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The Science of Hitting
The Science of Hitting
Articles (524) 

An Update on Costco

A look at the retailer following 2018 results

February 27, 2019 | About:

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.


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.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (4 votes)



Dunyuliu - 2 months ago    Report SPAM

Just started to be interested in Costco. Thanks for the summary and analysis!

Batbeer2 premium member - 2 months ago

>> It’s worth noting that the company plans on opening its first warehouse in China this year (expected in September).

Didn't know that, thanks!

I wonder how many members that first shop attracts. Also, should be interesting to see the price of membership in China.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Dunyuliu - Glad I could help! Thanks for the comment.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Batbeer2 - I haven't seen the numbers lately, but I remember in the past they've said warehouses in nascent markets have often added ~60k new members in a few months. Maybe that first Chinese warehouse can get all the way to 100k! Thanks for the comment.

Batbeer2 premium member - 2 months ago

>> Maybe that first Chinese warehouse can get all the way to 100k!

I'll bet the over on that one. We shall see.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Think you're probably right :)

Extramiler - 2 months ago    Report SPAM

It's interesting that their 2018 net income of $3.1 billion equals the membership fee revenue. Appears that all their retail operations make $0? Sort of like Amazon?

I think it was Munger I heard talk about Costco a few years ago. He said that they turn their inventory 12 times a year, and they take 30+ days to pay suppliers, so essentially they get their goods on an interest free loan. He said that they sell their products at cost and make their money on the membership fees. This is an interesting business model, but seems like the investor is relying on them getting more and more members.

Batbeer2 premium member - 2 months ago

Hi Extramiler, you say:

>> Appears that all their retail operations make $0? Sort of like Amazon?

LOL no, that is not interesting at all. Bear in mind that this company is called Costco Wholesale. The company has a duty to its members to not turn a profit on the retail side. That is why it carries a surprising number of SKUs from leading brands. Those are the SKUs retailers charge the highest margin on and that is where a wholesale club can undercut retailers the most. They are simply doing their job!

What's interesting to me is that people find that interesting :-)

Of course, all the analysts covering the company are retail analysts. They apply their retail models/spreadsheets to Costco's operation and then express surprise that the retail operation does not turn a profit. Well, I got news, Costco is not a retailer. Forget the model and get rid of that spreadsheet. Just read and think a bit to understand what they do. Same applies to Amazon by the way. They too are not a retailer. IMHO Amazon provides real estate in the digital world. Amazon.com is one of its assets and it is a digital mall. The more people think the stuff sold there is cheaper and/or more convenient, the more that mall gets worth.

Anyway, Costco's moat is simply that it is just too hard for anyone else to replicate Costco's culture of simply walking the talk. Others succumb to the temptation of marking up some of their SKUs for a quick profit. Yes, you make a quick buck but you also betray your members. In due course you become just another retailer. This is also why Costco doesn't hire management from other companies.

Just some thoughts.

P.S. So with Costco going to China, how many potential new members could that bring within the next decade or two? That is why I'm interested in the membership cost in China.

Extramiler - 2 months ago    Report SPAM

Batbeer, seems like those are all reasons it's good to be a member at Costco, not the reasons it's good to be an investor? Especially paying ~$100 billion for $3.1 billion in profits.

Not a direct analogy, but a friend owned a restaurant, very popular, tons of customers, good food, good atmosphere, etc., but he never made any money at it. Essentially he sold the food and bev at cost. Of course, he did not charge membership fees. Just having loyal customers was not enough.

Batbeer2 premium member - 2 months ago

Yes, at these prices I don't own Costco. Bear in mind though that there are two ways to think about Costco.

1) It is trading at a 3% yield so you earn 3 cents on the dollar.


2) Every dollar they retain compounds at more than 20%.

It's actually more. They pay out most of their earnings and still grow at a fair clip. The asset that goes up the most as they grow is inventory. As you pointed out, they get that for free. Costco is one of those rare companies that does not eat cash as it grows. It's an interesting and rare business where you can grow earnings without spending a lot of cash on more assets.

So if one is confident that they'll continue doing for another decade or two what they have been doing for the last two, then the latter is the more relevant framework. This is also why I kick myself for not buying in 2011, or 2009 or... Costco always looks expensive but over time the value compounds at a satisfactory rate.

Just some thoughts, sorry for the long rant.


You want to own a franchise with similar economic characteristics trading at single-digit multiples, then Kraft Heinz qualifies. Of course, a lot of reasonable people will argue that one is deservedly cheap. Investing is simple but not easy :-)

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