Putting capital to work
Working capital is the cash a company needs to have on hand in the short term to keep the business running — pay its employees, suppliers, taxes and so on. If you haven’t got the cash to keep your business moving, you’ll be out of business, as numerous hedge funds and others learned the hard way in the financial crisis that began in 2007. In his book, Getting to Plan B (co-authored with Randy Komisar), John Mullins extols the virtues of negative working capital.
Failure to earn a profit won't put you out of business, as long as you still have cash. But if you run out of cash, even if you are profitable, you'll be gone in a heartbeat. Cash, as they say in entrepreneurial circles, is king. Consider the case of Costco, a US-based company with over 550 membership-only warehouses that, in 2008, generated over $71 billion in revenue. Costco has become the pre-eminent warehouse club retail chain, largely because management designed its working capital model to gain competitive advantage.
While Costco's working capital model was revolutionary; it was by no means original. Its model was based largely on Price Club, created in 1976 by Sol Price in San Diego, California. His original and prescient leap of faith was that, by changing the working capital model in retailing to permit vastly lower prices, he could charge customers for the privilege of shopping at his stores. The key to Price's early success was his counter-intuitive credo, his refusal to try to squeeze an extra dollar out of his customers. As Goldman Sachs retail analyst Stephen Mandel, Jr., would later attest, Price Club was the industry's best practitioner, turning its inventory about 20 times annually, while possessing negative working capital of about $3 million per warehouse. "Negative working capital" is a cash flow model in which stores can sell and deliver a product before they ever have to pay for it.
Move inventory quickly and charge a membership fee? It held the makings of a working capital model that was little short of spectacular. Costco co-founder and CEO James Sinegal recalls (and lives by) Sol Price's principles. "Many retailers look at an item and say, ‘I'm selling this for 10 bucks. How can I sell it for 11?' We look at it and say, ‘How can we get it to nine bucks?' And then, ‘How can we get it to eight?' It's contrary to the thinking of a retailer, which is to see how much more profit you can get out of it. But once you start doing that, it's like heroin." There was another element, too. "You had to be a member of the club. People paid us to shop there."
In 1981, Jeffrey Brotman recruited James Sinegal away from Price Club, where Sinegal had worked since his teens, rising rapidly through Price Club's ranks. In 1983, they launched Costco Warehouse in Seattle. At the heart of the Costco strategy was the Price Club working capital model. First, there was the membership fee. For families the fee was $50 per year; corporate customers paid up to $100, collected before the customer ever started shopping. Second, Costco collected cash from its customers almost immediately - no credit cards, thank you, but cash, a check, or your debit card (which gave Costco instant cash) - maintaining just three days of accounts receivable.
With its customers providing the cash needed to grow, Costco soared. By 1996, Costco was generating $19 billion in sales and $423 million in pre-tax net income. Costco's working capital model let it get away with razor-thin overall profit margins, since earning an attractive return on investment when your investment is near zero (thanks to negative working capital) can be accomplished with very modest profits. So Sinegal passed on to his customers the benefit in lower prices. He was underselling his competition while growing the business on its customers' cash.
How did Sinegal and his team take the fat out of margins? First, they were tough negotiators. Second, they bought items to sell in very high volumes and used that as a leverage to ask more of their suppliers than others could. For example, when Costco was selling $100,000 worth of salmon per week, they were able to use that volume to convince the salmon supplier to remove the skin and debone the fish and ultimately charge even less for the fillets.
Costco also insisted that no item could be marked up to a gross margin over 14 per cent. Contrast that with supermarkets and department stores, which carried 20 to 50 per cent gross margins; discount stores like Kmart and Target had even greater average gross margins across their product mix, ranging from 25 to 30 per cent. To turn inventory quickly, Costco carried just 4,000 items. A typical supermarket, Sinegal explained, carried 40,000 items, while a Wal-Mart super centre would stock some 150,000. With only 4,000 items at rock-bottom prices, Costco could pick items that it knew would move off the floor quickly. Items were transported straight from the vendor to the sales floor. No costly warehouses full of expensive inventory tying up precious cash.
There was one key element, though, on which Sinegal parted ways with Price Club. Price Club targeted small businesses and working-class families - something that rival Sam's Club mimicked. For Costco, Sinegal targeted small businesses and more upscale families, more than a third of which had household incomes greater than $75,000.
Three quarters of Costco's product assortment were basics, from 24-count packages of toilet tissue, Costco's top-selling item, to a lifetime supply of panty shields. The excitement that brought customers back, however - returning once every 17 days on average, lest they miss out on a bargain - came from the other quarter. From $800 espresso machines this week to $29 Italian-made Hathaway shirts next week to $1,999 digital pianos the week after, Costco's stores offered something for everyone, and at bargain prices other merchants simply could not touch. "We always look to see how much of a gulf we can create between ourselves and the competition," says Sinegal.
By 2006 Costco had 48 million members and its stores were generating an average of $120 million in annual sales. Best of all, its working capital model had become even stronger, with inventory down to 32 days, half of Target's. The average Costco generated almost twice the revenue of Wal-Mart's Sam's Club stores. Compared with Sam's Club, Costco had 82 fewer outlets, but generated about $20 billion more in sales, some $59 billion. Its pre-tax profit of $1.7 billion, of which nearly $1.2 billion was membership fees, was a slim three per cent of sales. With customers paying for the privilege of shopping, thereby providing the cash needed for running and growing the business, who needed high profit margins? Costco was ranked number 29 in the ‘Fortune 500' in 2008 and was the world's fifth-largest retailer.
Lessons from Costco
The negative working capital model offers significant benefits that are well worth striving for, and it is not an exotic financial scheme. The quest for more efficient working capital models is far more widespread than Costco. In the 1990s, companies such as American Standard, Whirlpool, General Electric and others sought to move from the ‘Fortune 500' average of 20 cents in working capital for each dollar of sales to zero working capital. In the 2000s, retailers other than the warehouse clubs began singing the same tune. Between 2000 and 2004, Tesco, the leading grocery chain in the United Kingdom, began stretching the payables terms it obtained from suppliers, freeing up £2.2 billion (nearly $4 million at that time) in cash that it could use for growth.
For aspiring entrepreneurs and for businesses already up-and-running in other more capital-intensive industries, a negative working capital model is worth searching and working for. It makes it easier and less costly to get into business in the first place. And it makes it much easier for your business to grow. Consumer services businesses - haircutters, landscapers, tax preparers and the like - seek and find it by nature, since they get paid in cash and have little need for inventory. It is no wonder that these some of these formerly fragmented industries are increasingly dominated by fast-growing chains, as savvy entrepreneurs have realised that these businesses are easy to get into and easy to grow, from a working capital perspective.
Costco offers an additional - and perhaps unexpected - lesson for aspiring entrepreneurs. If you aim to start a new venture, why not do it in an industry whose working capital requirements can be modest - or even negative? Periodicals publishing is one example of such an industry; trade show operators, cable television companies, payroll processors and other human resources outsourcers are other examples. You'll need much less capital to get started, and less capital to grow, than in other industries.
John W. Mullins (jmullins@london.edu) is Associate Professor of Management Practice and Chair of the Entrepreneurship group at London Business School.
Getting to Plan B is published by Harvard Business Press.