Description

Ticker: COST

Price: $563.91

Market Cap: $250B

Price Target: $674

 Overview

Costco’s impressive track record is fairly well known at this point, with the stock having increased in absolute terms for 13 consecutive years and having outperformed the S&P 500 in 15 of the last 20 years. Despite its recent re-rating and strong 2021 performance, we believe that Costco will sustain elevated comps with potentially significant upside and continue to generate attractive long-term value for shareholders.

 Description

Costco Wholesale Corporation is a membership-only big box retailer of groceries and general merchandise. The company currently operates 823 warehouses worldwide, with 69% in the US and the remaining 31% in international markets. Its warehouses average more than 140,000 square feet, larger than those of both Sam’s Club and BJ’s.

Since its founding in 1976, COST has been able to offer its members low prices on bulk items due to its membership fee-based business model.

 Business

Costco’s business model is driven by its membership fee revenue, which allows it to offer bulk products at low prices to its customer base. Its business is split into two larger categories (Core Merchandise and Ancillary/Other businesses) with its Core Merchandise categories being split into three sub-groups: Food and Sundries, Fresh Foods, and Non-Foods. The Food and Sundries category includes sundries, dry grocery, cooler, freezer, and deli while its Fresh Foods category includes meat, produce and more. The Non-Foods group includes Hardlines and Softlines (i.e. major appliances, electronics, hardware, garden & patio, office supplies, and more). Its Ancillary business, comprised of gasoline, pharmacies, food courts, and others, operates within or next to their warehouses with the goal of driving in-store traffic. Lastly, its Other business contains e-commerce, business centers, travel, etc. As of FY21, approximately 54% of sales came from groceries, ~30% from general merchandise, and the remaining ~16% coming from its warehouse ancillary and other businesses.

However, it is Costco’s merchandising strategy that sets it apart from other club and mass retailers. Its goal is to offer its members a broad range of high-quality merchandise at consistently lower prices than its competitors. It achieves this by implementing strict inventory discipline. By limiting products to fast-selling models, sizes and colors, COST is able to significantly increase product velocity and have relatively leaner inventory levels. COST warehouses typically carry around 3,700 SKUs, substantially less than its competitors. As a frame of reference, BJ’s has reported previously that it carries around 7,200 SKUs and Walmart Supercenters carry around 140,000 SKUs. This “narrow” strategy allows Costco to be more flexible when buying goods and allows it to use its scale to give members its iconic low prices around the world.

As of November 21, 2021, Costco operated 823 warehouses worldwide. Of those, 571 are in the United States (46 states, Washington D.C., and Puerto Rico), 105 are in Canada, 39 in Mexico, 30 in Japan, 29 in the UK, 16 in Korea, 14 in Taiwan, 13 in Australia, three in Spain, and one in Iceland, France, and China. Additionally, the company has e-commerce websites in the US, Canada, Mexico, UK, Korea, Taiwan, Japan, and Australia.

Costco’s significantly larger retail footprint and ability to drive both higher sales per store and sales per square foot has distanced itself from its competitors.

While Costco certainly benefited from some temporary tailwinds over the last 18 months, including COVID-induced pantry stocking, government stimulus and enhanced unemployment benefits, these factors ultimately have led to a more durable gain – increased membership levels. The culmination of all these factors led to double digit comps in FY21, a dramatic increase from the fairly consistent pre-pandemic MSD comps. In fact, COST has had positive SSS (ex-gas) for 20+ consecutive years. Below is a chart that shows COST comps (ex-gas) against those of Sam’s Club and BJ’s Wholesale Club.

As illustrated above, from 2000-2019, COST consistently outperformed its peers with comps averaging more than 300bps above Sam’s Club and BJ’s. While both BJ’s and Sam’s Club did outgrow COST in COVID-impacted 2020, COST has resumed its outgrowth in 2021 outpacing its peers by more than 180bps. While Costco clearly benefited from the pandemic, the company has demonstrated that it can sustain comp levels much higher than its pre-COVID rate. As evidence, the two-year stack (ex-gas) in FY21 actually accelerated to +22.4%, up from +15.4% in FY20. While the future is tough to gauge with precision, particularly since the company does not provide guidance, COST has thus far been able to lap its very difficult comps.

 Investment Thesis

While Costco was initially deemed a COVID beneficiary, it is now in an even stronger position exiting the pandemic and should be able to sustain MSD to HSD comps – above its pre-COVID levels. Despite its elevated headline valuation and recent run, we believe that COST can continue to provide investors with strong returns based on several factors: a unique membership model and customer mix, store growth, and an elevated cash balance.

The unique aspect of Costco’s business is its membership model. Membership levels have grown for each of the last 20 years to its current level of 61.7mm members. Currently, a regular membership costs $60 and the Executive membership costs $120. Typically, COST takes pricing on membership rates every five years or so and increases rates by $5 – the last increase was in 2017 so it is likely due for one within next year. COST’s renewal rate in the US and Canada was 91% in 2021 and 89% worldwide. As reference, 2021 membership revenue was ~$3.9B. Being slightly generous and assuming all of this revenue flows down to the bottom line, membership would make up about 45% of EBITDA. The recurring nature of the flywheel – sticky membership revenue with upfront payments allows COST to keep grocery/merchandise prices low, therefore driving increased membership – is what allows Costco’s growth algorithm to continue each year.

While the overall health of the consumer is projected to deteriorate in 2022 relative to the past 18-24 months, we believe COST will remain largely unaffected due its membership makeup. Costco members tend to skew to the middle to upper income classes and therefore, the reduction in SNAP benefits and the lapse of stimulus and enhanced unemployment benefits should not play as big a role compared to its competitors. For reference, it is estimated that 18% of BJ revenues came from SNAP benefits in FY21.

Over the past 7 years, COST has increased store count by ~3% annually. Moving forward, the company plans to expand the number of warehouses by 3% or 25-30 per year – about 50/50 in terms of mix between US/International. In FY22, COST is increasing CapEx spend by about $400mm to $4B. One of the largest areas of increased spending will come from international warehouse expansion. Our analysis suggests Costco can maintain this rate of warehouse expansion over at least the next two decades.

Lastly, in FY21, COST accumulated record amounts of cash, more than 1.5x its average cash balance over the past five years. The company has a history of offering special cash dividends every several years (FY15, FY17, FY20, FY21) and noted on its last earnings call that it was “a matter of when and not if” COST will authorize the next special cash dividend.

We believe that COST’s current market position, high cash generation and ability to navigate elevated cost environments sets it up nicely heading into next year.

 Valuation

In terms of the stock, valuation has expanded over the last 18 months with the stock currently trading at ~45x FY22 EPS. However, this premium is warranted because of its highly recurring membership revenue model and strong underlying business. We have long valued COST on a two-part DCF, separately valuing the membership fee cash flow and the merchandising cash flow. Applying a ~3.25% terminal growth rate and a 7.5% WACC, we arrive at a combined per share value of $674, ~20% upside from the current share price. While the stock has had a massive run, our DCF valuation continues to imply solid upside and suggests the myopic focus on near-term headline valuation multiples is somewhat misplaced. Costco’s flywheel is stronger than ever and we believe the company is well positioned to continue delivering outperformance for shareholders.

Risks

· Continued elevated supply chain costs

· Loss of members gained during pandemic

Catalyst

· Authorization of special cash dividend

· Membership fee increase

· Supply chain pressure easing

· Price increase on products