Costco Wholesale Corporation (COST, Financial) operates an international chain of membership warehouses in the U.S. and Puerto Rico, Canada, United Kingdom, Mexico, Japan, Australia, Spain and through majority-owned subsidiaries in Taiwan and Korea. Most of these chains operate under the Costco banner.
Costco’s main business strategy is to operate as the industry’s lowest cost buyer and lowest cost seller of a limited selection of brand-name and private-label products in a wide range of merchandise categories.
Its success is largely dependent on its ability to stock only the fastest-selling products in each product category in order to achieve maximum volume. As such, Costco carries significantly fewer product line variations than most other retailers. Most products are also sold in bulk form only.
Costco targets sales to small- and medium-sized businesses, allowing them to purchase products in bulk for consumption purposes or to resell at a markup. However, it should come as no surprise the main growth driver for this company over the last two decades has been through membership and product sales to household consumers. The company strives for operating perfection by purchasing from manufacturers in huge volumes, through efficient distribution and reduced handling expenses. Selling at massive volumes and turning inventory over quickly allow the firm to operate profitably on razor-thin margins.
Given the firm’s purchasing power and long-standing relationships with key manufacturers, the firm is usually able to sell and generate cash-flows from inventory before it is required to pay for it. This helps the firm limit liquidity risk.
Costco is the third-largest retailer in the United States, behind Walmart (WMT, Financial) and Kroger (KR, Financial), Â the second largest international retailer (after Walmart) and the largest membership warehouse club chain in the United States. Costco’s average warehouse space is approximately 144,000 square feet, with its newest units being slightly larger. Floor plans are designed for economy and efficiency in the use of selling space, the handling of merchandise and the control of inventory. Because shoppers are attracted principally by the quality of merchandise and the availability of low prices, its warehouses are kept very simple.
Costco’s warehouses on average operate on a seven-day, 70-hour week. Costco’s merchandise categories include dry and institutionally packaged foods, snack foods, candy, alcohol, tobacco, cleaning, institutional supplies, major appliances, small appliances, electronics, hardware, seasonal items, meats, baked goods, jewelry, office supplies, cameras and apparel products.
The company also offers gas station filling services at its North American operations as well as pharmacy products, optical services and food court services. Approximately 22% of revenues come from packaged food sales, 21% from sundries and another 14% from fresh food sales. About 16% of revenues come from hardlines (including major appliances) and 11% from softlines (including small appliances) with the remainder coming from the catch-all “other” category.
Costco follows a membership-based business model. That is, registered members are permitted access to any of its warehouse locations. It has two types of members: Gold Star memberships which are available to individuals and business memberships which are available to individuals with a business license. As of 2015, Costco had 34 million Gold Star members, which increased by 7.6% since 2014. Costco also had 10.6 million business members, which increased by 1.9% since 2014, and 36.7 million household members, which increased by 6.7% over the same period. Costco’s 2015 membership renewal rate was approximately 91% in the U.S. and Canada and approximately 88% on a worldwide basis.
Recent financial highlights
- Unlike some other retailers, namely Walmart, Costco rebounded substantially from the U.S. recession and continued to benefit from the recovery in 2015. Sales were up 3.2% from fiscal year 2014 due to a combination of increased foot traffic and increased per customer sales.
- Earnings advanced 15.5% over the same period outstripping the sales increase due to heightened pricing power and increased sales of higher margin items.
- The company earned $1.09 cents a share on revenue of $26.63 billion, for the latest quarter ended Nov. 22.
- The market expected the company to deliver earnings of $1.17 a share on revenue of $27.57 billion.
- Earnings declined by 3.2% year over year, negatively affected by currency fluctuations and sluggish growth in membership fees.
- Even though membership revenue increased 1.9% to $593 million, this was the slowest growth in years as Costco reported a 6% rise over the same period last year.
- Comparable sales for the quarter fell 1% from the same period a year ago.
- The market expects EPS of $5.71 for 2016 and $6.37 for 2017.
Upside considerations
Costco is one of the best companies you could own: it has won consumers’ minds as one of the best places to shop for low-cost high-quality items, and due to operating efficiencies and negotiating power with manufacturers enjoy the benefits of being a lower cost buyer than much of the competition. We also continue to like Costco’s international expansion opportunities and think that its business model will work well in overseas markets.
Anyone who has visited Europe over the last five years knows how difficult it is to find a comparable type of retailer. We expect that management’s push to grow internationally will remain the firm’s primary growth driver over the next decade. The company has a well-recognized brand in a highly competitive sector but continues to grow its market share and is run by a shareholder-oriented management team. Also, while its 1% dividend yield is not terribly attractive, management has remained committed to growing the dividend each year since 2004. The company is also becoming more aggressive with its share repurchase activities.
Some downside considerations
Our biggest concern with Costco is whether, moving forward, it will be able to maintain its margins. Its volumes are primarily driven by packaged and fresh food sales – two very low margin items. With increased competition for Walmart, Kroger, Target (TGT, Financial) and Whole Foods (WFM, Financial), Costco might not be able to maintain its status as the “preferred choice” among consumers. That said, food products remain the main anchor into its stores. We are also concerned about the firm’s ability to support margins in the face of any major supply challenges or cost structure breakdowns which can quickly wipe out profitability. Most domestic expansion opportunities run out of steam eventually, as they run out of opportunities to open new stores and per-capita consumption reaches a point of satiation.
Although Costco’s international expansion opportunities alleviate this concern somewhat, Costco’s rapid growth cannot continue forever. With very high growth rates currently impounded into stock prices, the market’s current valuation might be a bit rich.
Fundamentals-based technical valuation
Overview
Technical valuation provides a basis for evaluating stocks by analyzing the statistics generated by market activity, such as past prices. Most technical indicators do not measure a stock’s fair value, but instead use charts and other tools to predict directional patterns and ranges in stock prices in an attempt to predict the future. In this section, we do precisely that, however, we use different types of technical indicators: they are what we call “Fundamentals-Based Technical Indicators.” That is, while each of the indicators relies on price patterns, price patterns are always viewed in combination with drivers of company fundamentals, such as business sales, earnings, cash-flows or book value. Our combined use of historical price and fundamentals data is what separates them from their traditional technical counterparts in which the only thing that really matters is the stock’s past price and/or volume pattern.
Technical indicators
A brief description of each indicator is presented below, with results to follow.
Earnings Calibration Model: A forecasting method that calibrates the company's forward price trend with the company’s EPS trend using 15 years of quarterly price data. This method assumes that there will be no multiplier expansion or compression. Price is projected forward based on a moving weighted average of the firm's trailing 12-month earnings line calibrated to the last three-year, five-year, 10-year and 15-year periods. The stock's average annual trading range is used to establish upper and lower price bounds. If an investor believes that the firm's earnings multiplier will expand (compress), then they might want to adjust our price estimate upwards (downwards).
Least Squares Regression Model: A forecasting method built using linear econometrics processes. Price is projected forward based on a linear econometric model built using 15 years of quarterly data. Explanatory variables include sales per share, earnings per share, free cash-flow per share and book value per share. Results are tested for statistical significance and projected forward based on estimates of sales, earnings, free cash-flows and book value.
Correlated Time Series Model: A forecasting method built using various time-series processes, including MA, AR, ARMA, GARCH, GBM and BMMR processes, that model the 15-year quarterly historical correlations between the company's stock price patterns and the company's sales per share, earnings per share, free cash-flow per share and book value per share and then uses these correlations to forecast the company's future stock price pattern. The stock's annual trading range is used to establish upper and lower price bounds.
Neural Network Model: Price is projected forward based on the results of a proprietary neural network forecasting model. The neural net was developed, trained and tested on the company's financial statements over the last 10 years. Pro forma financial statements are then incorporated into the neural net to generate estimates of the company's stock price two years forward.
1-Standard Deviation Valuation Bands: Valuations bands based on 1 standard deviation P/E (TTM) multiple (outliers removed) over the past 10 years applied to (1) trailing 12 months earnings and (2) the market's earnings estimates for the next two years. A price line that trends within the upper and lower price bounds signals that the stock is approximately fairly valued.
Proprietary Valuation Bands: A forecasting method that helps identify the market direction of the company's stock giving investors a heads-up as to whether the stock is likely under or overvalued. This method involves the development of three price lines. A market price trend that exceeds the upper price bound is likely to fall in value or trend sideways until it is back within the upper and lower price bounds. Do not expect much from your position. A price line that falls below the lower price bound might be a strong buy.
Expect the price line to trend upward until it is back within the upper and lower price bounds. The upper and lower price bounds and target price line are built using a closely held proprietary market based valuation model that simultaneously quantifies the simplicity/complexity of the business' operations, the extent to which the business' future is predictable, the strength of the firm's competitive advantage, the sustainability of the firm's competitive advantage, and the financial strength of the firm.
Results
Figure 1 below presents model results with prices forecasted forward two years for our first three models; Figure 2 presents results for our last three models.
Figure 1: Earnings Calibration, Least Squares Regression and Correlated Time Series Models
Figure 2: Neural Network Model, 1-Standard Deviation Valuation Bands and Proprietary Valuation Bands
The price estimates derived using each of these indicators with upper and lower price bounds is summarized in Figure 3.
Figure 3: Estimation Results and Market Estimates
Conclusion
Our earnings calibration model indicates a value of $180.75. Costco's current price of $160.02 trends below the lower price bound of $172.56 and is a bullish signal. Our least squares regression model and neural network model point to fair-valuation, with Costco's stock trending within their upper and lower price bounds of $156.13 to $172.50 and $156.17 to $172.54 respectively. The correlated time series model points to undervaluation, with Costco's stock price trending below the lower price bound of $187.44. Taking an average of all model results, we carry a neutral rating on Costco, setting a 12- to 24-month price target of $166.02 and a price range of $153.27 to $175.33. These results are fairly consistent with those of the market overall. Our target price is 2% below the markets. Our upper valuation is 11% lower while our low valuation is 13% higher than the markets.
