Walmart and Kmart and Target start, 1982 when all this is happening, another Bernie, this time a Seattle retailer named Bernie Brotman and his son Jeff call up Saul. And they say, Saul, this Price Club thing is fantastic.

1:07:38We're retailers up in the Northwest, up in Seattle. We'd love to open a franchise up here, a Price Club franchise in Seattle. This is just like the Fedco, FedMart days. And Saul and the Price Club management team think about it, and they make the very poor decision to say no. And in the same echo of what happened, gosh, 30 years earlier, Bernie and Jeff say, OK, we understand. We're going to do it anyway. We're going to clone the Price Club model and start the same thing up in Seattle.

1:08:11And again, I think Saul is totally fine with this. Because was Price Club growing aggressively? They were, but they weren't planning to go to the Northwest. They were following the old sort of trade routes of the FedMart playbook of Arizona, Texas, Florida, going out across the South and the Midwest.