Why Costco Excels In A Tough Environment (NASDAQ:COST) (2024)

Investment Thesis

While some investors believe Costco (NASDAQ:COST) is overvalued based on their forward price-to-earnings (P/E) and revenue metrics, especially for a retailer, I disagree. Looking at these metrics, Costco has a P/E Non-GAAP (FWD) ratio of 53.88, significantly higher than the sector median of 17.11. However, despite this high valuation, I believe Costco remains a strong buy due to their business model and unique features that allow them to thwart off many of the issues we are seeing with current retailers. Costco's shares have been strong compounders over the years, delivering consistent returns to investors. I expect this to continue.

One example is their ability to create immediate value with each new store. For example, the daily revenue on average for a Costco location is $530,000 meaning that in 1 year, one location can generate roughly $193 million in revenue. This is incredible that a single warehouse can generate nearly $200 million in revenue annually. Underpinning all of this is the membership. It's powerful even in this higher inflation economy.

In essence, the purpose of this research is to talk about why in a market with slowing retail demand, rising retail theft, threats from Amazon, and inflation, Costco continues to excel. Based on these factors I’ll go over, I believe Costco will continue their strong performance, making them a strong buy. I believe the high P/E ratio is worth it.

Background: The Power Of Membership

A big part of my strong buy thesis (and what I believe allows them to perform well) is due to Costco’s business model. One key aspect of this business model is their growing membership program, which generates a recurring revenue stream, much like what a software company would see.

Having a growing recurring revenue stream provides Costco with financial stability, which I think is key to help solve shrink, inflation, and general retail slowdowns. With these memberships, Costco has opportunities for pricing growth, which could add further growth to their revenue. For example, their membership fees increase roughly every 5-6 years. Considering that membership numbers continue to grow, an increase in price I believe will not deter consumers.

As I mentioned above, this model contributes to their financial stability and growth by providing a steady stream of income. Costco has over 74.5 million paying memberships and a renewal rate of 90.5% worldwide (most software does not have a 90.5% renewal rate). This renewal rate showcases strong customer satisfaction and loyalty. Having loyal customers is extremely beneficial during economic fluctuations. Consumers seem to be continuing to purchase these memberships, as Gary Millerchip stated during Costco’s earnings call:

we reported membership fee income of $1.123 billion, an increase of $79 million or 7.6% year over year -Q3 2024 earnings call.

Magical Membership Fights Shrink

Despite challenges within the retail industry, Costco continues to go against these trends with foot traffic continuing to increase. In fact, in the third quarter of 2024, Costco’s comparable foot traffic increased 6.1%. Yet at the same time, the company has an incredibly low shrink (theft) rate of under .2%, which is one tenth of the average within the industry.

This is because Costco's business model is designed to minimize shrinkage. The membership requirement to enter the store acts as a deterrent to shoplifting, ensuring that shrinkage remains low compared to other retailers (you literally have an idea of everyone who has entered the store, meaning your suspect list is low)​​. Additionally, before leaving the store, all customers get their carts manually checked. This is key to help reduce shrink as it makes it hard for people trying to steal to hide goods.

Membership Helps Fight Inflation

In addition to the regular membership, consumers also have the option of the executive membership. The regular subscription costs consumers $60 a year, while the executive is $120. This subscription allows members to earn an extra 2% back on some purchases, additional insurance benefits, and other savings on Costco services, helping save money to fight inflation.

These services include their car buying programs, pet insurance, payment processing services, and bottled water delivery. The executive plan has shown to be attractive; Gary Millerchip mentioned on the latest earnings call that:

At Q3 end, we had 34.5 million paid executive memberships, an increase of 661,000 since Q2 end. Executive members now represent over 46% of paid members and 73.1% of worldwide sales" -Q3 2024 earnings call.

Members are paying up for an executive membership so they can help fight inflation. Very few places in retail do consumers elect so often to go with the higher priced model/package of anything. This is an exception.

Contributing to Costco's success is their pricing strategy, which appeals to cost-conscious consumers (along with bundled services mentioned above that all come with the membership).

Items like the $4.99 rotisserie chicken and bulk purchases of essentials such as paper towels offer unbeatable value, making Costco a go-to destination for families and groups looking to save on everyday expenses​​. Many people come to Costco to save money on food (like the chicken) and leave with more product. This chicken is called a “loss leader” product.

Gas is another big loss leader. Purchasing gas at Costco, on average, saves about $0.20 per gallon (I know people that will drive out of their way to save on gas). This aspect isn’t only beneficial for consumers, but also of course for Costco, as this helps attract current members and promote new members. During the earnings call, Ron Vachris stated that Costco:

.. [was up] 5% up in gallons [volume]... I think all those things when you can save people on gas, that's also going to lend to your traffic as well. But gallons were up 5% for the quarter.-Q3 2024 earnings call.

Culture Icon

What is so fascinating about this key membership is not only the practical place is fits in a consumers' wallet, but also the emotional one it fits in American pop culture. It's another great reason why it (and Costco) continue to excel.

Costco’s budget friendly pricing is appealing to the younger generations, such as Gen Z meaning they are locking in a new generation of consumers. Their blend of value, quality, and convenience resonates well with Gen Z, who need affordable prices for essentials and bulk purchases​​ given they are just starting out on their adult lives.

This popularity has led Costco to become a part of pop culture and gain a presence in social media trends and viral content. For instance, a popular video on Twitter showcased a man presenting his Costco membership card to impress a date, highlighting the cultural significance of being a Costco member.

Bucking Retail Slowdown

A strong membership program creates strong loyalty and strong retail sales. This tool is the secret sauce that powers the rest of the company.

With retail trends hurting companies, Costco has been able to beat these trends, maintaining strong performance despite industry disruptions. One of the biggest challenges for retailers has been the rise of e-commerce companies like Amazon, which has reshaped consumer shopping habits and put immense pressure on traditional retailers. Costco has not only survived but thrived in this environment.

Looking at Costco's continued strong retail sales, their resilience to these trends is obvious. The broader U.S. retail sector is experiencing slowing growth, but Costco hasn’t. For instance, in May 2024, while U.S retail sales on the whole rose by just 0.1%, Costco achieved a 6.4% year-over-year growth in comparable sales in May. This is a huge growth differential, rejecting the trend of retail slowdowns.

Given the economic effects on the rest of the industry, Costco’s ability to have this drastic comparative growth is very impressive. They are taking market share and consumer wallet share. Membership powers this by allowing Costco the consistent revenue stream needed to provide great value to customers (Rotisserie chicken and gas) while not having to worry about costs. Consumers see this gesture and reward the store is high sales figures.

Overall in the Q3 FY2024 (last quarter), Costco reported a 9.1% increase in revenue to $57.4 billion, with a net income of $1.68 billion, an increase of 29.1%.

Valuation

Costco's valuation metrics may appear overvalued, particularly when compared to sector averages, but I disagree. The company's forward P/E ratio stands at 53.88, significantly higher than the sector median of 17.11​​. I believe this premium valuation reflects the market’s confidence in Costco's business model and growth prospects. When looking at Costco's return on common equity (ROE), these numbers demonstrate their ability to generate substantial shareholder value. With an ROE of 31.64%, which is 183.16% higher than the sector median of 11.17%, Costco's exceptional efficiency in utilizing their equity base to generate profits​​ is proven. Again, the high margin membership helps power this.

Over the long term, if Costco can maintain this impressive ROE, it is likely to result in faster growth of book value compared to the company's stock as a whole. The company's efficient use of capital is further shown by their return on total capital (ROTC) of 17.72%, which is significantly higher than the sector median of 6.86%​​.

Looking at Costco's enterprise value-to-sales (EV/Sales) ratio, this number is slightly below the sector median of 1.67, standing at 1.51. However, given that their ROE is 183.16% higher than the sector median, their forward EV/Sales ratio should be at least at the sector median due to their incredible ability to payback debt holders and reward common equity shareholders with incredible capital allocations. If this was converged on the sector median, there would be a 10.6% upside potential in shares. Keep in mind that the EV of Costco ($383.83B) is actually lower than the market cap of shares ($386.03B) with means the company has net cash on the balance sheet. This is really assuring for shareholders.

Risks

While Costco's strong performance and growth potential makes the stock an attractive investment, there are several risks that investors should be conscious of. The company's valuation is highly dependent on continued growth and a continued strong ROE, meaning any indication of a slowdown a huge issue. Currently, Costco's P/E ratio is significantly above their long-term trend, sitting at 53.88. A graph of this is shown below.

This elevated valuation could pose a risk if the company's growth does not meet investor expectations, potentially leading to a sharp correction in the stock price.

Although growth deceleration is a risk, I am not concerned. Growth has continued to excel for Costco due to their multiple avenues for future growth and the key membership model. For the second half of this fiscal year, Costco is planning on opening more stores in the U.S, Japan, South Korea, and China.

I believe the rewards drastically outweigh these risks.

Bottom Line

Costco's business model, built on their attractive membership and strategic pricing, positions themselves as a standout performer in the retail sector. Despite their seemingly high valuation, I believe Costco's strong return on equity and efficient capital utilization justify the premium. The company's ability to consistently generate value, attract a loyal customer base, and maintain strong sales growth, even in challenging retail environments, showcases their resilience and growth potential. The company is literally using their membership program to bring in high-margin repeatable cashflow (there is little other recurring revenue in retail), help consumers fight inflation, solve for shrink, and fight e-commerce like Amazon. It is in a lot of ways the silver bullet and justifies the valuation (in my opinion).

While there are risks associated with their high valuation, Costco's proven track record and business initiatives provide a solid foundation for continued success. Therefore, I believe Costco remains a compelling investment, making the stock is a strong buy.

This account is managed by Noah's Arc Capital Management. Our goal is provide Wall Street level insights to main street investors. Our research focus is mainly on 20th century stocks (old economy) undergoing a 21st century transformation, but occasionally we'll write on companies that help transform 20th century firms as well. We look for innovations in a business model that will cause a stock to change dramatically. Associated with SA contributors Thomas Potter and Elijah Buell.