Investment Thesis
Costco (NASDAQ:COST) delivered a robust performance in its fiscal third quarter, surpassing analysts' expectations on both revenue and earnings. The warehouse giant reported net sales of $58.52 billion, exceeding estimates of $57.98 billion. This translates to a 9.1% YoY, showcasing continued customer demand for Costco's bulk offerings.
Strength wasn't limited to just overall sales. Comparable store sales, a key metric that excludes the impact of gasoline prices and FX fluctuations, jumped 6%. I find this growth to be particularly impressive in international markets, with sales surging 8.5% compared to the US's 6%. Even e-commerce defied expectations, witnessing a 20.7% leap, fueled by a surprising surge in demand for gold and silver bullion.
However, despite the positive earnings report, a shadow of uncertainty loomed over Costco's stock price. Investors reacted with a slight dip after the earnings call, likely due to the lack of a highly anticipated membership fee increase, a potential sign of caution amidst inflation worries and potential recessionary headwinds. However, Costco's new CFO, Gary Millerchip, sought to reassure investors, indicating a fee increase remains on the table, but the company is carefully considering the "right timing" to implement it.
We've historically looked at increasing the membership fee every five years or so. And obviously, we're beyond that time period now in terms of what would be the typical cycle. There's nothing about anything that we see within how the business is performing that's changing our view on that. We feel really good about membership renewal rates. We feel really good about the test of are we delivering significantly more value to members than we were or have since we last increased the membership fee.
For me, this suggests that Costco is carefully weighing the potential benefits of increased revenue against the risk of alienating its loyal customer base in a potentially volatile economic climate.
Costco recent earnings call, highlighting continued market share gains, strong financials, and a loyal customer base, makes it a potential addition to my growth-oriented portfolio as a long term play. While the stock's all-time highs might suggest otherwise. Costco's future long-term growth potential remains attractive.
To assess this thoroughly, I will delve into every factor surrounding the company from management effectiveness, corporate strategy, and the company's financial health. As you will read later, I consider the stock valued at a fair priced at the moment but Costco's long-term prospects are compelling, including their expansion in the US and internationally. Therefore, I am starting my coverage with cautious buy on any price weakness as a way gain exposure to this promising long term growth story.
Management Evaluation
Costco's new CEO, Ron Vachris, brings nearly 40 years of company experience to the table. Having served in various leadership roles across operations, merchandising, and real estate, he boasts a deep understanding of Costco's inner workings. In fact, he started his career driving forklifts at the warehouse. This extensive tenure suggests what I consider a "high alignment ratio" with the company long-term goals, further reinforced by his compensation package which is heavily weighted at around 85% in stock awards.
Vachris takes the reins at a time of high employee satisfaction, with Glassdoor reviews exceeding industry averages. Maintaining this positive momentum will be crucial for his success. I believe his proven track record within Costco positions, most recently as their COO, positions him well to navigate the challenges ahead.
Replacing Costco's long-time CFO, Richard, brings in Gary Millerchip, a seasoned finance professional with extensive retail experience, having previously served more than 15 years at Kroger (KR), most recently as their CFO and over 20 years in banking in the UK. Gary's challenges lie in balancing Costco's ambitious growth plans with maintaining heathy financials.
While Richard leaves behind a legacy of strong financial performance, including an average growth in ROE of 9.73% but that its currently expected to decline. Gary will need to keep debt in check to fuel Costco's expansion while navigating a potentially trickier economic landscape. Richard's continued presence in an advisory role for the next year is helping ensure a smooth transition and knowledge transfer.
Costco's leadership shuffle brings new faces: Vachris, the CEO, boasting 40 years of company experience and strong alignment to the company future success. He will need to maintain high employee satisfaction. Millerchip, the new CFO with extensive retail and banking experience, inherits a strong financial legacy but faces managing potential decline and keeping debt in check for growth. Therefore, based on their latest earnings call I believe they have a good understanding of the company and I am inclined to give them a rating of "Meet expectations" for now as more information becomes available.
Corporate Strategy
Costco unique strategy prioritizes member value, fueling their market share dominance. A loyal customer base, cultivated through annual memberships, unlocks exclusive deals on high-quality products, leading to repeat business and higher spending. This focus on value is further enhanced by Costco's efficient supply chain and strong Kirkland Signature private label brand. Despite the bulk approach, quality remains a priority, strengthening customer trust. While competitors offer wider selections, Costco strategically curates products, like it did with gold and silver bullion, negotiating better deals and streamlining operations for lower member prices.
I have created the table below comparing Costco current strategy to some of it current competitors:
Costco Sam's Club (WMT) BJ's Wholesale Club (BJ) Corporate Strategy Low-cost leader with membership model: Focus on offering a limited selection of high-quality products at bulk prices to members who pay an annual fee Similar to Costco, but with a larger product selection and lower membership fees. *Aims to attract broader customer base with a wider variety of products and lower membership fee. Value focused with emphasis on coupons and promotions *Targets a budget conscious customer by offering frequent deals and promotions alongside its warehouse club model. Market share 62% 31% 7% Advantages Strong customer loyalty *High average transaction value * Efficient supply chain *Focus on private label brands Convenience of being part of Walmart ecosystem. *Lower membership fees *More national brand recognition. Lower membership fees than Costco and Sam's *More promotional activity to attract customers *focus on national brands Disadvantages *Limited product selection *Requires membership fee *Crowded warehouses Lower average transaction value compared to Costco *Potential for lower quality on some products *Less emphasis on private label brands Lower average transaction value to competitors *smaller store footprint limits product selection *Less emphasis on private label brands.
Source: From companies' website, presentations, SeekingAlpha, *CFRA Research
I believe Costco edge comes from a trifecta: strong member loyalty from the membership model, an efficient supply chain minimizing costs, and powerful private labels like Kirkland Signature. Challenges from competitors exist but Costco's focus on quality, member loyalty, and efficiency allows them to maintain their dominant position.
Valuation
Costco currently trades at around $825, pretty flat since it last reported earnings in late May.
To assess its value, I employed a conservative 11% discount rate, this rate reflects the minimum return an investor expects to receive for their investments. Here, I am using a 5% risk free rate, combined with the additional risk premium for holding stocks versus risk free investments, I'm using 6% for this risk premium. While this could be further refined, lower or higher, I'm using it as a starting point only to get a gauge for unbiased market expectations.
Then, using a simple 10 year two staged DCF model, I reversed the formula to solve for the high-growth rate. To achieve this, I assumed a terminal growth rate of 4% in the second stage. Predicting growth beyond a 10-year horizon is challenging, but in my experience, a 4% rate reflects a more sustainable long-term trajectory for mature companies. You can find historical GDP growth data to explore past trends here. Again, these assumptions can be higher or lower, but from my experience I feel comfortable using a 4% rate as a base case scenario. The formula used is:
$825 = (sum^10 FCF (1 + "X") / 1+r)) + TV (sum^10 FCF (1+g) / (1+r))
Solving for "x" = 26%
This suggest that the market currently prices COST FCF to grow at a rate of 26%. According to Seeking Alpha analyst consensus FCF is expected to grow at a 24.07%.
Therefore, I believe COST is at fair value at this point with the market not giving any premium and discount to the company. However, I have confidence in the management ability to carry out its growth strategy and maintain its leadership advantage despite the current price. An example of the revenue growth strategy is the so talked potential increase in membership fees, store expansions, and growth in e-commerce with unique products like gold and silver bullion.
Technical Analysis
COST continues to hit all-time highs with the stock trading around $825. This positive momentum is likely fueled by optimism on a potential future membership hike which could happen over the short-term or mid-term or even expected to be announced in the next earnings call. The stock gets an A+ momentum rating on SeekingAlpha:
Due to the stock all-time highs, I will be a cautious buyer for now and a buyer on any weakness as I believe there would some volatility as the stock currently crossed into overbought territory according to its relative strength index (RSI) which is currently at 78 and with a moving average over the last 14 days of 70 and in a declining trajectory.
Next earnings haven't been announced yet.
Takeaway
Costco's recent earnings solidify their potential growth. Loyal customers, strong financials, and market share gains paint a positive picture, despite a muted stock reaction. Their member-focused strategy with exclusive deals, high-quality curated products, and an efficient supply chain gives them a competitive edge, bolstered by strong private label brands. New leadership brings deep company knowledge, with CEO's tenure and stock-tied comp suggesting a "high alignment" with the company long-term goals. While Costco's valuation reflects high market expectations, I have confidence in the management ability to execute their strategy leading me to start coverage with a cautious buy, especially on any price weakness.
Matteo Sada, CFA
Over 12 years of dynamic experience in the financial industry, I excel as a trader, portfolio manager, and equity research. As a CFA charter holder, I meticulously navigate the financial landscape, employing a comprehensive approach that blends top-down and bottom-up analysis. My investment philosophy centers on synthesizing Growth At a Reasonable Price (GARP) and value strategies, though I remain adaptable to market shifts. Completing an MBA has enriched my investment perspective incorporating corporate strategy standpoint. My extensive trading experience has honed my understanding of momentum factors which also influence my investment decisions. Follow me to stay tuned.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of COST either through stock ownership, options, or other derivatives. 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.
Rating systems don't consider time horizons or investment strategies. My articles aim to inform, not to make decisions.
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