Why And When To Buy Costco

About: Costco Wholesale Corporation (COST)
by: Beulah Meriam K

There are three reasons why Costco is a buy-and-hold-forever stock: expansion potential, membership growth, and renewal rates.

All three are sustainable growth pillars with advantages specific to Costco's operating model.

Considering its high valuation, the key to investing in Costco is to figure out when the dips might come.

Costco (COST) is the third-largest retailer in the world, with 772 warehouses by the end of the third quarter of 2019. Despite the many challenges that have stumped retailers around the world, Costco has managed to swim against the tide and emerge even stronger than before.

Here are three reasons why Costco is a buy-and-hold-forever business.

Reason 1: Room to Grow Warehouses

Costco now has 772 warehouses spread across Canada, United States, Mexico, U.K, Japan, South Korea, Taiwan, Australia, Spain, Iceland, and France. Though the bulk of warehouses is in the domestic market (635 in North America), it has enough of a footprint in key markets in Europe and Asia to expand more rapidly in the future.

On a global scale, Costco still has plenty of room to grow. The company has taken a slow and steady approach to expansion and, so far, it has worked well and will help the company increase its top line at a steady pace over the next ten to twenty years, if not more.

There have been concerns that international markets won’t be as successful as U.S. stores because of buyer preferences, spending capacity, and other factors. However, this excerpt from TheBalanceSMB suggests otherwise:

“The Costco Craze is not just a result of the American bigger-is-better psyche. The Costco international stores in ten countries have proven that the Costco formula works just as well with consumers outside the U.S. And, unlike other U.S. retail chains that are opening international locations as a defensive strategy, Costco's international expansion isn't compensating for domestic weakness because currently, it has none.”

Saying that Costco isn’t expanding overseas to compensate for U.S. sales weakness might seem like a tall claim, but it’s actually not. Expansion into international markets brings a new set of challenges comprising possible currency headwinds, lower margins and lower sales per square foot in secondary markets, and other factors. But Costco operates a business model that is largely resilient against many of these challenges. For example, the 2018 Annual Report showed that 13% of Costco’s revenue comes from outside North America, but the contribution to operating income is 17%. That means international sales are not dragging down operating margins, which is quite a feat in itself. Here’s a clue to that from the third quarter report for 2019:

“Our operating model is generally the same across our U.S., Canada, and Other International operating segments (see Note 10 included in Part I, Item 1, of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefits costs as a percentage of country sales, and/or less or no direct membership warehouse competition.” - Q3 2019 Quarterly Filing

Assuming Costco doesn’t change its business model when opening new warehouses in new and existing markets, the ability of non-U.S. warehouses to bolster U.S. margins will continue. Not many large U.S. retailers can claim this, and it is a major advantage as Costco continues to expand overseas. Moreover, membership fees contribute a significant portion of operating income, as we’ll see in the third section of this article - Renewal Rates.

By comparison, Walmart (WMT) U.S. posted an operating margin of 5%, while Walmart International posted 2.5% for Q1 2020 (quarter ended April 30, 2019.) That’s not a problem Costco has to worry about with their business model.

Source: Walmart Q1 2019 Earnings Release

That’s not to say that international expansion doesn’t pose any risks for Costco. They still have to deal with many of the other problems faced by other large retailers entering new markets. However, as I said before, Costco has enough of a global footprint to keep expanding in existing markets, which I believe is one of the pillars of its growth structure.

In addition, there’s also a key benefit to launching in new markets - higher revenues from new member signups when compared to existing markets. This model will allow Costco to keep expanding its presence in existing as well as new markets without any significant negative impact on operating margins.

Reason 2: Ability to Grow Memberships

Source: Costco 2018 Annual Report

Costco’s paid membership base has grown from 42 million in 2014 to 51.6 million by the end of 2018. Total paid membership count reads 53.1 million by the end of the third quarter of 2019, a 2.2 million increase when compared to the previous year (Q3-18). What makes the growth spurt even more admirable and validates Costco’s business value in the eye of the customer is that this growth came after Costco increased membership fees in June 2017:

“Starting June 1, annual membership fees for individual, business and business add-on members in the U.S. and Canada will rise $5 to $60. Executive memberships in the U.S. and Canada will increase from $110 to $120.” - USA Today

When retailers around the world struggled to increase traffic despite discounts, Costco increased its membership fees but still managed to increase its paid customer base by more than 3 million since 2017. This was also a period when competition from Amazon (AMZN) and Walmart continued to intensify in the United States.

Costco’s growth in the last few years is no accident. It happened because of the value the company offers shoppers and the way it has differentiated itself from other large retailers.

We’ve already seen that new markets can actually help margins because of at least one factor, which is new signups. That brings China to mind, where Costco will open its first warehouse on the mainland this year. Although Costco will face the same challenges as Walmart’s Sam’s Club, its primary membership-based competitor, a carefully selected portfolio of merchandise and proper pricing strategies can go a long way in ensuring that its first foray into the PRC is a success.

It’s an upside waiting to be realized, and I have every confidence that the management team’s measured approach to international expansion in new countries will serve them well in this market.

Reason 3: Membership Renewal Rates

Costco’s membership renewal rates make you wonder whether there is any competition in the retail segment at all. In the third quarter of 2019, renewal rates were 91% in the United States and Canada and 88% worldwide, slightly better than the 90% and 88% renewal rates the company reported for fiscal 2018.

The high membership renewal rate, coupled with membership fees, forms a huge moat around Costco. During the third quarter of 2019, Costco collected $776 million as membership fees, accounting for a whopping 69.2% of its operating income of $1,122 million during the period.

Investor’s Angle

Chart Data by YCharts

Costco is now trading at more than 33 times forward earnings, which makes it expensive when compared to its peers in the retail industry. There's no doubt that it's trading at expensive valuation multiples, but the potential to grow warehouses and memberships remains.

Chart Data by YCharts

Expansion into new markets might be a carefully thought-out exercise, but existing markets offer known risks and challenges that the company has thus far been able to successfully overcome. Moreover, as the chart above shows, Costco has been able to nearly double its revenues over the past decade - not bad for a company that had already been around for more than 15 years at the start of that period.

The next decade might not bring such growth, but revenues will keep increasing as long as Costco keeps delivering positive comps in all reported market segments, which we've seen over the past three months since the Q3 2019 report.

Source: Costco

Source: Costco

Source: Costco

Despite its high valuation, this is a business that investors should buy and hold forever, so I recommend waiting and continuing to add Costco during market weakness. Such windows of opportunity aren't very frequent with a company like Costco, but they do present themselves from time to time.

Source: Indicators added to data from Google

Interestingly, you'll also notice that prior to the dips, COST typically goes through a brief period of moving sideways.

Source: Indicators added to data from Google

This cyclic phenomenon is an indication that a window of opportunity might soon present itself, and one that investors should keenly watch for.

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.