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Costco is a retail apocalypse survivor

Don’t be fooled by the retailer’s low margins – as the company’s membership model is the true profit driver
Costco is a retail apocalypse survivor
  • Costco is a low-margin business, but that is by design
  • The warehouse retailer is dedicated to keeping prices low in order to grow its lucrative membership base
IC TIP: Buy at $362
Tip style
Growth
Risk rating
Medium
Timescale
Long Term
Bull points

Strength of membership model

Resilience to e-commerce threat

Expansion opportunities

Analyst upgrades

Bear points

Valuation

Potential post-pandemic slowdown

Costco (US:COST) is a no-frills warehouse retailer that sells everything from groceries and household goods to large electrical appliances and petrol. With an average size of 146,000 square feet, the company’s stores are not like your typical supermarket. Costco’s global network of 803 warehouses can only be accessed if you have purchased an annual membership and they cater to bargain-minded customers that typically buy in bulk. There are no fancy displays as Costco follows a lean approach throughout its business in order to keep costs down and prices low. It buys its products directly from manufacturers and has the goods delivered straight to its warehouses and depots. Because they are displayed on their original racks and pallets in large quantities, this reduces the labour needed in store to stack shelves.

The majority of Costco’s stores are spread out across North America – where it has 660 warehouses – and this region accounted for 87 per cent of revenues and 83 per cent of the company’s net operating profit in 2020. There is still plenty of room to expand. The company continued to open new stores last year despite the difficult retail landscape, albeit at a slower pace. It opened a net 13 new warehouses in the year to 31 August 2020 – versus an average of 25 over the past five years – and plans to open 20 to 22 new stores this year. New warehouses have yet to cannibalise sales from existing locations and they also provide a long runway for growth as they mature. For example, stores that opened in 2012 had seen their annualised sales per warehouse rise by more than two-thirds by 2020, from $105m to $173m.

But Costco is also extending its international footprint, and it opened its first warehouse in China in 2019. It’s a savvy move to try to tap into China’s rapidly expanding middle class, although many other retailers have tried and failed. Even the mighty Amazon (US:AMZN) shut down its domestic marketplace in China amid stiff competition from the likes of Alibaba (US:BABA) and JD.com (HK:9618). Costco’s arrival in China was met with a lot of initial enthusiasm – the store was forced to temporarily close its doors on its first day after being overwhelmed with customers – and the company has plans to open a second location on the mainland as well.

 

Look beyond the low margins

Many investors shy away from lower-margin businesses as they typically indicate a high degree of competition and bring the possibility that margins will be wiped out when times are tough. But low margins don’t always go hand in hand with low quality and Costco is a case in point. While the company’s margins are low – its gross margin was just 11.6 per cent in the three months to 22 November – this is a deliberate result of its business model.

Costco aims to keep its prices as low as possible to lure in customers. It does so by offering a smaller selection of products than its competitors – 3,700 ‘stock-keeping units’ (SKUs) versus the tens of thousands of SKUs typically carried by supermarkets – and concentrating its buying power to get better prices from its suppliers. It then passes these savings on to its customers.

UK fund manager Nicholas Sleep – who is something of a cult figure in the investment world – calls this business model a “perpetual motion machine”. Mr Sleep points out that “savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages growth and extends scale advantages”. He says that “most companies pursue scale efficiencies, but few share them. It’s the sharing that makes the model so powerful”.

The reason Costco does this is because the bulk of its profit comes from its membership fees – which are pure profit – rather than what it earns from selling actual products (see chart).  

Costco operates a subscription model whereby customers pay an annual fee to access its stores – $60 for a standard membership and $120 for an executive membership. Executive members can get a 2 per cent discount on certain purchases and they typically shop more frequently and spend more than regular members. Costco’s paid membership base reached 59.1m at the end of November – up from 54.7m a year earlier – and executive members accounted for almost two-fifths of the total.

The company enjoys a high level of customer retention, with a membership renewal rate of 91 per cent in North America, and 88 per cent worldwide. This loyal customer base represents a competitive moat and helps provide protection from rising competition from e-commerce. The membership fees are also a predictable earnings stream and can help smooth out any sales volatility.

Costco’s e-commerce offering is relatively underdeveloped. It has partnered with Instacart in the US and Canada for same-day grocery delivery and purchased last-mile logistics company Innovel for $1bn last year to boost its ability to deliver bulky goods such as furniture and fitness equipment. Still, e-commerce sales surged by 86 per cent year on year in the three months to 22 November, equivalent to around 7 per cent of total sales.

But while Costco is building out its online offering, bricks-and-mortar remains central to its business model. E-commerce fulfilment typically eats into retailers’ margin and Costco prefers to lure punters into its stores where it can encourage them to make more impulse purchases.

“It’s still important to get people physically in the stores,” chief executive Craig Jelenik told CNBC in December. “I still think bricks-and-mortar is not going to go away. We want to continue to get people in the stores, and there’s no better way to do it than a $1.50 hot dog.”

Costco’s famous $1.50 hot dog – which has been kept at the same price since 1985 – is an example of the loss-leading products it used to keep customers coming into its stores. This means that in an era where shopping is increasingly moving online – a trend that has been supercharged by Covid-19 – Costco continues to rebuff the likes of Amazon and draw customers to its warehouses. It’s not just the low prices on staple items, but also the surprise in-store deals on a rotating selection of other goods that turns customers’ trips into a treasure hunt – imagine the middle aisles of Aldi and Lidl on steroids. Afterall, there aren’t many retailers where you can purchase toilet paper and a near-$400,000 diamond engagement ring under the same roof.

 

A pandemic winner

Costco’s buy-in-bulk offering and spacious warehouses have made it the go-to place for consumer stockpiling during the pandemic, with customers spending more per trip. Same-store sales rose by 8 per cent in the year to 30 August. While its ancillary businesses such as its petrol stations and food courts have been squeezed, it has benefitted from consumers shifting their spending from areas such as travel and eating out to fresh food and investing in their homes.

Pantry-loading is likely to wane as the Covid vaccine is rolled out, although the company predicts that elevated buying patterns will continue until the middle of this year. Its track record of customer ‘stickiness’ also bodes well for it holding on to its new members post-pandemic. Analysts certainly believe that the momentum will continue and have been getting more bullish on Costco’s outlook, upgrading their forecasts.

 

Defying the retail odds

Costco was sitting on $4.2bn of net cash at the end of November and it has a good track record of free cash flow generation as well. Investors are not likely to be bowled over by the dividend yield of 0.8 per cent, although the company is known for handing shareholders special payouts from time to time – it paid out a $10 special dividend in December 2020. Still, the tax complications associated with overseas dividends mean a low yield should not be too much of an issue for UK-based investors.

Reflecting its strong performance during the pandemic, Costco’s shares have risen by almost a quarter since the beginning of last year and are currently trading at 33 times consensus 2022 earnings, with an enterprise-to-operating profit ratio of 23. That’s pricier than rival retailers Walmart (US:WMT) and Target (US:TGT) respectively on PEs of 25 and 22, but the strength of Costco’s membership model justifies the premium valuation. It also isn’t too far off Costco’s five-year average price/earnings (PE) ratio of 32.

Costco may seem out of place in an era when we can have something delivered the next or even same day with just one tap on our smartphones. But its value-for-money proposition should not be underestimated as it has underpinned a resilient bricks-and-mortar approach. The relentless focus on maintaining low prices is an attractive quality throughout the economic cycle, meaning that it should continue to do well in the long term in the post-pandemic retail landscape.

Costco Wholesale Corporation (US:COST)  
ORD PRICE:36,216¢MARKET VALUE:$160bn  
TOUCH:36,132-36,300¢12-MONTH HIGH:39,315¢LOW:27,128¢
FORWARD DIVIDEND YIELD:0.8%FORWARD PE RATIO:32  
NET ASSET VALUE:3,456ȼNET CASH:$4.2bn  
Year to 31 AugTurnover ($bn)Pre-tax profit ($bn)*Earnings per share (ȼ)*Dividend per share (ȼ) 
20181424.44683214 
20191534.77819234 
20201675.37875260 
2021*1876.241,0251,284** 
2022*2016.731,119294 
% change+7+8+9-77 
*Raymond James forecasts, adjusted PTP and EPS figures
**Includes 1,000¢ special dividend paid on 11 Dec 2020
£1 = $1.35     

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