Costco (COST): Loyal customers and excellent management justify high ratings

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Thesis

When it comes to wholesale retail, Costco (COST) is the creme de la creme in my opinion. With an attractive pricing model that benefits consumers, Costco has built a very loyal customer base over time. I believe customer loyalty is represented by consistent revenue growth over time as well as a growing member base supporting their recurring revenue stream. Costco’s management team also has an excellent track record in my opinion. Costco management has managed to maintain extremely consistent margins over time, return capital to shareholders, and maintain some of the highest retail customer satisfaction scores. In the short term, I believe Costco’s business model will also continue to be positively affected by the tailwinds reopening.

Although Costco’s valuation is high in my opinion, these thesis points can support a high multiple against competitors in the short and long term.

Fund

Costco was founded in Seattle in 1983 and primarily operates membership warehouses in the United States, Canada, United Kingdom, Mexico, Japan, Korea, Australia, Spain, France, Iceland, in China and through a majority-owned subsidiary in Taiwan. As of August 29, 2021, Costco operated 815 warehouses worldwide. Costco warehouses and e-commerce websites are based on the concept that by offering their members low prices on limited national brands (and private label products), they will be able to capture extremely high sales volume. high and rapid inventory turnover. By focusing on efficient volume purchasing and distribution, Costco believes it can remain profitable while maintaining significantly lower gross margins than most retailers. Costco’s quick turnover usually allows them to sell inventory before being obligated to pay for it, even after taking advantage of prepayment discounts. This level of efficiency also helps justify a premium multiple in my opinion. Costco is also able to increase its margins through its membership program where customers currently pay $60 per year to access Costco stores.

Costco’s core business is divided into three segments and also reports a fourth segment for other business units.

Main commodity categories

  • Food and miscellaneous items: Includes Sundries, Dry Grocery, Candy, Cooler, Freezer, Deli, Liquor, and Tobacco.
  • Inedible : Previously Hardlines and Softlines; including major appliances, electronics, health and beauty aids, hardware, garden and patio, sporting goods, tires, toys and seasonal products, office supplies, auto care, postage, tickets, apparel, small appliances, furniture, housewares, housewares, special order kiosks, and jewelry
  • Fresh foods: Includes meat, produce, deli service and bakery.

Warehouse Assistant

  • Includes gas, pharmacy, optics, food court, hearing aids and tire installation.
  • Other businesses include e-commerce, business centers, travel and others.
  • Usually operate inside or right next to warehouses.

Thesis support

Costco is currently trading at 38.8x the next twelve months [NTM] earnings per share [EPS]. About a month prior, the stock traded at the highest P/E in its public history (45x), surpassing the previous high of 39.6x set in 1999. In order to maintain a high multiple or continue to produce returns with slight multiple contractions, I believe Costco will need to continue to grow steadily and maintain high returns on invested capital. I believe Costco has the opportunity to do so for the long term through continued customer loyalty and growth and high level management performance.

Management

I believe that Costco’s management team is one of the main reasons for the steady growth since 1995 (the year CEO W. Craig Jelinek became a member of management). Following Mr. Jelinek’s appointment, Costco shares rose at a compound annualized growth rate of 20.44%. [CAGR] against the S&P 500 at 11.51%, adjusted for the reinvestment of dividends.

In my opinion, one of the biggest reasons for Costco’s success is their inventory management. Not only does Costco have a higher inventory turnover compared to the competition’s average, but it also has enough turnover to sell inventory before being required to pay for it, even taking full advantage of discounts. prepayment of distributors. On average since 2015, Costco’s inventory turns are approximately 25% higher than the competition’s average, and the average number of days of inventory remaining is approximately 27% lower:

Inventory statistics

Author using data from COST Investor Relations

Costco’s inventory turns have also increased by 11.21% since 2015. I’ve highlighted the LTM column because it shows management’s ability to keep inventory turns steady during this supply chain debacle. , in my opinion.

Although inventory turnover has increased steadily over time, revenue growth has been strong and consistent, while gross and net margins have remained stable and increased over time, respectively:

Margins

Author using Koyfin data

Management has also been successful in returning capital to shareholders over time through dividends. Since 2011, Costco has increased its dividend from $0.89 per share to $2.98 per share, a CAGR of 12.85%. While Costco’s current dividend yield is only 63 basis points, they issue a seemingly reliable special dividend. Costco has issued four special dividends over the past eight years entirely funded by its strong balance sheet and stable free cash flow. The last special dividend of $10 per share paid in December 2020 boosted the yield at the time to 3.6%.

Consumer loyalty

During the last quarterly conference call, when answering a question related to inflation, Costco’s chief financial officer mentioned:

In our DNA, we hate raising prices. We want to be the last to raise it and the first to lower it.

While this attitude could potentially disrupt margins in an inflationary supply chain-induced environment, I believe it’s one of the reasons customers are so loyal to Costco. In my opinion, one of the great things about Costco is that they have that mindset, but they’ve still been able to grow net income margins while keeping gross margins relatively stable over the of the last six quarters:

Margins

Koyfin

Because Costco places so much emphasis on providing low prices to its members, it’s generally hard to beat their product offerings in my opinion. It’s one of the many reasons Costco’s business model is loved by millions of customers and members. I believe this can be seen in their membership numbers which continue to grow year on year:

Employment statistics

Author using data from COST 10-K

One of the reasons Costco is able to drive membership growth is because its turnover rate is so high. In fiscal 2021, Costco has a membership renewal rate of 91% in the United States and Canada and 89% globally.

I believe Costco is able to maintain such amazing membership renewal and growth rates because of the benefits customers receive from Costco’s low cost/high quantity products. I think these perks are representative of Costco’s high net promoter score [NPS] compared to major brands and other grocery brands:

NPS

Customer Guru

NPS

Customer Guru

Net Promoter Score is a measure of customer loyalty that measures a customer’s willingness to return to the store and the likelihood of them recommending it to family, friends, and co-workers. Costco is not only the highest rated grocery brand in terms of NPS, but it is also the highest rated brand according to Customer Guru. Costco also received the highest Consumer Trust Score (86.5) and Business Recommendation Score (87.4) as of March 12, 2021.

Finance

Model Highlights

Model Highlights

Author using COST Investor Relations

My forecast is that Costco will deliver just under $15 per share in fiscal year 2025 and increase ROI over the next 4 years to 42.12%.

Evaluation

When looking at Costco’s historical NTM P/E, it’s clear that the metric has stretched well over the past few years and is now above levels set in the early 2000s:

COST MNT P/E

Koyfin

Compared to the average of competitors [Walmart (WMT), BJ’s (BJ), Target (TGT), and Kroger (KR)], Costco has historically traded ~15x above its competitors in historically, Costco’s multiple against its close competitors has increased by an average of nearly +20x in the prior year:

Evaluation

Author using Koyfin data

Given the competition’s average NTM P/E multiple of 18.2x and Costco’s historical premium of 15x, I have a P/E target of 33.2x.

Price targets

Price targets

Author

Source: created by the author using data from Koyfin

EPS-based PTs are calculated by multiplying EPS of $14.77 by P/E multiples of 40x, 33.2x and 25x. The % Return and CAGR columns use a current value stock price of $503. CAGR uses an n=4 years.

Risks

Valuation is the biggest risk for Costco in my opinion. I believe the quality of Costco as a company has forced the stock to rise exponentially in recent years. While I still think a premium is warranted for management execution and customer loyalty, I think fundamental support for future returns is now limited. With current valuation multiples well above all-time highs, the long-term risk of rewarding Costco stock is minimal in my view.

A mitigating factor to this risk is that many valuations within the market are high relative to history. Compared to unprofitable software companies, Costco’s valuation may seem more reasonable because the company’s perceived quality may justify higher premiums in a frothy market. I also believe that in a bullish scenario, NTM P/E can expand further if ROI continues to grow over time.

Summary

Although Costco’s valuation may seem stretched compared to other retailers, I think the premium is warranted as they really are an amazing company in my opinion. Driven by what I consider to be an excellent management team, Costco has been able to deliver incredible financial results alongside the highest customer satisfaction scores in the industry. I believe that customer loyalty and a high quality management team are two of the most important quality aspects a business can have, and Costco has both. I think it’s fair to hold a higher valuation than its close peers, but relative to its historical valuation levels, I think buying opportunities are limited at the moment.

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