I wrote several articles lately about retailers such as Walmart (WMT) and Dollar Tree (DLTR), so here is an update on Costco (COST), another retailer I’m fond of.
In 2018 Costco’s revenues increased 10% to $141.6 billion (inclusive of membership fees). Over the past five years, revenues have increased at a mid-single digit CAGR (comp store sales have consistently increased at a mid-single digit rate over this period excluding gas and currencies). Sales growth in 2018 was largely attributable to strong comps (up 7% excluding the impact of gas and currencies), as well as 4% net unit growth. The company ended the year with 768 warehouses around the globe, with about 70% in the U.S. (those warehouses average $160 million in annual sales, significantly more than Sam’s Club). As that suggests, Costco still has a sizable opportunity around the world: The company has only 100 or more warehouses in a single country outside the U.S. (Canada, where they have exactly 100). It’s worth noting that the company plans on opening its first warehouse in China this year (expected in September).
In addition to building new warehouses, Costco is investing in ancillary services that drive traffic and sales. For example, Costco now has 567 gas stations at its warehouses, nearly twice as many as they had a decade ago. They’re also making investments to improve the efficiency of these ancillary services (for example, they’re developing a fob that will allow members to pay for gas with a single swipe as opposed to swiping their membership card and credit card).
Costco’s e-commerce business reported $5.5 billion in revenues in 2018 (up 30% over 2017). While the company has seen solid growth in the past few years (revenues have more than doubled since 2013), it took time to get there. For example, consider this comment from the 2006 shareholder letter:
“As expected, our sales for 2006 increased 59% over 2005, and profits were up again. We project sales will be well over $1 billion in 2007 and hope to reach $5 billion in five years.”
The company has reached $5 billion in online sales – but it took 11 years instead of five. At less than 5% of revenues, it will take some impressive results for the e-commerce business to be a meaningful driver of growth for Costco in the short term (even with 30% growth, e-commerce would only contribute 120 basis points to the company’s overall growth rate from 4% of sales).
Costco ended 2018 with 52 million paid members and 94 million total members, which drove the 10% year-over-year increase in membership fees to $3.1 billion. Membership renewal rates remained near 90%, where they’ve consistently been for well over a decade. That speaks to the value the company provides for its customers. As CEO Craig Jelinek noted in the opening to his 2018 shareholder letter, this has been the company’s purpose and focus since day one:
“When Costco was founded 35 years ago, we did not envision that we would become a $138 billion retailer, employ over 245,000 people, operate over 750 warehouses or serve more than 94 million members worldwide. Nor did we envision the breadth of products and services we now offer; or that what began as a “cash-and-carry” operation would extend to delivering products to our members’ doorsteps. What we did know, and set out to do, was maintain a steadfast commitment to value and integrity. We honor this commitment in all aspects of our business, from providing quality merchandise at terrific prices; to treating members, employees, and vendors with courtesy and respect; and to working closely with suppliers to promote fairness, dignity, and safety throughout our supply chains.”
A lot of companies talk about these kinds of commitments. The difference, at least based on what I’ve seen and heard, is that Costco lives up to them.
A great example of that “steadfast commitment to value and integrity” is the company’s Kirkland Signature private label products. Sales for Kirkland Signature crossed $39 billion in 2018, up 11% from 2017. Private label now accounts for nearly 30% of Costco’s revenues, compared to 15% in 2006 and 20% in 2011. As that growth suggests, customers find value in the company’s private label offerings (I’m a big fan of the $13 bottles of vodka, but that’s a discussion for another day).
Warren Buffett (Trades, Portfolio) presented an interesting way of thinking about Costco’s private label success while discussing the recent struggles of branded consumer packaged goods (CPG) companies like Kraft Heinz (KHC) in a recent CNBC interview (bold for emphasis):
“Heinz was started in 1869 and it has had all that time to develop various products, particularly ketchup, things like that. The Kraft part is a little murkier but it goes back to C.W. Post in 1895. Those companies have brought all kinds of brands out - you know them, you had them when you were a kid, and you have them now, some of them. They’ve been distributed worldwide through hundreds of thousands of outlets… they’ve spend a fortune on advertising. Their sales now are $26 billion. Costco introduced the Kirkland brand in 1992 (27 years ago) and that brand did $39 billion last year whereas all the Kraft and Heinz brands did $26 billion. Here they are, a hundred years plus, tons of advertising, built into people’s habits and everything else, and now Kirkland, a private label brand, comes along and with only 750 or so outlets and does 50% more business than all of the Kraft Heinz brands. So, house brands, private label, is getting stronger… and it’s going to keep getting bigger.”
Conclusion
Costco’s net income in 2018 was $3.1 billion, with diluted earnings per share climbing 17% to $7.1 per share (helped by a lower effective tax rate). Over the past decade, earnings per share have cumulatively increased by roughly 150% -- a compounded annual growth rate (CAGR) just shy of 10% for the decade.
At $215 per share, Costco trades at roughly 30 times trailing earnings. That’s a significant premium to retailers like Walmart and Dollar Tree, which trade at roughly 20 times trailing earnings on my numbers (with some adjustments for Dollar Tree). The question is whether Costco’s long-term growth prospects, which are clearly superior to Walmart and Dollar Tree, justify such a large premium.
In my model, I assume continued unit growth of roughly 4% per year. I also assume low-to-mid single digit comp store sales growth, which collectively drives high-single digit revenue growth. Even with continued unit growth, Costco has a fair amount of free cash flow left over. I assume those funds are used towards dividends (with a payout ratio of roughly 40%) and repurchases (with the diluted share count declining by roughly 1.5% per year).
With those and a few other assumptions, I end up with earnings five years out of roughly $11 per share. With a terminal price-earnings multiple of 20 to 26 times earnings and a 9% discount rate, we’re left with a fair value today of $150 to $200 per share. In summary, unless you’re willing to make assumptions beyond 2023 (which you could either do explicitly or by applying a higher terminal multiple), it’s tough to make the case that Costco shares are undervalued at current levels.
Disclosure: Long Kraft-Heinz.
