It Pays to Bulk Up on Costco
By Jim Krapfel, CFA, CFP
September 6, 2022
Background
I have long been a loyal customer of Costco Wholesale Corp. (ticker COST), drawn to its quality merchandise at significantly discounted prices. In December 2018, prior to founding Glass Lake Wealth Management, I conducted a deep-dive analysis of the company for possible inclusion in a dividend growth strategy at my predecessor firm. I concluded that the company’s long-term dividend growth prospects and franchise quality were sufficiently strong to overcome its seemingly expensive valuation. Following my recommendation, we purchased the stock for clients and shortly thereafter I started purchasing the stock for my personal account at around $200.
Since our launch of Glass Lake in April 2020, we have consistently purchased the stock for client accounts. It was the third largest aggregate stock position as of August 31, 2022.
Company Description
Costco operates 829 membership warehouses globally as of May 8, 2022, including 573 in the US, 105 in Canada, 40 in Mexico, 30 in Japan, and 29 in the United Kingdom, and 52 elsewhere, as well as 636 gas stations worldwide. Its annual membership fees are $60 for Gold Star and Business, and $120 for Executive. Executive members receive an annual 2% reward on Costco purchases. Membership fees make up only 2% of revenue but constituted 58% of operating income in its fiscal year ended on August 29, 2021.
Costco sells a wide variety of goods and services:
Foods and sundries: includes sundries, dry grocery, candy, cooler, freezer, deli, liquor, tobacco.
Non-foods: includes major appliances, electronics, health & beauty aids, hardware, garden & patio, sporting goods, tires, toys & seasonal, office supplies, automotive care, postage, tickets, apparel, small appliances, furniture, domestics, housewares, special order kiosk, jewelry.
Fresh foods: includes meat, produce, service deli, bakery.
Warehouse ancillary and other businesses: includes gasoline, pharmacy, optical, food court, hearing aids, tire installation, e-commerce, business centers, travel. Gasoline makes up 9% of total sales.
Figure 1: Sales by Merchandise Category in FY21
Sources: Company filings, Glass Lake Wealth Management
Costco was incorporated in 1983, went public through an initial public offering in 1985, and is headquartered in Issaquah, Washington.
Investment Thesis
We believe Costco offers a rare combination of growth, quality, and defensiveness that should allow the company, and its stock, to perform well in most economic environments. It should be able to sustain annual warehouse count growth of 2-3%, membership growth of 4-6%, and ex-fuel same store sale growth of 5-8%. Further, as detailed shortly, Costco operates one the best business models in the world that should help ensure its growth comes with strong returns on invested capital for decades to come.
Costco’s strong value proposition resonates with its members, especially in times of economic upheaval, such as in today’s high inflationary environment. Although members might curtail spending on more discretionary categories when budgets are constrained, Costco ought to generate a greater share of customers’ overall spending. Costco’s notorious discounts on gasoline is especially compelling with national gasoline prices near $4.00/gallon. If consumers’ primary concern shifts from inflation to job security, Costco’s sales should similarly hold up fine.
Costco also has a couple of nearer term catalysts that could lead to stock outperformance. The company is likely to increase its membership fees in the next year or two to align with its historical pattern of increasing fees every 5-7 years. The last increase -- $5 for Gold Star and Business members and $10 for Executive members -- was put into effect in June 2017. Any price increase should have a material impact on profitability since there is no associated cost and customer losses ought to be contained. Still, I would not expect an announcement imminently because management’s recent public remarks indicate they are sensitive to customers’ challenges with inflation.
Another stock catalyst could come from its next special dividend announcement. In addition to its regular quarterly dividend, which currently stands at $0.90 (0.7% yield), it pays out large special dividends every two to three years. The recent sequence was $7/share in December 2012, $5/share in February 2015, $7/share in May 2017, and $10/share in November 2020. I would expect the next special dividend to total $11-14/share and be paid out in the first half of 2023.
Economic Moat
We believe Costco possesses one of the widest economic moats, or sustainable competitive advantages, in the world. Its superior scale and differentiated operating model give it major cost advantages that allow it to offer customers low prices while still earning strong returns on invested capital.
There are several elements that help to keep Costco’s costs lower than its competitors. First, it has tremendous bargaining power with its suppliers given its sales base ($196 billion last year) and limited stock keeping units (less than 4,000 per warehouse versus about 80,000 per Target store and 120,000 per Wal-Mart supercenter). The limited selection of branded and private-label products under the Kirkland brand also makes for efficient distribution, reduced handling of merchandise, and rapid inventory turnover. It turns over its inventory so fast that it generally sells its products before it pays its suppliers.
Second, the warehouses are operated with efficiency top of mind. The warehouses are no-frills, are self-service, and operate under constrained hours (~70 hours per week store average) for maximum labor productivity. Its membership format and strict control of entrances and exits help it keep inventory losses (also known as shrinkage, or stealing) to below that of typical retailers.
Costco has successfully created a virtuous cycle. It shares much of its cost savings with its members (only 11.1% gross margins), who increasingly shop at Costco, which generates even greater bargaining power against suppliers and enhanced operational efficiencies that can be used to push selling prices down further.
Growth, Profitability & Valuation
We expect Costco to sustain revenue growth at least in the high single digits for many years given our expectations for warehouse growth, member growth, and same store sales expansion. That growth rate is less than what it achieved in fiscal 2021 and is likely to achieve in the just-completed fiscal 2022 (see Figure 2) because the past couple of years were supported by less frequent and bigger basket shopping during the heights of the Covid-19 pandemic and escalating gas prices.
Meanwhile, excluding low-margin gasoline sales, we expect its operating income growth to mirror sales growth given historical patterns. With flattish margins, little debt, and a steady share count, we expect EPS and long-term dividend growth to approximate operating income growth.
Figure 2: Costco’s Growth Is Likely to Normalize to Still-Strong Levels
Sources: Company filings (historical results), Koyfin (analysts’ consensus estimates), Glass Lake Wealth Management
Costco’s stock is priced at 38x next 12 months’ (NTM) consensus earnings, well ahead of the S&P 500 at 17.5x NTM. We believe Costco has earned its valuation premium because of its superior growth track record, long growth runway, strong economic moat, high returns on invested capital, high dividend payout ratio, and net cash (more cash than debt) balance sheet. Its earnings multiple is near the midpoint of the 30x to 45x range it has resided in the past three years.
We expect Costco’s stock to continue to exhibit less beta, or sensitivity to the overall stock market, than the average stock given its lower levels of idiosyncratic, or company-specific risk, and economic cyclicality. Although it is unlikely to be a big winner over a 3-5 year timeframe, we think it can continue to grind higher and serve as a ballast in investors’ portfolios.
Key Risks
The biggest near-term fundamental risk to the company is a post-Covid growth hangover as people prioritize spending on experiences over things. We have already seen ex-gas, ex-foreign currency same store sale growth decelerate somewhat in recent months. Moderating gas prices could also compel fewer people to fill their tanks at Costco’s gas stations and tack on a visit to the warehouse.
An additional risk to the stock’s valuation is a continued rapid increase in the 10-year U.S. treasury yield because Costco’s stock trades at a relatively high valuation multiple. Investors who own Costco for its perceived safety and total dividend yield might switch to bond alternatives such as even safer, higher yielding U.S. treasuries.
Disclaimer
Advisory services are offered by Glass Lake Wealth Management LLC, a Registered Investment Advisor in Illinois and North Carolina. Glass Lake is an investments-oriented boutique that offers a full spectrum of wealth management advice. Visit glasslakewealth.com for more information.
This blog expresses the views of the author as of the date indicated and such views are subject to change without notice. Glass Lake has no duty or obligation to update the information contained herein. Further, Glass Lake makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, whenever there is the potential for profit there is also the possibility of loss.
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