I believe Costco does more good for civilization than the Rockefeller foundation. I think it’s a better place.Charlie Munger, vice chairman of Berskhire Hathaway
With 380% capital gains in 10 years, Costco’s average annual return of 38% is almost fourfold the S&P’s return over the same period.
While the stock appears expensive, I recommend long term investors add Costco to their portfolio for the reasons I will present below.
A visionary founder whose vision lives on
Costco co-founder Jim Sinegal is one of the most brilliant business minds in America. Charlie Munger even dubbed him the “one of the most admirable retailers to ever live on this planet“.
Munger explained that Jim Sinegal has a “frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It’s almost a religious duty. He’s sacrificing short-term profits for long-term success“. Munger concluded his gushing remarks by stating that “Generally speaking, I believe Costco does more for civilization than the Rockefeller Foundation“.
What sets Jim Sinegal’s philosophy apart from other retail bosses?
Jim Sinegal was a protégé of Sol Price, the founder of Price Club, the original warehouse-retailer, whom Costco merged with in 1993. Sinegal is famous for his hands on and benevolent management style that postulates that well treated employees will treat the customers well.
While many retail giants are criticized for low wages and lack of benefits, Costco has long been far ahead of its competitors. Average hourly pay is much higher than other retailers and 90% of Costco employees qualify for employer-sponsored health insurance, compared to the U.S. retail industry average of 60%. These policies have certainly paid off as Costco has the lowest turnover rate in retail.
Wall Street has often criticized Sinegal for being too kind to his workers and customers. They believe that his benevolent management style and obssession with customer service sacrifice shareholder value. Sinegal responded by stating that “We want to build a company that will still be here 50 and 60 years from now“.
Sinegal retired in 2018 after captaining the ship for 35 years, declaring that the “company is in very good hands“.
A global empire
Jim Sinegal has created a global empire.
Today, Costco is the 3rd largest global retailer and processes an average of 2.3 million transactions per day. It has more than 254,000 employees worldwide, including 163,000 employees in the USA.
As of March 2020, there are 787 Costco warehouses spread out throughout the world. The majority are located in the USA and Canada, but Costco’s global presence is increasing. In 2019, Costco opened its first warehouse in mainlain China, with more than 139,000 people signing up for memberships. Costco warehouses are huge, with average square footage being 145,000 feet (14,000 square meters).
A mature, but still growing business
In addition to being a very well established global business, Costco’s business is still growing.
In March, Costco released its Q1 2020 earnings report:
- Net sales increased 10.5% to $38.26 billion from $34.63 billion in Q1 2019.
- Net Income increased 4.72%, to $931 million, from $889 million in Q1 2019.
- EPS increased 4%, to $2.10 per share from $2.01/share in Q1 2019.
While the strong start to the year was largely due to coronavirus-driven panic buying, Costco’s performances have been very strong for years.
From 2016-2019, all of Costco’s key metrics increased:
- Revenues increased 28%, to $152.7bn from $118.7bn
- Normalized Income increased 56%, to $3.6bn from $2.3bn
- Normalized EBITDA increased 28%, to $6.3bn from $4.9bn
- EPS increased 56.6%, to 0.0083 from 0.0053.
- Basic Average Shares remained almost constant, which means the company did not dilute shareholder value by emitting shares.
Costco’s financial success is impressive.
What are the foundations of this success?
A consumer-focused business model
Costco’s claims that its mission is to “continually provide members with quality goods and services at the lowest possible prices”. The foundation of their business is quality and cost leadership.
Did you notice Costco uses the word member rather than customer?
Costco is a subscription business: As crazy as it sounds, customers have to pay a yearly membership to access the store and purchase goods.
This seemingly counterintuitive feature is a powerful psychological tactic: Paying for membership means that members feel part of a private club and are more likely to shop there and take advantage of the store’s benefits. Ultimately, this creates strong brand loyalty. Additionally, Costco claims that charging people to shop discourages shoplifting, which reduces the company’s losses.
But why would someone pay to shop at Costco?
Costco operates as a de facto direct-to-consumer wholesaler. Its warehouses provide a limited selection of goods sold in bulk at lower prices than in grocery stores. The company uses economies of scale to buy huge quantities of goods in order to sell them to its members for cheaper. The entire concept is to provide goods and services as close to wholesale price as possible. This is why the stores are called warehouses.
In sum, Costco gives customers access to products at lower price than grocery stores. Costco’s prices are often even cheaper than Amazon’s, who has the reputation of being the retail price leader. Thus, Costco provides a service and you must pay a fee to access it,
How does Costco offer lower prices than grocery stores?
To keep prices as low as possible, Costco enforces a strict margin rule whereby no item can be marked up more than 14% over wholesale cost. If a particular product costs $1 wholesale, it will not be sold for more than $1.14. This appears insignificant but the result is that Costco’s margins are up to three times lower than the average grocery retailer.
Due to this strict low-price policy, the average Costco warehouse carries less than 4,000 products. In comparison, the typical Walmart carries approximately 140,000 products. Costco’s policy dictates that if the wholesale price of a product is too high, it will simply refuse to sell it.
This policy is applied to every product, regardless of notoriety: In 2009, Costco refused to restock Coca-Cola products because Coke refused to lower its wholesale price: “Costco is committed to carrying name brand merchandise at the best possible prices. At this time, Coca-Cola has not provided Costco with competitive pricing so that we may pass along the value our members deserve,” the company said at the time.
While a beverage insider claimed that Costco’s ultimatum would not “bully Coke into changing its pricing strategy“, Coke and Costco quickly renegotiated terms and within a month Coke was back on the shelves.
Costco’s business model is a hit because consumers want to find quality bargains and Costco warehouses are setup to keep them coming back to find them. Costco also offers luxury items at attractive prices in order to entice consumers to spend more than they normally would. They constantly rearrange the luxury offers to keep customers coming back for more.
If Costco’s margins are so low, how does it make money?
Membership fees and Kirkland Signature
Membership fees are crucial to the business’ profitability. While they represent less than 2.5% of net sales, they go straight into the bottom line. In fact, they make up 80% of Costco’s gross profit margin and 70% of its operating income.
As of March 2020, Costco has 100.9 million members (55.3 million households). From 2014-2020, 24.5 million people signed up for membership, a very impressive 32% increase. Over the period, the average annual growth rate in memberships was 4.71%.
However, we notice a progressive decrease in membership growth rate in recent years: From 2014-2016, growth averaged 6.5% per year; from 2016-2019 it averaged 4.3% per year and from 2019-2020 growth was just under 2.5%. This represents a considerable 61.5% decrease in membership growth rate in just six years.
This suggests that Costo has reached full maturity in the North American markets and that future membership growth will be driven by international expansion. The Chinese market presents a great growth opportunity but it remains to be seen if the concept will prove as successful as in the more Westernized Asian nations of Taiwan, Korea and Japan.
Nevertheless, Costco’s membership model is popular and membership renewal rates are 91% in the U.S. and Canada and 88% worldwide. Maintaining a very high customer satisfaction is crucial to sustaining a large chunk of its profits. As long as customers renew their memberships at high rates and Costco keeps growing, the business model remains viable.
The second main source of profits comes from Costco’s in-house Kirkland Signature line.
Kirkland Signature is the only brand in the store that is marked up at more than 15% over cost. Kirkland is allowed higher margins because it is produced by Costco and has fewer middlemen involved in the supply chain. By having higher margins on its Kirkland line, Costco is able to offset the brand name products sold on thin margins.
Low margins? High volume!
Costco’s Gross margin is only 11%, which is very low.
How does Costco survive on such thin margins?
The answer: High volumes.
Costco has very high inventory turnover: In 2019, Costco’s inventory turnover is 11.9x. This basically means that stocks are replenished once a month. From 2015-2019, Costco’s median inventory turnover was 11.8x. For the past 10 years, inventory turnover is consistently above 11 each year.
High sales volumes combined with rapid inventory turnover leads to higher revenues. Despite the low prices, the sheer volume of products sold results in massive revenues.
Costco’s inventory turnover is roughly double the consumer staples’ sector. While some of its peers have higher turnover, Costco’s turnover places it comfortably in the middle tier.
Ultimately, the high sales volumes leads to increased operating efficiency. Costco is able to achieve high operating efficiency through the minimization of its variable costs. The higher the volumes, the lower the variable costs.
Costco is also looking for ways to increase its net margins.
From 2016-2019, net margins increased by 10.93%: In 2019, the Net Profit Margin was 2.38%, compared to 1.96% in 2016. Costco claims that the increase in net margin is due to a rise in sales of the Kirkland Signature products.
Very effective cost control
Considering its razor-thin margins, the company’s profitability depends on strict cost control. As a result, operating expenses tend to never exceed 10% of revenues.
Expenses are minimized in several ways.
First, Costco refuses to spend money on departments it considers non-essential. Costco representatives say that “choosing not to staff departments that aren’t critical to our day to day business is one more way we’re able to keep prices low and pass on saving to Costco members“.
Two departments Costco believes are non-critical are PR and advertising. Indeed, Costco doesn’t have a public relations department and it doesn’t buy external advertising. Costco co-founder Jim Sinegal famously declared that he considers advertizing to be “evil because it costs money; anything that is going to raise our price on merchandise is bad. We’ve got to have that type of an attitude“.
Not spending money on PR and advertising saves Costco billions a year. In comparison, Amazon spends more than $6bn a year on advertising, Walmart spends $3.1bn and Target spends $1.4bn a year.
Second, in the search of minimizing costs, no expense is too small to be slashed. One major source of savings is minimizing electricity costs: Costco warehouses have skylights which reduce the number of hours it turns on the lights per day; during the sunniest days of the year, Costco doesn’t turn on the lights at all. Added up between each store, adds up to substantial savings each year.
Ultimately, Costco’s biggest expense is the real estate purchases required to open new stores. Opening a new warehouse cost anywhere between $80m to $120m since it requires roughly 14,000m² of ground space, a sizeable parking lot, and sometimes a gas station.
As you will see on the financials statements below, Costco spent $2.99 billion on Capital Expenditure in 2019. In 2019, Costco opened 20 new warehouses. $2.99 billion divided by 21 warehouses equals to roughly $142 million per warehouse. (This may not be the actual figure spent on opening new locations but provides you a general idea of the cost incurred).
Reasonable debt levels
As of March 2020, here is the breakdown of Costco’s assets & liabilities.
This snapshot reveals that Costco’s Balance Sheet is very healthy: The $5.5bn of long term debt is very well covered by $8.7bn of cash and equivalents and the $16.6bn of total stockholders’ equity.
Let’s analyze this in further detail by looking at the 2/29/2020 assets and liabilities breakdown.
- Current Ratio of 1.04 is reasonable: Costco has sufficient short term assets to cover short term liabilities.
- Debt to Equity Ratio of 1.91 is poor: Costco is more leveraged than the initial snapshot led us to believe.
- However, the total non-current liabilities of $9bn are indeed well covered by stockholders’ equity.
- The Debt to EBITDA ratio of 1.5 is actually reasonable.
Like many companies, Costco is taking advantage of the current zero-interest rates to raise liquidity through cheap debt. It just issued $4bn dollars of secured notes at interest rates of 1.375%, 1.6% and 1.75% that will mature in 2027, 2030 and 2033, respectively. The proceeds of this offering will go towards repaying notes and balance for general corporate purposes.
The fact that Costco is able to emit notes with such low rates is a testament to the company’s quality. Rates are proportional to the risk associated with the investment and sub-2% rates are proof that investors have no worries about Costco honoring the debt when it matures.
Increasing Cash Flow
As we can see on the table below, Costco’s 2019 Free Cash flow is just over $3.3bn, up from $2.8bn in 2018 but down from $4.2bn in 2017. This is a significant amount of free cash left over after paying off debt and dividends, which gives Costco flexibility to finance its operations without having to take on too much debt to do so.
Below is the quarterly data which provides an updated view of Costco’s Cash Flow situation. Free Cash Flow is down compared to previous quarters due to a huge $1.2bn debt repayment.
Costco still has room to grow
Despite being a very mature business, Costco still has room to grow.
The first reason is steady membership growth that bring in stable profits. As we have seen earlier, membership is still growing although we do notice a slight decrease in growth rate from previous years. Nevertheless, with a 91% renewal rate among existing members and a 2.5% yearly growth rate in new memberships, Costco’s cardholder count should continue increasing.
The second reason is international expansion. While Costco may have reached maturity in the U.S., it is opening new warehouses in foreign countries. The opening of the first warehouse in China could be the start of something big if the business model proves popular there.
Third, an increasing focus on e-commerce and delivery. Today, e-commerce represents less than 4% of Costco’s sales. The company is actively working to increase its online presence and recently purchased Innovel Solutions for $1 billion. Innovel is a logistics company which specializes in storage, transport and delivery of ‘big and bulky” items and claims that it can reach 90% of the US and Puerto Rico. I expect Costco to continue growing its e-commerce presence in the coming years.
The dividend is modest but growing
Costco’s current yearly dividend is $2.80 per share, which represents a dividend yield of less than 1%. Obviously, this is a very modest dividend for a company this profitable.
However, there are two important factors to consider: The impressive dividend growth rate and the special dividend payments.
- Dividend growth rate
Costco has increased the dividend for the past 15 consecutive years. Even better, in the midst of the coronavirus crisis, it actually raised the quarterly dividend by 7.9% from 65 to 70 cents per share, which now gives an annual payout of $2.80.
The dividend’s 5-year annual growth rate is an impressive 15%. Given the stellar financial results, I fully expect the dividend to keep growing at a rapid pace in the coming years.
- The special dividend
Every few years, Costco pays out a “special dividend” to its shareholders: In 2015, Costco paid a special cash dividend of $5.00 per share and in 2017 it paid another special cash dividend of $7.00 per share.
This means that from 2015 to 2019, a Costco shareholder actually received a total dividend payment of $21.78 per share, or an average annual dividend of $4.35.
This is a significant difference compared to the regularly scheduled dividend of $9 (annual average payment of $1.8). Naturally, potential investors should not include hypothetical future special dividend payments in their expected return calculations forecast and should simply view them as a pleasant, unexpected bonus.
Conclusion: A good long-term investment?
I believe that Costco is still a viable long term investment for the following reasons:
- The company’s consumer-focused business model is a success
- Low margins are viable due to high inventory turnover
- Despite low margins, Costco generates substantial cash flow
- The debt is well managed
- Considerable room for growth in e-commerce
- Considerable room for international growth
- The dividend is modest but growth is solid and reliable
- The special dividend payments are the cherry on the shareholder’s cake.
At $300+, is Costco stock overpriced?
I am not a Discounted Cash Flow expert so I usually conduct very brief DCF calculations using this free DCF calculator.
- Simulation n°1: Optimistic DCF valuation:
To obtain an optimistic DCF valuation, I input the following metrics into the calculator:
- TTM EPS: 8.52
- Annual growth rate of 8.5% for the next 5 years (based on average annual growth rate of past 3 years)
- After 5 years, growth would level off at 6%
- Discount rate is 8% (S&P 500 average annual return).
A quick DCF valuation from this free DCF calculator gives COST a fair value of $505.31. This represents a 65% upside potential.
- Simulation n°2: Conservative DCF valuation
If I keep the same EPS but lower annual growth rate to 6% for the next 5 years and level off growth at 5%, with an 8% discount rate, the fair value comes to $348.36.
- Average of both DCF valuations
If we average both results we get a fair value of $426.83. This represents an upside potential of 39.9%.
At current price of $305, Costco appears underpriced compared to its conservative intrinsic value of $426.83. Given that the dividend will most likely continue increasing in coming years, the current price represents a decent entry point.
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DISCLAIMER: This is not financial advice. Conduct your own research before investing in any asset.