Costco Wholesale Corporation (NASDAQ:COST) is well-known for being one of Charlie Munger’s favourite businesses. He expressed his love once again during this year’s annual shareholder meeting of the Daily Journal Corporation (DJCO).
There are a few reasons why Charlie Munger admires Costco so much. Costco has a unique business model which is characterized by passing cost savings onto customers. Management prioritizes long-term success over short-term profits by keeping merchandise prices low rather than maintaining high gross margins. Selling high-quality products at relatively low prices translates into happy customers who are more willing to purchase a membership and consequently do more shopping at Costco warehouses.
Furthermore, Costco has built a strong brand over the past decades. The cost leadership position in combination with the membership model and high customer satisfaction has resulted in a near impenetrable moat.
The prioritization of long-term success is clearly visible in the financial results. For years, sales have been growing in the high-single-digit to low-double-digit range, resulting in impressive earnings and dividend per share growth. In the coming years, Costco will likely post earnings and dividend per share growth rates in the high-single-digits.
Another reason why Munger is addicted to Costco is that the company earns a very high return on capital invested. Companies that maintain a high return on invested capital over a long period of time tend to be compounding machines, and Costco is no exception.
In this article, I will discuss all of these points in detail and conclude with some risks and the stock valuation.
Costco in general
Costco is a very well-known company among investors. It operates an international chain of membership warehouses, selling a wide variety of merchandise at substantially lower prices than are typically found at conventional retailers. Because Costco warehouses offer one of the largest product category selections under a single roof, it acts as a one-stop-shop for small and medium-size businesses as well as individuals.
Besides, Costco operates self-service gasoline stations at most U.S. and international locations. Inside the warehouses, Costco offers additional services such as a food court, pharmacy, travel agency, optical dispersing center, and hearing-aid center. All these ancillaries encourage members to do more shopping at Costco warehouses.
On top of physical warehouses, Costco operates e-commerce websites in the U.S., Canada, Mexico, U.K., Korea, Taiwan, Japan, and Australia. Net sales for e-commerce represented approximately 7% of total net sales in 2022.
The Costco Flywheel Model
What really distinguishes Costco from other retailers is that the business model is not so focused on maximizing gross margins on products sold, but on driving high sales volumes and rapid inventory turnover. Due to operating efficiencies (such as lower labor costs, advertising costs, marketing costs etc.), Costco is able to operate profitably. Customers benefit from this as operating efficiencies are translated into lower product prices.
The thing is that you are only allowed to shop at a Costco warehouse if you are a member (this also holds for Costco operated gasoline stations). This drives the Costco Flywheel Model (see figure below).
The low prices, high-quality products and ancillaries attract more people who need a membership to be allowed to shop at Costco. This increases the number of memberships. Because people have a membership, it is likely that they do more purchases at Costco which drives up Costco’s sales volumes. Consequently, Costco’s scale increases so it has more negotiating leverage with suppliers for even lower purchasing costs, and so the circle repeats.
It’s all about memberships
Memberships are the key of Costco’s business model. While membership fees were only 1.9% of total FY2022 revenue, they were responsible for more than half of total operating income. This is because the operating margin on net sales is very low, and membership fees are directly translated into operating income.
Currently, Costco offers three types of memberships: Executive, Business, and Gold Star. Gold Star memberships are meant for individuals who don’t own a business. Business members must own a business to qualify for this membership type and may purchase additional membership cards for ‘affiliates’. Paid cardholders can upgrade to an Executive membership for an additional annual fee of $60. It is important for Costco to grow the share of Executive members, because this increases the average fee per member. Moreover, Executive members are even more inclined to shop at Costco, driving up sales volumes and customer loyalty.
Customer loyalty can be easily measured by taking the historical membership numbers. The member renewal rate was 93% in the U.S. and Canada and 90% worldwide at the end of FY2022 (excluding affiliates of Business members).
The following graph shows the number of paid memberships and total cardholders. There has never been a year with a decline in the number of memberships, even during the great financial crisis. Surprisingly, YoY membership growth has been in the 5%-8% range for years. So it’s a very positive sign that membership growth is not slowing down despite the growing membership base. I think that this growth can continue as Costco expands its worldwide footprint.
Costco’s wide moat
A competitive industry
The retail industry has always been highly competitive based on factors such as price, merchandise quality and selection, location, distribution strategy, and customer service. Costco competes on a worldwide basis with global, national, and regional wholesalers and retailers. The main competitors in the U.S. according to the annual report are: Walmart, Target, Kroger, and Amazon. These are only the largest players.
Despite the high competition on all fronts, Costco has built a strong moat around its business. The main competitive advantages are the brand and cost leadership.
Brand: Costco has a very strong brand awareness. If you ask random people in the U.S. and mention the word ‘Costco’, the first reaction is that they simply love it. Brand recognition in the rest of the world is lower, but that’s because the warehouse penetration rate is still very low in most countries outside U.S. and Canada. I believe this will change in the future with the international expansion strategy.
Private-label brand Kirkland Signature is also becoming more popular. Kirkland Signature products are high quality, offered at prices that are generally lower than national brands, and they help to differentiate in-warehouse merchandise offerings, and generally earn higher margins on products sold. Management expects that the increase in sales penetration of private-label items will continue.
Cost leadership: As I mentioned earlier, Costco sells merchandise at lower prices than competitors. Instead of increasing gross margins as much as possible (like other retailers do), Costco shares its scale advantages with their members. And that’s fine, because in the end Costco’s profits are less dependent on merchandise sales. Keeping up the membership renewal rate is the key priority.
The annual report of 2022 stated the following:
“We do not focus in the short-term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” – consistently providing the most competitive values.”
I believe that both the brand and cost leadership will become even stronger in the future as the company continues to grow its global footprint, and more people around the world will come into contact with the Costco brand and likely become members.
Net sales and membership fees
Total sales can be divided into net sales and membership fees.
Net sales include all merchandise categories, warehouse ancillary and other businesses (e-commerce, business centers and travel). Net sales growth mainly depends on warehouse count growth and same store sales growth. The current annual warehouse count growth hovers around 3%, but is expected to slowly decline in the future. That’s logical as Costco’s global footprint increases, but it means that same store sales growth is becoming a more substantial component of net sales growth. Same store sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket).
The table below is copied form the FY2022 annual report. What we can see here is that, once a warehouse is opened, sales per warehouse tend to grow as time progresses. If we take the average of all 838 warehouses at the end of FY2022, average sales per warehouse grew from $160mln in FY2013 to $245mln in FY2022 – that’s a 4.8% CAGR.
Now let’s look at net sales development throughout the history (again, this is without memberships). Net sales growth has been negative in only a single year since 1995, namely during the great financial crisis. The average net sales growth rate lies at 10.3%.
How about those memberships? Membership fees have grown every year since 1995 with a CAGR of 9.8%. This rate slowed to 7.7% on average over the last ten fiscal years, probably driven by a lower warehouse count growth rate. Expected fee increases plus membership growth drive future membership fees growth. Costco also aims to increase the penetration of Executive members to generate a higher average fee per member.
For me, return on invested capital (or ROIC) is the most important metric when analyzing a business as it indicates the competitive advantages. Charlie Munger is also a huge fan of businesses with a high ROIC:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.”
The following graph shows the ROIC of Costco since FY1995. I also added the ROE as this metric is more conservative for companies with a net cash position. We can see that Costco’s ROIC and ROE have long been in the 10%-15% range until 2012. After that, both metrics gradually increased to the high 20s. A ROIC above 15% is extraordinarily high for a retail company, highlighting Costco’s strong competitive advantages.
So given the fact that the current ROIC is 29%, will future total annual returns on COST stock also lie around that rate? Maybe, but I think that this is not a probable scenario. The issue is that valuation multiples have also increased together with the growing ROIC. More on the relationship between ROIC and PE ratio later in this article.
Costco is a special company, not only for its business model, but also for the dividend policy. Unlike most dividend stocks, Costco pays regular and special dividends.
The regular dividend is paid every quarter and Costco aims to increase this dividend every year. Currently, Costco has raised the quarterly dividend for 18 consecutive years – a future dividend aristocrat in the making! The following graph shows the regular dividend per share, earnings per share, and corresponding pay-out ratio since 2005. The pay-out ratio on earnings per share has been pretty constant in the 25%-30% range.
Costco also pays special dividends from time to time. These amounted $7.00/share in 2012, $5.00/share in 2015, $7.00/share in 2017, and $10.00/share in 2020. I don’t know the exact reason why Costco chooses this strategy, maybe it’s because it offers them more flexibility in capital allocation. They certainly have the balance sheet and cash position to be a bit more aggressive on share buybacks and dividends, so I think we can expect further special dividends in the near future.
The PE or ‘price to earnings’ ratio is the most well-known and simple valuation method out there. In the following, I will value Costco stock based on historical PE multiples. Moreover, I will address the relationship between PE, earnings growth and ROIC to get a better grip on Costco’s fair PE ratio.
Let’s start with the historical PE ratio. In the graph below I plotted the PE ratio since 2000 based on underlying earnings per share and the average share price for each year. The first thing I noticed is that Costco stock has always been pricey relative to the market average PE. Even during the great financial crisis when multiples of most stocks plummeted to single-digits, Costco’s PE remained above 20. The average PE ratio since 2000 is 27.1x. Assuming earnings per share of $14.52 for FY2023, this would result in a fair value of $393 per share. Currently, Costco stock is trading around $499, so this is significantly higher than the historical average.
I have always found Costco’s high valuation multiples pretty scary. But for some reason, investors are always willing to pay a big premium for the stock. Even Charlie Munger said during last year’s Daily Journal Meeting that he would be willing to buy Costco now with a multi-decade time frame. So I asked myself why.
One important aspect of Costco is the 29% return on invested capital over FY2022. This is an extraordinarily high return. Logically, one would be willing to pay a higher multiple for a business with high returns on investment. Likewise, higher earnings growth justifies to pay a higher premium for a business. So is there a method to estimate the fair PE multiple based on these metrics? Yes there is!
The Gordon Growth Model is a simplified version of the DCF analysis. This article describes how you can reformulate the Gordon Growth Model in a more explicit manner:
P/E = (ROIC – g) / ((r – g) * ROIC)
In the formula, ‘ROIC’ is the return on invested capital, ‘g’ represents the earnings growth rate, and ‘r’ is your personal required rate of return.
The formula has some simplifications. However, it is a really simple way to show how the fair PE ratio is correlated with the ROIC and earnings growth rates. Let’s showcase this by using Costco’s numbers.
I assume that Costco can grow its earnings by 8.0% annually and my required rate of return is 10%. In FY2008, Costco’s return on invested capital was 16% while in FY2022 it increased to 29%. The following table shows how the fair PE multiple for Costco has changed from 25x in FY2008 to 36x in FY2022. At least, this is what the market should be willing to pay for Costco stock according to this theory.
Earnings growth rate
Required rate of return
Return on invested capital
Fair PE ratio
Going back to the historical average PE chart, we can see that Costco was trading at an average PE multiple of 21x in 2008 and 39x at the end of 2022. So the formula turns out to be pretty accurate for Costco stock!
The question is whether the ROIC with continue to expand going forward. If the ROIC falls back to 16% like it did in FY2008, the current valuation is way too high. On the other hand, if the ROIC stays at 29% or higher Costco stock is currently undervalued. It’s nearly impossible to predict the future, so as an investor you can only try to be as conservative as possible. Therefore, I consider Costco stock a reasonable buy below $450 and a good buy below $400 (which would be in-line with the historical average PE).
Before investing in a business, it is important to address the most important risks. In the following I will briefly go through a number of risks for Costco stock.
1: Costco fails to maintain membership growth, customer loyalty, and brand reputation
Membership fees are the key driver for future profit growth. Membership fee growth is driven by increasing the annual fee per membership, increasing the penetration of Executive memberships, and adding new members by entering new markets. If for some reason Costco’s brand or reputation gets damaged, this could have a negative impact on customer loyalty, membership renewal rates, and eventually income from membership fees and merchandise sales. Like Warren Buffett said:
“It takes 20 years to build a reputation and five minutes to ruin it.”
2: Costco fails to maintain cost leadership
Besides damage to Costco’s brand or reputation, losing cost leadership to competitors could also have disastrous effects on future earnings. The whole reason why Costco has such a high customer loyalty and thus steady membership fee growth is because Costco passes on cost advantages to their members. The retail business is highly competitive and if a competitor with great financial recourses chooses to copy Costco’s business model, this could have a negative effect on Costco’s member base. I don’t think that this is a very likely scenario as it will take a lot of time and costs for a competitor to overtake Costco’s scale. On top of that, Costco has a very good reputation among members.
3: The stock is currently valued for perfection
In the previous section I showed that Costco is trading at a premium (34.5x PE ratio) compared to the historical average PE ratio of 27.1x. This doesn’t mean that the stock is overvalued per se, because the ROIC was 29% in FY2021 and FY2022, implying a fair PE ratio of 36x according to the simplified Gordon Growth Model. However, if for example the ROIC falls to 20% and earnings grow with 7% annually, the fair PE ratio decreases to 22x. Thus, Costco is currently priced for perfection which is a risk in itself.
Maybe the biggest risk for investors is to never invest in Costco. Costco is a prime example of a company with a unique and understandable business model, strong competitive advantages, decent growth numbers and high ROIC. In short, a must-have for dividend growth investors. But that valuation…
Currently, I do not feel comfortable adding Costco shares, but this business is at the top of my watchlist. If the share price falls just below $400 per share, the 2023 forward PE would decrease towards the historical PE ratio, offering a good margin of safety. On the other hand, Costco tends to perform well during recessions so it is very realistic that this will never happen. My personal game plan is to initiate a position below $450 and add if the share price continues to fall. For now, I rate Costco stock a solid HOLD.
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