Costco (NASDAQ:COST) is a beloved discount retailer able to offer consumers their essentials at the lowest prices due to its efficient business model and cost-focused corporate culture. It is even becoming somewhat of a cultural icon due to its consistent focus on delivering value for decades. It is no surprise that increasing numbers of consumers turned to Costco during the period of rising inflation.
Costco is a great quality business. It will continue growing at home and abroad, and it will most likely maintain its cost advantage in North America. The profit margins also seem to be set for growth, especially when the overdue membership fee increases are introduced.
There is just one nagging question that bothers us, - the price. Costco is trading at a 50X earnings multiple, twice the long-term average. We believe that the stock is considerably overvalued, on the other hand, we strongly advise against shorting it. In this article, we will explain why.
Has The Meme Stock Bug Bitten Costco?
What’s not to love about COST? The sky is the limit for this stock, especially considering how much traction the company is getting in China. It is practically a no-brainer for momentum-focused speculators.
On top of this, Costco is an everyman brand. The rich wall-street types probably do not frequent their budget-friendly stores. The company takes a stand for the simple people who struggle with their grocery bills. Costco is the protagonist in the story of the continuing struggle of the everyman.
You probably have already guessed where I’m going with this one. In case you have missed the news, the meme stock mania is back, and the already overvalued Costco just keeps on surging higher.
COST is a lot more liquid than GameStop (GME), neither is it broadly shorted, and therefore nobody should expect the violent intraday price spikes witnessed with GME. Tesla's surge during 2019-2021 was also much more rapid, as the company experienced financial issues in the years prior. The price action of COST is not as violent as it is of high quality, nevertheless, it is riding the same market trend.
Meme stocks as well as other speculative behaviours in the markets mostly correlate to market peaks. Markets have been hot this year, boosted by resilient economic performance and potential FED rate cuts. Soft landing! - the markets concluded, and the stocks started roaring higher.
Costco is overvalued, but nobody cares. The herd instinct is strong, and traders fearing to miss out will not look at your discount dividend model or listen to your well-reasoned arguments. The stock price makes no sense, but you should not stand in the way of the herd. Your calculator is not a good shield from a stampede. Do not short Costco!
The Growth of Costco
Costco is a great business that will most likely maintain its growth for years to come. But the growth has been and will continue to be rather gradual, and it would take many years for the business to grow into the current valuation.
COST has three main drivers of its top-line and earnings growth: (i) New store openings; (ii) Same-store sales growth, and (iii) Membership subscription and fee growth and (iv) E-commerce sales. Let’s look at each one of these drivers individually.
New store openings:
Costco has 874 warehouses worldwide and typically opens 20-30 new stores annually, which equates to ~3.4% of selling space expansion.
Costco has recently opened their first stores in China, and the customer reception was quite positive. Costco Bulls are excited about the growth potential in this enormous market.
We also believe that Costco has the potential to grow in China, though the business there is still very small and has only a marginal effect on the overall sales of the group. Only 6 stores are operating there, and the expansion plans are still quite gradual.
Retail is a ferociously competitive and dynamic industry. Customer preferences change quite often as new formats arise, and tastes are also different across markets. There are very few examples of internationally successful mass market retailers, as formats do not travel well. Costco operates in a niche cash and carry market in most of the international locations.
Costco is strong in the US as it is the lowest-cost retailer of commodity staples and does not have to worry about changing consumer preferences. In China, though, the company will have to find a format and market approach that works, if they plan to penetrate the market to a significant extent. So far, it is just a niche seller of premium-quality goods, it is not the lowest-cost retailer.
It remains to be seen if Costco can emulate the success of Sam’s Club in China. Having said it, Walmart entered the Chinese market years ago and has been rather successful there. If the Chinese expansion potential was the main driving force behind the share price of COST, then similar, or even greater, growth potential should be priced into Walmart as well. The latter trades at a lot more modest 26X earnings multiple and has a viable e-commerce strategy.
Same-store sales growth:
Same-store sales growth has accelerated in recent years due to rising inflation, as well as the increasing popularity of the budget retail model and the growing acceptance of private-label consumer staples.
Over the past 4 years, same-store sales at COST have grown by ~8.4%. During the 4 years prior, the same-store sales were growing at around 3%. Given the reduced inflation and assuming some recovery in disposable income, a lower-bound same-store growth trend of probably about 4-5% would be a reasonable assumption. Combining this with 3-4% growth in stores, an overall 7-9% merchandise revenue growth trend looks likely.
Membership subscription and fee growth:
Membership numbers are likely to grow in line with new store openings, as an increasing number of customers join the club in new locations. Membership numbers should also be expected to grow with same-store sales volume growth, as Costco gradually gains market share in the markets it already operates in.
Assuming a continuing ~3% new store expansion rate, as well as say ~2% same-store volume growth, a 5% membership growth rate seems likely. Over the last 2 years, total paid members have grown at a rate of ~6.5%. Growth acceleration in the latter years was likely due to the favourable operating environment.
The second important characteristic in determining the membership revenues is the average fee levied. Costco in the past has raised the fees about every 5–6 years, and the next uptick is now overdue. In 2017, the cost of Gold Star membership was raised from $55 to $60, - a marginal increase. We could also expect a marginal increase this time around.
Overall, the membership fees are likely to rise by 5-10% over the next 5 years, depending on the aggressiveness of the rate rises.
E-commerce sales:
We added this as a category as it is now being broadly discussed, though we do not believe that e-commerce will have a meaningful impact on the sales growth of Costco. Yes, online sales are growing, but they are growing from a very small base. During the first 24 weeks of fiscal 2024, E-commerce sales have grown 12%.
It is quite clear though, that Costco will not rival Amazon and neither will it be able to compete with Walmart in selling goods online.
Costco’s business model is based on large warehouse-like destination stores, with significant local-scale advantages. Costco's business was designed to stand up to growing e-commerce, it was not designed to take over e-commerce. Costco might have an efficient sourcing operation, but it has no last-mile logistics capabilities.
Costco is continuing to roll out the network of pickup lockers, and in time might introduce other initiatives, which increase shopping convenience for its members. For example, Costco has partnered with Instacart to offer same-day delivery services from a number of its warehouses.
Order pickup and last-mile delivery are not cheap. Given the razor-thin gross margins of Costco, it’s hard to see how the company would make money with home deliveries unless the customer pays for it. Costco’s trademark strategy is to forgo shelf stocking expenses altogether by simply placing stock on pallets on their shop floor. Why would anybody expect the company to pick up individual grocery items and deliver them to the customer a few miles away? E-commerce is completely opposite of what this company is.
Overall top-line growth:
Putting it all together, Costco merchandise sale revenues are likely to grow in the range of 7-9% and membership fees could grow by about 5-10%. Overall, a 7-9% top-line growth trend looks reasonable in a world of reduced inflation. This is an attractive growth rate, but does it warrant the earnings multiples at which Costco is trading? - The answer is definitely no for us.
Costco Valuation Multiples
Let’s look into the valuation of COST. Costco is a stable cash-generative business operating in a mature industry, and the EPS of the company gives quite a good indication of what the free cash flows of the business are.
COST is currently trading at an all-time-high price-to-earnings ratio of 50X. It is the same business as it was 10 or 20 years ago, operating in the same market, with the same business model, but now the marketplaces twice as high a valuation multiple on it as before.
Looking at next year's earnings projections, Costco is one of the most expensive stocks in the market, with a valuation even considerably greater than that of Walmart (WMT) or Amazon (AMZN). Surely, Amazon is also a retailer, and just like Costco it is expanding in China, but Amazon also owns a leading cloud business which will benefit enormously from the roll-out of AI. Walmart also has great e-commerce ambitions and has been successfully operating in China with Sam's Club for years. So why is Costco significantly more expensive than Amazon and Walmart?
As noted above, Costco does have solid long-term growth prospects, just like before, and will continue growing. The Chinese and especially the e-commerce growth opportunities are overblown, though. On top of this, other industry peers, with strong e-commerce and Chinese businesses, such as Amazon or Walmart, trade at significantly lower multiples.
We believe that Costco trades at 49X forward earnings precisely because of price momentum! It’s not the earnings growth that is driving the stock at this point.
Beware of Shorting
The valuation multiples of Costco look unreasonable and will come down eventually, but nobody knows when. Before going down, they can also climb up considerably. John Maynard Keynes liked to say, “markets can stay irrational for longer than you can stay solvent”.
Short selling is dangerous, especially when trendy stocks are concerned. Fundamentals do not matter in these situations. The company could be trading at 100X or 200X earnings, if the stock price was rising, some people would still be buying.
Costco is an established high-quality business, but surprisingly, it seems to have been bitten by the momentum trading bug often associated with meme stocks or sexy growth companies. We see this company as being significantly overvalued, but we do not intend to short-sell it.
Bottom Line
Costco is a well-established, great quality growing business beloved by its customers for great value products. The company is likely to continue growing its revenues at an average rate exceeding 7% and the earnings are very likely to exceed this rate as the margins expand.
It’s no surprise that investors are rushing into the stock, especially after the company delivered a stellar performance in the inflationary environment. First, Costco was able to pass on the inflationary cost increases, and second, a larger share of budget-strapped customers have started frequenting their stores. Member numbers have grown 16% over the last two years, significantly above the multiyear trend.
Can the stellar performance of the last two years continue? Very likely no. The stock price, on the other hand, is assuming acceleration of the growth into an impossible territory as COST is trading at 2X its historic valuation multiples.
We believe that Costco is trading up, boosted by its price momentum. Putting it in simple words, people are buying the stock as they expect the price to go up, just because of that.
In our opinion, the fundamental value will eventually prevail, and valuation multiples will come down, on the other hand, trendy stock can be disconnected from fundamentals for extended periods. COST is overvalued, but we caution against shorting it.