- Costco is growing its footprint in the United States and Overseas.
- A strong business model, smart strategies, happy employees and repeat customers are instrumental assets.
- Could be a good addition to long term portfolio at a reasonable entry point.
The oversized shopping carts and supersized merchandise of Costco (NASDAQ:COST) are familiar to most Americans and even some customers overseas. As a members only warehouse it provides a diverse selection of merchandise to its customers at a discounted price. While the loaded shopping carts and long checkout lines at the warehouses suggest that people have bought into Costco's idea of quality at a reasonable price, but does the bargain end inside the store? Or are the company's shares a good value for money for the long term investor? The following is my view of Costco's growth potential and valuation.
Business Model: The Company operates over 550 warehouses in the United States and Canada. It also has a smaller, but growing, footprint in the United Kingdom, Mexico, Japan, Korea, Taiwan, Australia and Spain. While targeted towards small business owners, the warehouses also meet the needs of households with their selection of groceries, home supplies, furniture, furnishings, pharmacy and even gasoline. The business is built on the principle of providing cost savings to customers by sourcing merchandise directly from manufacturers and shortening the distribution channel. In addition the warehouses have shorter hours, minimal aesthetic displays and limited number of active SKUs to reduce labor costs and increase efficiencies.
Growth: Costco's two main sources of revenue are sales and membership fees. Since 2009 both have expanded over 10% annually on a compounded annual growth rate basis. Food and sundries (such as candy, alcohol, cleaning supplies, etc.) contribute the largest share in revenue. The company operates with tight margins and needs to maintain its fast inventory turnover along with growing its membership base. Its in-house brand, Kirkland Signature, generates a higher margin and could be a useful income source if it continues to grow as a proportion of sales.
When it comes to sales it is important for the company to grow organically, as well as add new warehouse locations. Same store sales of the company were in negative territory in the aftermath of the financial crisis in 2009, but have recovered admirably since. In comparison to its major direct competitor Walmart's Sam's Club, Costco's comparable store sales performance has been stronger.
Change in Comparable Store Sales*
* Sam's Club and Costco fiscal years are different.
The company has also been expanding through new stores both domestically (an average of 11 new stores per year in the United States since 2009) as well as internationally. In fact by the end of this month, the company expects to open 3 new warehouses. There is more room for growth in the international markets where the company's presence is still not as large. Same store sales performance of warehouses overseas has been at par with the United States in the last couple of years, but international markets are more profitable than the domestic market. So there are opportunities to grow both sales and margins in those markets as well.
Treasure Hunt: An approximation of revenue per square foot also shows that Costco's generates over $1100 per square foot racing ahead of Sam's Club over $674 figure. The company has been maintaining this strong performance through large sales volumes and quick inventory turnover supported by its limited yet high quality and fast moving selection of merchandise. Since the company is on the lookout for the best deals, it does not consistently carry the same products that it may have sold before. Anecdotally, while this can be frustrating for some shoppers it also leads many to stock up whenever their favorite product is being sold in the stores. Additionally there can be an element of curiosity pulling people into the stores to discover what new product lines are being sold each time. Similarly the practice of moving products around within the warehouse also may help with putting customers face to face with new items they may not have bought otherwise.
Keeping it Simple: Another point in favor of Costco is that management understands its market and target customer. The focus is on offering low prices without compromising quality and so it has stayed true to simple warehouse style stocking of items and shorter hours that save on labor costs.
In terms of e commerce, there has not been an overly zealous approach in that area. Online sales are only 3% of total revenue and could be a potential growth area in the future. While management is cognizant of future opportunities/challenges in the ecommerce channel, I think it has wisely kept its focus on the warehouses which are the core of the business at present. Similarly marketing via its newsletter Costco Connection and other activities is limited but targeted.
Employee Satisfaction: One of the business ethics that Costco follows is that a happy employee leads to a happy customer. It is well known that the company pays an average of $21 per hour to its employees, much higher than its direct competitor Walmart. The company also does well in offering career growth opportunities to its employees since it follows a model of promoting people within the organization, from warehouses to corporate offices. Unsurprisingly, employee turnover rate is low and sales per employee are strong.
Brand Value: A harder to monetize yet important metric is what I like to call "brand value". In this case I looked at the loyalty that the Costco brand enjoys reflected in its total membership renewal rate which has continued to strengthen, reaching above 90% for U.S. and Canada and above 87% internationally in the last quarter. Among business members the renewal rate is even higher, that is, above 94%. This implies that the company has a stable, growing base of customers that are loyal to the brand as long as it maintains its product quality and pricing.
Valuation: The shares of the company were trading at $118.64 at the time of writing. This price is above the company's 100, 50 and 20 day moving averages and just below its resistance ceiling calculated with recent price data. Additionally the peak closing price in the last three months was $119.59, close to the current level at which the stock is trading.
The current price puts the trailing twelve months price to earnings ratio at 26.55, which at first glance is not inexpensive in my book. Alternatively, the forward P/E is estimated to be around 23.04, which is more reasonable. Also the trailing 12 month price to sales ratio for Costco is 0.48 which is lower than that of its direct competitors.
Another good forward looking measure to consider would be the price to earnings growth or PEG ratio. Given that the company has seen EPS growth of 9.88% per year compounded annually for the last 5 years we can make some assumptions about future growth. Assuming this growth will continue in the near future and adjusting for dividend yield (since that is another consideration for investors besides earnings growth) the result is a PEG ratio of approximately 2.4. This is on the higher side compared to its direct competitors in the industry.
A point to note is that the company has been continuously adding new warehouses domestically and internationally. Since profitability is higher overseas and major U.S. competitors have a limited presence there, it is a possibility that earnings growth may improve in those markets. Also if the company can continue to increase sales of its higher margin Kirkland Signature brand then that would be another impetus for better earnings.
Overall: Costco is an example of a company that has proven to be a sound business idea combined with good execution. It has potential to expand its footprint in the United States and overseas and I would look for a price level near the 100-day moving average ($115 - $116) to pick up some stock in the company.
Disclosure: The author is long COST. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.