At the 2011 shareholder meeting of Berkshire Hathaway (BRK.A), someone asked Charlie Munger about his favorite company outside of Berkshire. Munger answered, "That's easy. It's Costco" (COST). Being the other half of the most successful investor of our time, I thought it would be worth the time to look into this.
Retail is a very simple industry, but not necessarily a very rewarding one. You sell merchandise for more than you paid for it. Competitors compete on price and the one willing to sell for the lowest margins typically wins. Companies like Wal-Mart (WMT) and Amazon (AMZN) have been able to compensate for razor thin margins with huge transaction volumes.
Why I Love Costco
Costco is a little different. They don't make much if any money selling merchandise. Sales margins usually hover right around 0.45%. Instead, almost all of its profits are directly attributable to membership fees. Membership fees are paid up front, and membership renewal rates are consistently above 85%. Thus, Costco offers investors high cash flow visibility along with steady profitability, and a calculable means of predicting future value.
Over the long term, the loss leader capabilities of Costco will continue to result in new memberships and continued market share gains. The company sells two inelastic consumer needs, food and fuel, at cost or potentially even at a slight loss. The ability to be a price leader on these items is what drives store traffic. Costco has the ability to sell these products at cost because it derives all of its profits from membership fees.
In 2009, Costco wasn't satisfied with Coca-Cola's (KO) prices, so they simply stopped carrying Coca-Cola products. Suppliers to the likes of Costco and Wal-Mart have almost no bargaining power. Wal-Mart is notorious for pressuring suppliers on price and even receives criticism for this. In the 2009 dispute with Coke, Costco proved a point. They have the means to demand low prices, and they won't put anything in their stores if that can't beat the competitions prices.
Costco stores have much fewer stock keeping units (SKU's) then competitor Wal-Mart. Costco concentrates its merchandise to about 3,600 SKU's, versus more than 50,000 at the average Wal-Mart. From which they derive roughly $60 billion in sales and $265 billion, respectively. That averages out to about $16 million in sales per SKU at Costco versus about $5 million at Wal-Mart. This concentration on product offerings is what allows Costco to derive buying power on a par with its larger rival. Cost parity with rivals plus zero mark up policy derived from its membership business model results in Costco's sustainable competitive advantage: low price leadership.
With about 440 warehouse clubs in North America and about 65 million members, it may seem like Costco has maxed out its growth potential. However, with only 169 locations the rest of the world over (and 82 of these in Canada), the company is just in the early stages of its international growth. I think the success of the membership business model in the American retail market proves its scalability. With the U.S. accounting for only about 5% of the world's population, I think Costco has decades of profitable expansion before it.
Costco is the kind of stock investors can feel good about. They have a history of buying back shares, increasing the dividend, and growing earnings. They are the low cost provider in a huge market. Charlie Munger knows how to pick a company, and he has flat out told investors that this is his top pick after Berkshire.
Costco's moat is the membership business model. Moats are intangible things. The qualitative proof of Costco's moat is that the membership business model allows the firm to be the low cost provider of food and gasoline. The quantitative proof of Costco's moat is the ability to raise the price of membership in line with inflation.
The main drivers of Costco's share price going forward should be new store openings, continued membership retention, modest share buybacks, and consistent operating margins. Investors need to be mindful of membership fees and retention rates. If raising the price of membership reduces retention rates below the historic 85% level, that might be reason to believe Costco's business model is weakening against the competition.
Why I Don't Own Shares
Costco deserves to trade at a premium to the overall market, because it is clearly a higher than average quality company. Technically, they trade at a discount to Amazon. That having been said, the stock is expensive by any possible valuation method. Far too expensive to consider owning.
High expectations have been priced into the stock and then some. Using a reverse DCF analysis, the company would have to continue to grow EPS at 10% a year for the next 25 years to justify current valuations. An internet search tells me that about 1 in 6 North American consumers are Costco members, that means pretty much all of the companies growth will have to come from overseas. It may be possible, but I for one wouldn't bet on it.
The popular FAST Graphs product has a fair value estimate of $67 per share, representing a decline of about 33% from today's prices. The stock trades at a P/E multiple above 25 and a PEG of 1.75, thus Costco isn't growing fast enough to justify its valuation multiple. I typically won't buy any stock with a PEG above 1, and would prefer a margin of safety even for a high quality stock.
At some point investors have to get comfortable with the idea of paying a premium for quality. But I can't. I'm a discount shopper at heart. However, if the stock ever came down to near market multiples I wouldn't hesitate to buy.
- High cash flow visibility because of membership model
- Loss leader capabilities continue to drive market share gains
- Early stages of international expansion
- Operates in a profitable oligopoly
- Little room for further household penetration in U.S.
- Strong, capable competitors like Wal-Mart and Sam's Club
- Already trades at a premium multiple
- Business model could be easily replicated with sufficient resources