{"id":5333,"date":"2023-05-07T09:09:38","date_gmt":"2023-05-07T13:09:38","guid":{"rendered":"https:\/\/ifintechworld.com\/news\/costco-why-munger-likes-it-and-so-should-you-nasdaqcost\/"},"modified":"2023-05-07T09:09:39","modified_gmt":"2023-05-07T13:09:39","slug":"costco-why-munger-likes-it-and-so-should-you-nasdaqcost","status":"publish","type":"post","link":"https:\/\/ifintechworld.com\/?p=5333","title":{"rendered":"Costco: Why Munger Likes It And So Should You (NASDAQ:COST)"},"content":{"rendered":"
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Investment thesis<\/strong><\/h2>\n

Costco Wholesale Corporation (NASDAQ:COST<\/span>) is well-known for being one of Charlie Munger\u2019s favourite businesses. He expressed his love once again during this year’s annual shareholder meeting of the Daily Journal Corporation (DJCO).<\/p>\n

There are a few reasons why<\/span> Charlie Munger admires Costco so much. Costco has a unique business model which is characterized by passing cost savings onto customers. Management prioritizes long-term success over short-term profits by keeping merchandise prices low rather than maintaining high gross margins. Selling high-quality products at relatively low prices translates into happy customers who are more willing to purchase a membership and consequently do more shopping at Costco warehouses.<\/span><\/p>\n

Furthermore, Costco has built a strong brand over the past decades. The cost leadership position in combination with the membership model and high customer satisfaction has resulted in a near impenetrable moat.<\/p>\n

The prioritization of long-term success is clearly visible in the financial results. For years, sales have been growing in the high-single-digit to low-double-digit range, resulting in impressive earnings and dividend per share growth. In the coming years, Costco will likely post earnings and dividend per share growth rates in the high-single-digits.<\/p>\n

Another reason why Munger is addicted to Costco is that the company earns a very high return on capital invested. Companies that maintain a high return on invested capital over a long period of time tend to be compounding machines, and Costco is no exception.<\/p>\n

In this article, I will discuss all of these points in detail and conclude with some risks and the stock valuation.<\/p>\n

Business overview<\/strong><\/h2>\n

Costco in general<\/strong><\/h3>\n

Costco is a very well-known company among investors. It operates an international chain of membership warehouses, selling a wide variety of merchandise at substantially lower prices than are typically found at conventional retailers. Because Costco warehouses offer one of the largest product category selections under a single roof, it acts as a one-stop-shop for small and medium-size businesses as well as individuals.<\/p>\n

Besides, Costco operates self-service gasoline stations at most U.S. and international locations. Inside the warehouses, Costco offers additional services such as a food court, pharmacy, travel agency, optical dispersing center, and hearing-aid center. All these ancillaries encourage members to do more shopping at Costco warehouses.<\/p>\n

On top of physical warehouses, Costco operates e-commerce websites in the U.S., Canada, Mexico, U.K., Korea, Taiwan, Japan, and Australia. Net sales for e-commerce represented approximately 7% of total net sales in 2022.<\/p>\n

The Costco Flywheel Model<\/strong><\/h3>\n

What really distinguishes Costco from other retailers is that the business model is not so focused on maximizing gross margins on products sold, but on driving high sales volumes and rapid inventory turnover. Due to operating efficiencies (such as lower labor costs, advertising costs, marketing costs etc.), Costco is able to operate profitably. Customers benefit from this as operating efficiencies are translated into lower product prices.<\/p>\n

The thing is that you are only allowed to shop at a Costco warehouse if you are a member (this also holds for Costco operated gasoline stations). This drives the Costco Flywheel Model<\/em> (see figure below).<\/p>\n

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The Costco Flywheel Model (Author)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

The low prices, high-quality products and ancillaries attract more people who need a membership to be allowed to shop at Costco. This increases the number of memberships. Because people have a membership, it is likely that they do more purchases at Costco which drives up Costco\u2019s sales volumes. Consequently, Costco\u2019s scale increases so it has more negotiating leverage with suppliers for even lower purchasing costs, and so the circle repeats.<\/p>\n

It’s all about memberships<\/strong><\/h3>\n

Memberships are the key of Costco\u2019s business model. While membership fees were only 1.9% of total FY2022 revenue, they were responsible for more than half of total operating income. This is because the operating margin on net sales is very low, and membership fees are directly translated into operating income.<\/p>\n

Currently, Costco offers three types of memberships: Executive, Business, and Gold Star. Gold Star memberships are meant for individuals who don\u2019t own a business. Business members must own a business to qualify for this membership type and may purchase additional membership cards for \u2018affiliates\u2019. Paid cardholders can upgrade to an Executive membership for an additional annual fee of $60. It is important for Costco to grow the share of Executive members, because this increases the average fee per member. Moreover, Executive members are even more inclined to shop at Costco, driving up sales volumes and customer loyalty.<\/p>\n

Customer loyalty can be easily measured by taking the historical membership numbers. The member renewal rate was 93% in the U.S. and Canada and 90% worldwide at the end of FY2022 (excluding affiliates of Business members).<\/p>\n

The following graph shows the number of paid memberships and total cardholders. There has never been a year with a decline in the number of memberships, even during the great financial crisis. Surprisingly, YoY membership growth has been in the 5%-8% range for years. So it\u2019s a very positive sign that membership growth is not slowing down despite the growing membership base. I think that this growth can continue as Costco expands its worldwide footprint.<\/p>\n

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Membership growth trend (Annual reports; Author)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Costco’s wide moat<\/strong><\/h2>\n

A competitive industry<\/strong><\/h3>\n

The retail industry has always been highly competitive based on factors such as price, merchandise quality and selection, location, distribution strategy, and customer service. Costco competes on a worldwide basis with global, national, and regional wholesalers and retailers. The main competitors in the U.S. according to the annual report are: Walmart, Target, Kroger, and Amazon. These are only the largest players.<\/p>\n

Competitive advantages<\/strong><\/h3>\n

Despite the high competition on all fronts, Costco has built a strong moat around its business. The main competitive advantages are the brand and cost leadership.<\/p>\n

Brand<\/strong><\/em>: Costco has a very strong brand awareness. If you ask random people in the U.S. and mention the word \u2018Costco\u2019, the first reaction is that they simply love it. Brand recognition in the rest of the world is lower, but that\u2019s because the warehouse penetration rate is still very low in most countries outside U.S. and Canada. I believe this will change in the future with the international expansion strategy.<\/p>\n

Private-label brand Kirkland Signature is also becoming more popular. Kirkland Signature products are high quality, offered at prices that are generally lower than national brands, and they help to differentiate in-warehouse merchandise offerings, and generally earn higher margins on products sold. Management expects that the increase in sales penetration of private-label items will continue.<\/p>\n

Cost leadership<\/em>: <\/strong>As I mentioned earlier, Costco sells merchandise at lower prices than competitors. Instead of increasing gross margins as much as possible (like other retailers do), Costco shares its scale advantages with their members. And that\u2019s fine, because in the end Costco\u2019s profits are less dependent on merchandise sales. Keeping up the membership renewal rate is the key priority.<\/p>\n

The annual report of 2022 stated the following:<\/p>\n

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\u201cWe do not focus in the short-term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our \u201cpricing authority\u201d \u2013 consistently providing the most competitive values.\u201d<\/em><\/p>\n<\/blockquote>\n

I believe that both the brand and cost leadership will become even stronger in the future as the company continues to grow its global footprint, and more people around the world will come into contact with the Costco brand and likely become members.<\/p>\n

Financial performance<\/strong><\/h2>\n

Net sales and membership fees <\/strong><\/h3>\n

Total sales can be divided into net sales and membership fees.<\/p>\n

Net sales include all merchandise categories, warehouse ancillary and other businesses (e-commerce, business centers and travel). Net sales growth mainly depends on warehouse count growth and same store sales growth. The current annual warehouse count growth hovers around 3%, but is expected to slowly decline in the future. That’s logical as Costco\u2019s global footprint increases, but it means that same store sales growth is becoming a more substantial component of net sales growth. Same store sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket).<\/p>\n

The table below is copied form the FY2022 annual report. What we can see here is that, once a warehouse is opened, sales per warehouse tend to grow as time progresses. If we take the average of all 838 warehouses at the end of FY2022, average sales per warehouse grew from $160mln in FY2013 to $245mln in FY2022 \u2013 that\u2019s a 4.8% CAGR.<\/p>\n

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Average Sales Per Warehouse (FY2022 annual report)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Now let\u2019s look at net sales development throughout the history (again, this is without memberships). Net sales growth has been negative in only a single year since 1995, namely during the great financial crisis. The average net sales growth rate lies at 10.3%.<\/p>\n

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Net sales growth trend (Annual reports; Author)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

How about those memberships? Membership fees have grown every year since 1995 with a CAGR of 9.8%. This rate slowed to 7.7% on average over the last ten fiscal years, probably driven by a lower warehouse count growth rate. Expected fee increases plus membership growth drive future membership fees growth. Costco also aims to increase the penetration of Executive members to generate a higher average fee per member.<\/p>\n

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Membership fees growth trend (Annual reports; Author)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

ROIC<\/strong><\/h3>\n

For me, return on invested capital (or ROIC) is the most important metric when analyzing a business as it indicates the competitive advantages. Charlie Munger is also a huge fan of businesses with a high ROIC:<\/p>\n

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“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns<\/strong>. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result<\/strong>.”<\/em><\/p>\n<\/blockquote>\n

The following graph shows the ROIC of Costco since FY1995. I also added the ROE as this metric is more conservative for companies with a net cash position. We can see that Costco\u2019s ROIC and ROE have long been in the 10%-15% range until 2012. After that, both metrics gradually increased to the high 20s. A ROIC above 15% is extraordinarily high for a retail company, highlighting Costco\u2019s strong competitive advantages.<\/p>\n

So given the fact that the current ROIC is 29%, will future total annual returns on COST stock also lie around that rate? Maybe, but I think that this is not a probable scenario. The issue is that valuation multiples have also increased together with the growing ROIC. More on the relationship between ROIC and PE ratio later in this article.<\/p>\n

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ROIC and ROE trend (Annual reports; Author)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Dividend<\/strong><\/h3>\n

Costco is a special company, not only for its business model, but also for the dividend policy. Unlike most dividend stocks, Costco pays regular and special dividends.<\/p>\n

The regular dividend is paid every quarter and Costco aims to increase this dividend every year. Currently, Costco has raised the quarterly dividend for 18 consecutive years \u2013 a future dividend aristocrat in the making! The following graph shows the regular dividend per share, earnings per share, and corresponding pay-out ratio since 2005. The pay-out ratio on earnings per share has been pretty constant in the 25%-30% range.<\/p>\n

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EPS and DPS trend (Annual reports; Author)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Costco also pays special dividends from time to time. These amounted $7.00\/share in 2012, $5.00\/share in 2015, $7.00\/share in 2017, and $10.00\/share in 2020. I don\u2019t know the exact reason why Costco chooses this strategy, maybe it\u2019s because it offers them more flexibility in capital allocation. They certainly have the balance sheet and cash position to be a bit more aggressive on share buybacks and dividends, so I think we can expect further special dividends in the near future.<\/p>\n

Valuation<\/strong><\/h2>\n

The PE or \u2018price to earnings\u2019 ratio is the most well-known and simple valuation method out there. In the following, I will value Costco stock based on historical PE multiples. Moreover, I will address the relationship between PE, earnings growth and ROIC to get a better grip on Costco\u2019s fair PE ratio.<\/p>\n

Let\u2019s start with the historical PE ratio. In the graph below I plotted the PE ratio since 2000 based on underlying earnings per share and the average share price for each year. The first thing I noticed is that Costco stock has always been pricey relative to the market average PE. Even during the great financial crisis when multiples of most stocks plummeted to single-digits, Costco\u2019s PE remained above 20. The average PE ratio since 2000 is 27.1x. Assuming earnings per share of $14.52 for FY2023, this would result in a fair value of $393 per share. Currently, Costco stock is trading around $499, so this is significantly higher than the historical average.<\/p>\n

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Historical PE ratio (Annual reports; Author)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

I have always found Costco\u2019s high valuation multiples pretty scary. But for some reason, investors are always willing to pay a big premium for the stock. Even Charlie Munger said during last year\u2019s Daily Journal Meeting that he would be willing to buy Costco now with a multi-decade time frame. So I asked myself why.<\/p>\n

One important aspect of Costco is the 29% return on invested capital over FY2022. This is an extraordinarily high return. Logically, one would be willing to pay a higher multiple for a business with high returns on investment. Likewise, higher earnings growth justifies to pay a higher premium for a business. So is there a method to estimate the fair PE multiple based on these metrics? Yes there is!<\/p>\n

The Gordon Growth Model is a simplified version of the DCF analysis. This article describes how you can reformulate the Gordon Growth Model in a more explicit manner:<\/p>\n

P\/E = (ROIC \u2013 g) \/ ((r \u2013 g) * ROIC)<\/p>\n

In the formula, \u2018ROIC\u2019 is the return on invested capital, \u2018g\u2019 represents the earnings growth rate, and \u2018r\u2019 is your personal required rate of return.<\/p>\n

The formula has some simplifications. However, it is a really simple way to show how the fair PE ratio is correlated with the ROIC and earnings growth rates. Let\u2019s showcase this by using Costco\u2019s numbers.<\/p>\n

I assume that Costco can grow its earnings by 8.0% annually and my required rate of return is 10%. In FY2008, Costco\u2019s return on invested capital was 16% while in FY2022 it increased to 29%. The following table shows how the fair PE multiple for Costco has changed from 25x in FY2008 to 36x in FY2022. At least, this is what the market should be willing to pay for Costco stock according to this theory.<\/p>\n

<\/span><\/p>\n\n\n\n\n\n\n\n
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Scenario<\/strong><\/p>\n<\/td>\n

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FY2008<\/strong><\/p>\n<\/td>\n

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FY2022<\/strong><\/p>\n<\/td>\n<\/tr>\n<\/thead>\n

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Earnings growth rate <\/strong><\/p>\n<\/td>\n

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8%<\/p>\n<\/td>\n

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8%<\/p>\n<\/td>\n<\/tr>\n

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Required rate of return <\/strong><\/p>\n<\/td>\n

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10%<\/p>\n<\/td>\n

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10%<\/p>\n<\/td>\n<\/tr>\n

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Return on invested capital<\/strong><\/p>\n<\/td>\n

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16%<\/p>\n<\/td>\n

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29%<\/p>\n<\/td>\n<\/tr>\n

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Fair PE ratio<\/em><\/strong><\/p>\n<\/td>\n

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25x<\/em><\/strong><\/p>\n<\/td>\n

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36x<\/em><\/strong><\/p>\n<\/td>\n<\/tr>\n<\/table>\n

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