As always, below represents my opinions and should not be construed as financial advice. Always do you own due diligence. I welcome your feedback of my opinions and hope to have a civil discussion.
· Company Description
o ELI5 the company’s business model
§ Costco is a vertically integrated wholesale club store and ecommerce site. To access the store, you must be a member which comes with an annual fee.
· Company Soundness
o How does the company collect revenue?
§ The company collects revenue through selling goods and services as well as its membership fee.
o Does the company have a good or services that is purchased frequently or at a regular interval?
§ As a staple retailer their goods are purchased very frequently and across all economic environments. Their core merchandise categories are Food and Sundries, Non-foods and Fresh Foods.
o Do they operate with significant leverage?
§ No. They have an interest coverage ratio of 50x and operate with $0.42 of debt for every $1.00 of equity.
o Is their balance sheet well suited for a downturn and why?
§ Yes. They consistently have positive operating cash flow and are in a staple business. Additionally, they have ~$11 billion in cash as of last quarter. They operate with a Cash Conversion ratio that ranges between -2 and 6 days indicating their highly liquid inventory and cash management.
o Are there any large deviations in Operating Income and Operating Cash Flow and if so, why?
§ No, OI and OCF margins are nearly identical over short- and long-term averages.
o Is there evidence that market power is growing and that this will lead to strong financials?
§ Yes. Despite having relatively low debt, they have stunningly high ROEs. They averaged 27% whereas the consumer staples industry overall is at 7.8%. This occurs while they are still able to grow revenue at nearly a 10% clip over the past few years.
o Are there major company specific risks?
§ None that I am aware of.
· Can the company be replicated?
o What is the competitive advantage?
§ Costco has industry leading scale, vertical integration and a no-frills model leading to a low-cost provider position.
§ Scale: Costco has far fewer products in their store compared to other retailers but is one of the largest volume stores. This gives them enormous pricing power. If you are big laundry, would you want Costco to drop you?
§ Their vertical integration is probably the least understood advantage of Costco. For example, Costco orders directly from the manufacturer and meets their orders at docks or has them directly dropped off at their stores. Additionally, Costco Wholesale Industries, a division of the Company, operates manufacturing businesses, including special food packaging, optical laboratories, meat processing and jewelry distribution. These businesses have a common goal of providing members with high quality products at substantially lower prices. This also allows them to avoid markups that other retailers pay as they don’t have these investments.
§ By owning the production and having a strong store brand in the form of Kirkland Signature, they have additional leverage to squeeze excess costs from other product providers. In other words, Kirkland is preferred to many name brands meaning Costco can pass if they don’t feel terms are agreeable.
§ According to Craig Jelinek, the Company's CEO and director, “Costco is able to offer lower prices and better values by eliminating virtually all the frills and costs historically associated with conventional wholesalers and retailers, including salespeople, fancy buildings, delivery, billing and accounts receivable. We run a tight operation with extremely low overhead which enables us to pass dramatic savings to our members.”
§ Putting it all together Costco operates with a gross margin of 12%, a net margin of 2.5% with ROEs of 27%. The staples industry has a 30.7% gross margin, 4.3% net margin and ROEs of 7.8%.
§ All this value is enabled by their membership fee. You could think of the operating business as a massive non-profit but the membership as pure profit. Roughly 90% of their profits can be attributed to revenue from the membership fee. Given the tremendous value of the membership, they have significant pricing power to raise it. Especially with ~92% retention rate, this implies the average customer stays with them for 12.5 years.
o Is there evidence that the company has defended its market position in the past?
§ Costco got its start in 1983 and since then has only continued to gobble up market share. In an industry that has almost no switching costs and has been upset by the internet, Costco remains a pillar of financial strength.
§ Above I made the argument that Costco is the low-cost provider. The obvious challenger to this is Wal-Mart. Wal-Mart by comparison operates with a 25% gross margin (double Costco) and ROEs have averaged around 16% over the past 5 years (little less than half of Costco). Walmart’s higher margins are not being borne out with higher returns on equity. Costco really is king!
o Is technology likely to serve or harm the company?
§ I don’t believe so. Costco’s strengths are really being the low-cost provider. It does seem that Costco is lagging in ecommerce and delivery to homes. Having said that, low-cost provider is a timeless trait (assuming it upkept).
o Would $10 billion of capital be enough to re-create the company?
§ Absolutely not. Costco has about $20 billion of equity on the books. Costco offers a unique blend of low profit margins and high returns on capital. For a would-be new entrant, the low margins without scale are likely to be a fairly difficult hurdle.
o Are there structural reasons why the supply of new competition is likely to be limited?
§ No, there is nothing unique about the industry that would stop competition. While I just argued that competing with Costco on price is likely to be a losing battle, there are many other ways retailers can offer value to customers, such as convenience or service.
o Are there structural reasons why customers are likely to stay with the company?
§ Yes. Costco has cemented itself as the low-cost provider. As mentioned above, this has enabled customers to on average stay with the company for 12.5 years.
o Are parts of the company not able to be recreated with capital? Which parts and why?
§ Most of the model is based on the combination of simple businesses at scale with a willingness to adhere to a no-frills model.
o Are there competitive threats on the horizon?
§ Retail has always been a blood bath of changing industry leaders. Having said that, I don’t see any obvious challengers to disrupting their low-cost provider position. They seem to be outcompeting Walmart as Walmart has focused its efforts on convenience to take Amazon on in ecommerce.
· Growth
o Is there a 90% chance that earnings will be up 5 years from now?
§ Yes, revenue has gone up every year in the last 10 and earnings have nearly gone up every year in the last 10.
o Is there a 50% chance earnings will continue to grow in excess of 7% per year after the 5 year period?
§ It will likely be close. In recent years, growth has been well more than 7%, but prior to covid, growth was mixed around the 7% figure. Costco is well loved in China and expanding there giving them a long runway.
· Watch List Decision
o Do you honestly know enough about the industry and company to make an investment decision?
§ Yes
o Bottom Line: Based on your answers is the company well insulated from economic and competitive shocks while able to grow for many years to come?
§ Yes
· Valuation
o Value the company
§ Costco currently pays a dividend of $3.60 per share. I will assume a $3.80 dividend going forward for the next 3 years.
§ Share dilution has been minimal. I will assume a 0 to 0.25% increase in shares over the next 3 years.
§ Analysts estimate that revenue ending 08/31/2026 is expected to be $297.9 billion. Given the steadiness and predictability of their model I will assume revenues will be 5% above and below in the bull/bear case.
§ Costco’s FCF margins have been around 2.25% over the last decade. I will assume a 2 to 3% bear and bull margin for a midpoint of 2.5%.
§ FCF Yields have historically been around 1.8% to 3.8%. I will assume the same.
§ Putting the above together we get an estimated value of $629 in August of 2026.
o Would it be a prudent investment to buy the company at current levels?
§ A company with the consistency of Costco isn’t likely to need a high a discount rate to warrant purchase. For me, an investment in Costco should be expected to yield 8% or more. Given its current price of $485, this implies an annual return of 8.15% per year. To that end, per my assumptions it seems that Costco is fairly valued.
Sources:
Aggregated Data: https://finbox.com/NASDAQGS:COST
Investor Data: https://investor.costco.com/overview/default.aspx
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