Hands up! Who has not walked into a Costco store intending to buy $100 worth of groceries and walked out with a $300 bill. It’s a phenomenon that no Costco shopper can explain. And that’s not even how they make their profit!
Costco is one of two dominant Brick and Mortar retailers with their primary competition being Walmart (and Sam’s Club - owned by Walmart). Costco has approximately 17% market share with Walmart at 70%. The company uses a membership fee, warehouse-style, strategy leveraging prices and reducing costs by buying high quality goods that consumers want, and need, in large quantities and turning them over quickly. Costco has over 847 warehouses worldwide - 583 in the US, 107 in Canada, 40 in Mexico, 29 in the UK and is just beginning its expansion into the Asian markets of Japan (31 stores), Korea (18), Taiwan (14), Australia (14), China (2) and Europe - France, Spain, Sweden.
CHOOSING THE RIGHT STOCK
When considering an investment in any company, the Investment Thesis has to be considered within the context of three areas.
Best-in-Class - Costco prides itself on it’s ‘Take Care of Our Employees Philosophy’ which consistently earns it a position on Forbes Best Employers List with a base of 304,000 employees. Through its scale and scope, Costco is able to leverage the lowest prices and source the best supply chains, internationally, domestically and locally. Throughout the Covid pandemic the company navigated logistics issues by chartering its own ships to secure delivery of goods. Management has a very strong depth of experience with the CEO and CFO having started with the company in 1995 and 1993. Costco reports sales data on a monthly basis providing shareholders with a high level of transparency.
Secular Growth Trend - people are increasingly recognizing the importance of their personal time and money and they want to spend that time and money on the things that are important to them. This is creating a secular change in consumer spending patterns as they look for solutions that offer a single stop for the goods they want at the most affordable prices.
Strong Macroeconomic Environment - As of January 2023 the US economy is strong, causing the US Federal Reserve to increase interest rates. This is both a strength and a weakness. As a strength, Costco offers the best quality, lowest priced goods positioning it well in any economic environment. As a weakness however, many analysts view the interest rate policy as a deliberate move to force the economy into a recession which may affect employment levels and discretionary spending on non-essential items.
INVESTMENT THESIS
The Investment Thesis for Costco is founded on three pillars
1. Recurring Revenue Stream – Costco’s primary business is maintaining a recurring revenue stream through its membership fees.
|
YEAR |
ANNUAL REVENUE |
ANNUAL PROFIT |
MEMBERSHIP FEES |
|
2022 |
$222.7 Billion |
$5.8 BILLION |
$4.2 BILLION |
|
2021 |
$192 BILLION |
$5 BILLION |
$3.9 BILLION |
|
2020 |
$163 BILLION |
$4 BILLION |
$3.5 BILLION |
|
2019 |
$149 BILLION |
$3.7 BILLION |
$3.3 BILLION |
|
2018 |
$138 BILLION |
$3.1 BILLION |
$3.1 BILLION |
|
2017 |
$126 BILLION |
$2.7 BILLION |
$2.6 BILLION |
Membership fees are a 100% profit margin strategy. In 2022 the Annual Profit was $5.8 Billion of which $4.2 Billion came from membership fees. In 2022 Costco had 65.8 million paid memberships and 118.9 million total cardholders with a renewal rate of 93%. Low prices attract and retain members. This loyal customer base provides the foundation for exponential growth as current members attract new members, generations mature and get their own memberships and new store expansion opens new markets.
2. High Quality - Low Cost Strategy
Costco uses a membership fee, warehouse-style, strategy offering a wide variety of products including groceries, pharmacy, electronics, appliances, automotive, clothing, seasonal and gas. The companies strategy is to buy a limited number of products in large quantities which allows them to leverage significantly lower prices and then pass those savings on to consumers. Building on this leverage, Costco is also able to repackage many manufacturers goods and distribute them under the Kirkland Signature brand, which accounted for $59 Billion of sales in 2021. Leverage allows the company to offer additional benefits such as extended warranties and return policies and sell high quality products, limiting most items to fast selling models, sizes and colours which turns over inventory quickly and reduces carrying costs. An efficient logistics and distribution system, volume purchasing and reduced merchandise handling allow Costco to operate profitably at significantly lower margins than competitors.
3. Recession Resistance – If the economy deteriorates, consumers will ‘trade down’ to retailers where they can still get high quality items for lower prices, making Costco more resistant to a recession than competitors. With a 93% renewal rate, memberships gained in an economic downturn will remain ‘sticky’ or loyal, adding to future growth.
RISKS
There are Risks to the Investment Thesis
What does all that mean at stockmarketHQ
Costco makes money by selling memberships. Low prices attract and retain members.
Costco is a Best-in-Class retailer with a strong management team that has executed on its business strategy and can navigate any economic environment and prosper. A loyal membership base provides the foundation for the recurring revenue model and benefits from the secular change in societal shopping patterns.
In 2022 Costco added 23 new warehouses and plans to add 24 in 2023 with a consistent and steady growth strategy. E-commerce provides another avenue of continued growth and market penetration.
Risks focus on two areas
A shareholder friendly philosophy of returning profits to investors through a $3.60/share dividend combined with a history of issuing ‘Special Dividend’ payments provides ‘the reason’ for Big Money Managers to hold Costco in their portfolios. The monthly sales report provides transparency in any shift in business trends so investors can make financial decisions.
The Recurring Revenue Stream (membership) business model, High Quality- Low Cost Strategy and Recession Resistance set the foundation for an Investment Thesis which should provide consistent future growth.
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