Costco – Deep-dive Analysis

Time for another deep-analysis post. In my last post in this category, related to Johnson and Johnson, I covered one of my “Core” holdings. In this post, I would like to cover a holding from the “Growth” category. As I have stated previously, the “Core” holdings represent the “sleep-well-at-night” category i.e. the foundation of my dividend growth portfolio. On the other hand, the “Growth” category are relatively early in their dividend growth history. These stocks are currently in an aggressive phase of growth and will (hopefully) continue to be in this phase for atleast the next decade or so. Eventually though, these companies will graduate into the “Core” category. But my hope is that, I will be in my retirement by that point in time. 🙂

Alright, enough with the background! Lets dive into the deep analysis for Costco (ticker: COST)

History & background

My first introduction to Costco was when I went to shop there with my room-mates, one of whom was a Costco member. I was a graduate student back then and, like all people in their student-life, very watchful of what I am spending on and eventual load on my wallet. The Costco business model seemed very interesting at first glance: Unlike other big-box retail stores, the store is a warehouse with controlled entry and exit points. The available merchandise is limited, but items could be bought in bulk quantities at a cheaper average cost to the consumer. The catch is that the consumer has to sign up for a Costco yearly membership, and there are three distinct levels of membership with each level having their own perks.

Costco made its humble beginnings when it opened its first warehouse back in September,1983 under the leadership of Jim Sinegal and Jeff Brotman. Among the two founders, I was particularly impressed with Jim Sinegal’s background. From starting out as a grocery bagger in FedMart, he worked his way up the chain to eventually becoming the VP of merchandising and distribution.

A few years ago, I read about Jim in the book titled “The Everything Store” , which was Jeff Bezos’s biography. In a breakfast meeting that Jeff had with Jim, Jim explains Costco’s business model as follows:

Though the selection of products in individual categories is limited, there are copious quantities of everything there – and it is all dirt cheap. Costco buys in bulk and marks up everything at a standard, across-the-the-board 14 percent, even when it could charge more. It doesn’t advertise at all, and earns most of its gross profit from annual membership fees... The membership fee is a one-time pain, but it’s reinforced every time customers walk in and see forty-seven-inch televisions that are two hundred dollars less than anyplace else. It reinforces the value of the concept. Customers know they will find really cheap stuff at Costco.

The other striking thing about shopping at Costco, and this is something that I have noticed across several warehouse locations here in the US, I could visibly tell that the employees there were happy. They must be being treated very well. A little digging around showed why. Here is what Jim Sinegal mentioned in one of the interviews a few years back:

It’s really pretty simple. It’s good business. When you hire good people, and you provide good jobs and good wages and a career, good things are going to happen.. We try to give a message of quality in everything that we do, and we think that that starts with the people. It doesn’t do much good to have a quality image, whether it’s with the facility or whether it’s with the merchandise, if you don’t have real quality people taking care of your customers.

Costco is known to have a better average pay rate for its employees as compared to the larger retail industry. Over 90% of the Costco employees qualify for a employer-sponsored health insurance plan, while the rest of the industry is at about 60%. It is, therefore, no surprise that Costco sees less employee turn-over rate. At the time of writing this, Costco has about 273,000 employees worldwide, operating across 800 or so warehouse locations in the world.

Business Breakdown

As stated previously, Costco uses a membership-based big-box retail store model. Members have access to limited selection of branded and private-label merchandise in larger volumes at lower costs relative to other retail stores. Costco purchases its merchandise directly from the manufacturers, routing them to specific docking points before transporting them directly to the warehouse locations. This distribution model helps them eliminate “the middle men” and helps in lowering distribution costs.

Merchandise is categorized into the following:

  • Food and Sundries: including dry foods, packaged foods, groceries, candy, alcoholic beverages, cleaning supplies
  • Hardlines: major appliances, electronics, hardware, garden and patio
  • Fresh foods: meat, produce, deli and bakery
  • Softlines: small appliances and apparel
  • Ancillary: gas stations and pharmacy

I did a breakdown of the merchandise sales across these categories since 2015 and this is what I found out:

As one can see, the “Food and Sundries” category drives most of the merchandise sales. However, the sales across all categories are showing an upward trend during this time period.

As a Costco member myself, I can vouch for the quality of the products that I buy from their stores. Even the private label in-house brand, Kirkland Signature, matches the other well-known brands for quality. From my personal experience, this was especially useful when shopping for diapers and wipes. Any parent reading this post can back me up here, the number of diapers and wipes needed when you have a young one is no laughing matter, it can be quite expensive. Costco was a life safer here. I could get the Kirkland diapers and wipes from Costco at a relatively lower cost compared to other well-known brands such as Pampers and Huggies.

Another important detail for the consumer is that Costco has a fantastic return policy on its merchandise sales, 90-day return for all major appliances and no-time limit for the other merch. This makes the entire shopping experience for the consumer very rewarding.

Membership

It is amply clear that maintaining or improving the membership base is a critical metric for Costco. I wanted to explore how Costco was doing in this regard. For this purpose, I analyzed the membership data since 2015.

Year201520162017201820192020
Total paid members446004760049400516005390058100
Worldwide membership renewal rate88%88%87%88%88%88%
US and Canada membership renewal rate91%90%90%90%91%91%

So the total membership base is increasing steadily. From what I could tell, the average YoY growth in total number of paid members is about 6%. However, what is interesting to note is that the membership renewal rate is fairly constant during this period: 88% worldwide and about 91% in US and Canada. This is telling me that the existing members choose to renew more often that not and the number of new members is consistently growing.

I also wanted to analyze the membership fees and how much revenue Costco was earning relative to the total revenue. Here is the data since 2008.

So the membership fees are averaging around the 2.15% of the total revenue since 2008. During the same time frame, total revenue for Costco has grown at a CAGR of nearly 11%. This shows that the membership fees have remained pretty flat for more than a decade. Quite impressive!

Warehouses

I wanted to analyze the warehouse growth for Costco. Since 2010, this is what the data looks like:

Year20102011201220132014201520162017201820192020
Number of warehouses527540592608634663686715741762782

So this shows that the average YoY growth in number of warehouses is about 4%. From the last investor presentation, Costco has about 804 warehouses worldwide. About 90% of them are in the US and Canada. About 4% of stores in Europe, about 7% in Asia (Japan, Korea, Taiwan and China) and remaining in Mexico and Australia. This represents a decent geographical spread, however there is scope for growth here as far as expanding into newer geographical markets.

Dividend History

At the time of writing this, Costco has an annual forward dividend yield of 0.71%. So nothing to get excited about there. 0.71% is well below the standard inflation rate. So why would a dividend growth investor choose to invest in Costco? The answer lies in dividend growth rate. Here is what the data looks like for the last decade

3-year Dividend CAGR12.42%
5-year Dividend CAGR12.32%
10-year Dividend CAGR13.36%

So on an average a 12% dividend growth rate, and if the stock is bought at the right value, the yield on cost over the long-run would be phenomenal. If you are curious about this subject, please read my post on yield-on-cost to understand this better.

Apart from the regular quarterly cash dividend, Costco has a practice of occasionally rewarding its shareholders with a “special dividend” every now and then. The most recent special dividend of $10/share was announced last year (2020).

I also analyzed the dividend payout ratio since 2008 and found this:

So the payout ratio is currently hovering around the 30% mark. This mean that there is plenty of runway available to the Costco management to increase their dividends if they choose to do so.

Financial Performance

The central question that a dividend investor is interested in is how safe is the dividend in the long run. To answer this, I look over the company’s financial statements to decipher the following:

  • Is the company’s revenue growing?
  • How profitable is the company?
  • What are the company’s assets and how much does the company owe in the short-run and the long-run?

For Costco, the company’s revenue is growing steadily over the last decade, as seen in the previous section. I also analyzed the Net margin since 2008 and it has remained flat for nearly a decade, this is a sign of a good stable business.

For the same period, Free Cash Flow, which I obtained by using the Cash Flow from Operations less Capital Expenditures, is trending upwards.

I then analyzed the trendlines for assets as compared to liabilities.

In this case, I am looking for trendlines that are diverging apart with assets growing much faster than liabilities. And the above graph reinforces that.

I also looked at the total number of shares outstanding on the filing date for the same time period.

Ideally, I would like to see a trendline that grows downwards. But in this case, I see an trendline in the opposite direction. Share buybacks, when done for the right reasons, will boost shareholder equity. This is not concerning at the moment, but it is something that I will keep an eye on in the long-run.

For my final analysis, I wanted to see how the stock has performed for a long-duration with dividends re-invested as compared to other big-box retailers. For this analysis, I picked Walmart (ticker: WMT) and Target (ticker: TGT). The comparison with Walmart was going to be particularly interesting, since Walmart also highlights how they offer products at a lower-cost to the customer. The model uses a hypothetical $10,000 invested starting at 1995 to present.

Costco has absolutely crushed this with a total return of almost 6800% as compared to Walmart’s 1655%! The comparison between Costco and Target is more closer in this respect with both stores offering relatively similar total returns.

Valuation

At the time of writing this, Costco is trading at a forward Price-to-Earnings ratio of near 41. So right of the bat, it is ridiculously overvalued based on this metric alone. I actually went back through historical data to see the trend in PE ratio since 2008.

So the PE has been trending up and it is at its peak at present. I used two other models to estimate the fair value. I performed a Discounted-Cash-Flow evaluation with a perpetual growth rate of 2.5% and FCF to Profit Margin ratio estimate of ~90%. After accounting for debt and also adding in a margin of safety, my fair value estimate is about $209. I also used a two-stage Dividend discount model evaluation and this yielded a fair value of roughly $266. At the time of writing this, Costco is trading at a price to $447. So clearly, well over my fair value estimates.

Management

I have already talked about Jim Sinegal above. He was the CEO and chairman of board until 2011 and remained on the board until his retirement in 2018. The current CEO and chairman of board of directors, Craig Jelinek, has almost been with Costco since its early days. He started out as a warehouse manager and worked up the ranks to now become the CEO.

Craig has not changed a whole lot of the company’s core founding principles since Jim’s departure. But as far as Costco’s business, he has transformed the company into a retail powerhouse. At the start of 2021, Costco was the 3rd largest global retailer and 14th in the list of Fortune 500 companies, with a market cap of almost $164 billion.

The board of directors also includes a name that most people in the investing community are familiar with, Charlie Munger. Charlie, in numerous interviews, has raved about Costco’s business model and it is not surprising to see why.

As seen through Glassdoor, Costco sees favorable rating amongst its employees with about 90% of them approving of the current CEO.

Risks

Every investment comes with its share of risks, and even a great company like Costco is no different. The biggest risk that Costco faces is its competition with another heavy weight like Amazon. A few years back, when Amazon bought the Whole Foods business, there was a lot of scare amongst investors about what this would mean for other retail giants such as Walmart, Target etc. Based on my research, I think Costco is well-positioned to ward off such threats. It has a unique business model with plenty of scope to grow into new areas and markets.

Summary

Costco is one of my biggest bets in the “Growth” category of my dividend portfolio. I am very bullish about this business and will always be on the lookout for adding to my existing position, whenever such an opportunity presents itself.

Do you own this stock? If yes, does your analysis line up with what I have presented above? Please let me know in the comments below.

Thank you for stopping by and reading this!

Disclosure: Long COST, TGT, no position in WMT at the time of writing this

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