Costco (COST) is a well-loved retail behemoth. The $138B retailer consistently receives great press for its customer and employee friendly policies (two quick examples here and here). I count myself among the 94M very satisfied customers and have been an Executive member since 2009. The Costco brand stand for high quality at a great value - a balance the company has managed very effectively. However, a great company is not always an attractive stock buy. Below, I argue that all of Costco's future growth and more has already been priced into the stock, making it a bad investment at current stock levels.
Business Overview and Performance
Costco has grown merchandise revenue from $110B in FY14 to $138B in FY18, at a CAGR of 6.5%. Merchandise gross margins are very stable at around 11%, and in fact the company has a commitment to maintain this level of gross margin and pass on any savings to customers.
The vast majority of Costco's operating profits are driven by membership fees, where it enjoys high retention rates and some pricing power. The number of paid members has grown at an annualized rate of 5% over the past 4 years, while annual revenue per member grew 1%. The company has two avenues to grow per member revenue: growth in executive membership (which provides more benefits) and by raising prices. It exercised the pricing lever in FY17, and I believe that future pricing increases will be muted for at least another 4-5 years. I attempt to analyze whether the current levels around $250-260 are an attractive entry point.
There are two components to modeling Costco's future growth - the first is the classical retail model of store growth, growth in same-store sales, and gross margin improvements. Costco has had remarkably stable gross margins over time (in fact it targets not to exceed a certain margin level), so I assume that merchandise margins will stay stable at 11% over time. The same goes for SG&A expenses, which have been around 10% of sales. I assume same store sales growth of 5% annually over the next five years and store growth of 2%, which are similar to what the company has achieved historically. Due to Costco's very low operating margin on merchandise that hovers around 1% (11% gross margin less 10% SG&A), the sales and store growth assumptions are relatively not as important to the valuation model.
The key part of the valuation is modeling the growth in paid members and the average revenue per member. I have assumed a 5% growth in paid members annually over the next 5 years, and a 1% growth in revenue per member over the next 3 years from increases in Executive member mix. I also model a 5% growth in FY22 as Costco has historically raised membership prices every 5 years.
Using a low discount rate of 8% and a terminal value growth rate of 3%, I arrive at an FMV (fair market value) of $198 for Costco, which is a 23% discount from the current share price of $257. This suggests that Costco is significantly overvalued at current levels. The complete valuation model is attached below.
Even in spite of aggressive assumptions that account for sustained healthy growth in membership, price increases and merchandise revenue, Costco shares appear to be significantly overpriced. Although Costco has rewarded investors recently and is a model for a well-run organization, buying the stock at these levels would appear to be an unwise investment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short COST calls.