2024-01-03 11:55:07 ET
Summary
- Costco is a well-run business with excellent future prospects.
- The stock is currently overvalued, trading at a high multiple of earnings.
- A valuation framework suggests a reasonable buy price in the mid $400's range.
Costco Is Not Flying Under Anyone's Radar - Where To Buy The Stock?
My first article on Seeking Alpha after a 13-year hiatus will focus on Costco Wholesale Corporation (COST), a company nearly everyone agrees is currently overvalued. Nearly everyone also agrees it's a fantastic business, which justifies a lofty valuation. Costco recently reported decent quarterly results and the stock has headed further into the stratosphere. The stock is up something like 14% this month, >48% this year, and ~240% over the last 5 years, while currently trading north of 40x earnings.
Given this, how can a value investor add Costco stock to their portfolio? Strictly from a wonderful business perspective it could be considered a core "forever" holding, but as we know, overpaying for even a great company can lead to mediocre returns. Spoiler alert: I cannot justify buying the stock anywhere near current prices. So my plan here is to provide a framework to help decide what price is worth paying. The other reason I chose Costco is it was arguably Charlie Munger's favorite company, and with his recent passing it seemed a nice tribute to someone I have learned a great deal from. And oh yes - I don't own a single share but would really like to based on the business quality.
Not Your Average Warehouse Club
This article is not meant to be a deep-dive analysis of Costco's business. There are several good articles by other Seeking Alpha authors for that, and I think most folks are familiar with Costco's general business model. It builds large no-frills warehouses, stocks them with limited SKUs in large quantities that it sells for rock-bottom prices, and charges a membership fee to access the warehouses and a suite of additional services.
The brilliance though is in the details. This is not just another Sam's or BJ's (though management cites Sam's as their toughest competitor). For one, Costco has perfected the art of curating a limited selection of name-brand goods which their members find attractive, and offering them at the lowest prices found anywhere. Management states that they practice " pricing authority " vs competitors. Their private-label Kirkland Signature brand (20+% of non-gas sales) offers even better values, and has become a franchise in its own right. The business model is designed to make very little profit on the actual merchandise itself (~10.5% gross merchandise margins, ~1.5% operating margins before membership fees). But the $4.7B in membership fees drops straight to the EBIT line, so that the model nets an operating margin of ~3.5%, or $8.1B on $242B in sales in FY23.
Compared to other retailers, Costco has low overhead due to the no-frills warehouses which act as both warehouse and retail floors, along with limited business hours and hence lower employee hours. They pay market-leading wages and provide superior benefits, so they enjoy low employee turnover and reap the efficiency benefits of motivated, happy employees. They drive exceptional pricing from vendors through purchasing high volumes of limited (but very carefully chosen) products. In the case of Kirkland products, Costco is the only customer and stays very close to the vendors allowing them to drive pricing and quality. Costco's rapid turnover facilitates fast vendor payment which can result in early payment bonuses. Even so, they frequently pay vendors AFTER the goods are sold. I.e., a negative cash conversion cycle and free vendor financing. Any cost benefits are passed on to their customers.
Membership Has Its Benefits
Costco further delights its members with a treasure hunt atmosphere created through superior merchandising of interesting and unexpected products. Costco has successfully created an image of high-end panache while still being a warehouse club - something not shared by competitors. Specialty items including 6-figure jewelry, gold bars, $1,000 Wagyu beef , fine wines, fine foods and more attract a more wealthy and higher spending clientele. Online sales combined with an in-house logistics service provide members with convenient delivery of large and bulky products and free disposal of replaced items. So not only members confident they are getting rock-bottom pricing, but they receive valuable free services as well.
Costco Next allows members to have non-warehouse specialty items drop shipped from scores of manufacturers directly to their homes. Finally throw in a large suite of ancillary member benefits: pharmacy, gas, travel, tires, optical, car shopping, and the $60-$120 annual membership fee seems a mere pittance. The $120 executive membership even provides 2% cash back (up to $1000 annually). Over 90% of memberships are renewed annually. This rate looks worse than it is, as there is always some initial high turnover in first-time memberships when new warehouses open each year, with as much as 50% cancellations in year one (management calls these folks "looky-loos"). As an individual warehouse matures the renewal rate moves well above 90%. Over 60% of memberships are on auto-renewal.
Long Runway For Conservative Growth
The company grows through adding additional warehouses, and growing same-store sales and memberships at existing warehouses. Currently there are 867 warehouses with 591 in the US. Management expects to add another 150 clubs in the US over the next 10 years, and internationally there is plenty of room for expansion. In 2024 management expects ~30 net warehouse additions, 70%+ in the US. Management believes that growing same-store sales is the most important driver of profitability, and they have a consistent record of driving these at 4-5% per year. If you read the last quarterly transcript , you will see that management repeatedly cites that they are a sales-driven concept. And let us not forget those all important membership fees. They are periodically increased as well. In fact it's been 6 years since the last increase, and management has stated it's just a matter of "when" not "if" they will be increased, so the market expects this. I wouldn't be looking for a major bounce on an announcement of a fee increase, but it didn't come in the most recent quarter. On this topic, the CFO commented during the call:
We would want to look at strong renewal rates, strong new sign-ups, strong loyalty, and we have all that. So I think it's a question of, we haven't needed to do it. We like providing extreme value. Certainly, while we've gone a little longer than the average increase, we feel we certainly have driven more value to the membership. So I'll use my standby answer, my answer, it's a question of when, not if. But at this juncture, we feel pretty good about what we're doing.
Costco company presentation Costco investor presentation
The acid test of operational greatness, in my opinion, is return on invested capital. No worries there as ROIC has grown steadily over the past 20 years, now approaching 20%.
Mr. Market Agrees - Should We?
Hopefully you would agree that this is a fantastic business likely to keep growing well into the future, and one that you would love to own part of. Unfortunately for value investors, Mr. Market agrees, and the stock currently trades at a high growth tech-like multiple north of 42x earnings. So here I intend to demonstrate how I might determine where I would want to buy the stock. But not only that, how strict do I need to be with my buy price? If you are a long-term investor (a redundant phrase - all true investing is long-term), you can afford to fudge a bit on your buy price. I frequently see comments like "stock X is a little too expensive right now - if it goes down $5 though I am in." In my experience, it's far better to own at least a partial position in a great company, bought at a somewhat less than perfect price, than none at all. Don't hold out for the last few dollars. Buy some now. Plus, a long holding period dilutes the effect of a higher than ideal purchase price.
I use FAST Graphs to get an idea of where the market tends to value a particular company historically. It really can be a powerful tool IF you avoid making certain mistakes. Let's look at Costco's long-term plot of price relative to PE.
The stock has averaged ~27.5x earnings since 2004 - a premium PE for a premium company. But since 2016, Mr. Market seems to be much more enthusiastic about its value - you can see the price curve lifts off from the blue 27.45x earnings curve and heads skyward. Since then Costco stock has traded at ~36x earnings - a big jump, and a multiple very difficult for a value investor to stomach!
Costco normal PE multiple since 2016 (FAST Graphs)
Be Careful When Interpreting Past Valuations
This brings up cautionary point #1 - when using historical PE's the time frame used can massively change your view of the business's valuation. The question is, should it? A value investor would want to see a clear improvement in business fundamentals if the typical PE, the valuation the market has decided it likes to pay over time, suddenly increases by more than 30%. Is the company really so much more valuable? In this case we are going from a fairly high but arguably justifiable PE for a top-notch, high return, moderate yet consistent grower like COST to a tech-like high growth PE.
Analysts forecast earnings growth to slow from mid-teens recently to more like 9% in the foreseeable future. The company certainly got a boost during the "unusual" years of 20-22, with management stating that they "benefited in many ways." These would include comps north of 7% in 21-22. So the table looks at the "more normal" period between the GFC and the pandemic as well, and we see that growth was moderate versus the much higher mid-teens seen rates lately. No doubt the market has recognized the recent growth bump, contributing at least partially to the expanded multiple.
Author using company data
In addition, low interest rates have played a part in juicing valuation and growth in the prior decade. By 2012, the 10yr treasury had settled at 2-3%, a level not seen since the early 50's. And, of course, it bottomed below 1% during the pandemic period. Low interest rates translate to higher valuations through lower discount rates. The 10-year rate serves as the risk free rate, to which is added an equity risk premium to determine the discount rate for future cash flows. But now, as interest rates rapidly surged to more "normal" levels, Costco's valuation hasn't reflected the rise in the form of a contracting multiple. Higher discount rates = lower intrinsic value = lower price. Not for Costco stock though. Yet?
10 year treasury rates (St. Louis Fed)
Sales growth long-term is most likely to stay near high single digits in my opinion. We can expect a few percentage points from store count, plus 4-5% from comp sales growth. FY23 sales were up 9% vs FY22, and Q1 24 sales were up 6.1%. Net margin though has been increasing the past 10 years. Versus historic levels around 1.75%, recent margins are north of 2.5%. So this has helped the bottom line grow faster than sales. But remember Costco is not profit-margin driven. I wouldn't expect margins to grow indefinitely.
Are there other business developments that should prompt us to pay a significantly higher PE for Costco vs its long-term historical levels? Well we already know it is a fantastic company. And we shouldn't expect a significant acceleration in topline growth. In fact we should hope that growth doesn't accelerate too much. One of the best ways to destroy a business that grows partially by growing store count (retailer or not) is too-rapid or ill-advised (poor return) over-expansion. So my answer is no - it's still the same great company, the same conservative management, and if anything we should expect growth moderation simply due to its size (3rd largest retailer globally) and a potentially less favorable environment going forward. Management recently stated that store growth overseas is constrained both by real estate and the ability to move existing experienced teams to help open new stores. Again we shouldn't expect a material jump in long-term growth rate.
Setting A Buy Price Based On Prior Low Valuations
One way I set a target buy price is to examine whether there is a particular PE range for a company where it historically bottoms when the market is temporarily unhappy with it, or just generally unhappy. For many stocks, we repeatedly see them bottom at a characteristic (for that particular stock) PE multiple. For Costco, we can see that even during the great financial crisis ((GFC)) in 2008, it rarely traded for <20x earnings. The absolute low during the GFC was just under 15x. Assuming you missed the bottom, if you were able to pay 20x back then, you should've done so.
Costco normal PE ratio vs price 2006-2010 (FAST Graphs)
During the past decade we have seen that COST has rarely traded below 25x earnings (red arrows below) while bottoming closer to 31x earnings (including during the pandemic) since 2019 (blue arrows).
Costco normal earnings multiple: until recently the stock repeatedly bottomed around 25x earnings (pink line, red arrows), and more recently 31x (blue line and arrows). (FAST Graphs and author's interpretation)
So based on this simple analysis, what might one pay for COST? History tells us not to expect a 15 PE outside of a crisis. And even in a recent crisis, the best you got was twice that, over 30x earnings. Certainly mid 20's multiples seem quite safe, as the stock has rarely traded below that range for much of its history. And anything near 20x is a gift. Over the past 10 years, the stock has repeatedly bottomed at 24-25 x earnings. So to me a price that offers a mid-high 20s multiple of earnings, ~$400, would be a clear entry signal. Or, I could choose to start a position at more recent lows of 31x earnings - this would equate to a price of ~$490. This assumes of course, that the business doesn't change significantly for the worse (or the better). But with a company like COST, things don't change much. That's part of its beauty. Still, we are a long way from those prices.
Should We Extrapolate Recent Valuations Forward?
Then what to make of the last several years of nothing but 30x+ multiples? Does that mean we can expect that those will continue and this is a new trading paradigm for Costco stock? It may well be, especially if the market enters rally mode, but I would expect that over time it is far safer to assume that COST averages a mid-high twenties multiple. So I would buy expecting eventual multiple contractions, and if the multiple stays elevated, that's just a bonus.
When I wrote this, the stock traded at ~$658, very close to an all-time high. This is versus earnings of $14.16/shr in FY23 and a predicted $15.73/shr in FY24 (August), or an incredible 42x forward earnings. 25x forward would be $393, requiring a huge 41% drop. Over the last 11 years, the average earnings beat/miss was a 3.5% beat, and this is skewed by the unusual environment of 21/22. So I wouldn't expect any large earnings beats, the analysts generally predict them quite well for this very stable business. Costco updates sales results monthly so there are rarely any big surprises.
Expected Future Returns
So now it's decision time. If I wait to buy in the mid 20x earnings, it may be a very long wait before I can add this stalwart to my portfolios (I have never owned it). It's been more than 5 years since we last saw that valuation. What can I expect if I just buy now? For a truly long-term investor possibly holding for a lifetime, the buy price is less important, as any potential multiple contractions are diluted over decades. I rarely buy a stock expecting to sell it - ever. I am buying a great business, and I want to allow it to work for me indefinitely.
Looking at the following table, and assuming I want to earn at least 8% over time and preferably 10+%, the picture becomes clearer. Here I assume that eventually COST will sell for a 25x earnings multiple. This is still a premium multiple, but I feel it is justified for such a great company, even in its more mature years. This is a company that is better than the average S&P 500 company, and the S&P has traded around 18-19x earnings for decades. So with these multiple contractions to 25x, sometime in the future, we get the following:
Potential future returns of Costco stock depending on buy price and holding period (Author)
We see that if the multiple contractions are extended over many years, the expensive buy price becomes less important. But for me, I look at the 10 year holding period and a buy price of $450 looks like the most I would be willing to pay. In this scenario it gets me an ~8.5% CAR. Not great, but maybe good enough to initiate a position. It seems likely that double-digit price returns are going to require waiting for a far cheaper price or continued high multiples.
Dividends And Buybacks Won't Help Much
Dividends will add some return but alas COST currently yields only 0.62%. That said there have been 5 special dividends paid in the last 10 years (where they tend to take most of the net cash surplus on the balance sheet and distribute it to shareholders), the most recent to be paid in January 2024. Even so, this is still not anything close to a high yield stock. The company does buy back stock, but it mainly just offsets stock-based compensation. So we can't expect much icing on the return cake from these sources.
Costco diluted shares outstanding (FAST Graphs)
Intrinsic Value Estimates Won't Help Either
What about so-called intrinsic value? Might this provide a more optimistic picture? I have learned to stay away from overly complex DCF models - false precision does not lead to better outcomes, and in the end it's the basic assumptions (growth rate, discount rate, terminal value), not detailed financial modeling that drive the output.
Besides Costco's very stable operating results, we also find that free cash flow tracks earnings very closely over time (it tends to average about 97% of net income). So there are no surprises hidden here. GAAP accounting does a reasonable job. The fluctuations in FCF vs earnings are due mainly to short-term changes in working capital (e.g., inventory) which tend to average out over time. 2023 FCF was boosted (and 2022 FCF diminished) relative to net income due to inventory fluctuations exaggerated by pandemic responses.
Costco net income and free cash flow (FAST Graphs)
Reverse DCF Model
I use a simple reverse DCF model to get an idea of what assumptions are baked into the current price. In this case I will use the forecasted FY24 net income as a surrogate for year one FCF, and I will use a discount rate of 10% - which represents the minimum 10 year return that is generally acceptable to me for a company like Costco. So to get an intrinsic value close to today's $658 price/share, the FCF would need to grow by more than 16% for 10 years, and then you would need to be able to sell the stock for 21x FCF at that time (or it would need growth 15% with a 23x exit multiple).
Those are some stout assumptions in my view, and this doesn't leave any margin of safety ((MOS)). I really don't like using a terminal multiple >20 as this implies perpetual growth of >5% at a 10% discount rate- too high for a perpetuity in my opinion. To justify a price 20% higher than current levels (giving a 20% MOS), growth would need to top 17% for 10 years with a 25x exit multiple. My most ambitious but more realistic and possibly achievable model of 11% FCF growth rate for 10 years with a 20x exit multiple gives us an intrinsic value of only ~$460, 32% below current prices.
The table below will give you an idea of what's baked into the current price over a range of growth rates and terminal multiples at a 10% discount rate.
Costco intrinsic value/shr across a range of 10 yr growth rates and terminal multiples (Author)
I Can't Buy It At These Prices
So as much as I love Costco's business and would like to own the stock indefinitely, I cannot at current prices. For example, If the multiple contracts to the historic average blended PE of 27.45x by 2026, we would be looking at a 7.65% compound annual loss (or somewhat less if special dividends are issued).
Potential loss if Costco's multiple returns to historical average levels by 2026 (FAST Graphs)
Even with the multiple contractions diluted over a long holding period, I am going to need to see a near-term price somewhere near $450. The last time it traded close to there was very early in 2023, and it traded notably lower in May 2022, so it's not impossible we could see those levels again in a market downturn. As we move into next year I might accept $500 a share as an entry point. Until then, we watch and wait.
If I did already own COST, would I sell? No, the business is still humming along, it's still a great company. It would certainly be a candidate for trimming some shares if I wanted to raise cash and I was willing to accept the guaranteed tax hit (if held in a taxable account and assuming I had gains) in place of a possible price decline.
Risks
Costco stock could continue going up. The multiple might never contract, and we miss owning a great company. But history tells us these multiples won't last forever. As far as business risks, beyond the boilerplate in the 10k, I rank over-expansion and poor merchandising and inventory management as the biggest risks to the business. But I consider these very unlikely based on Costco's past record. A recession would temporarily hurt, but Costco's price leadership would soften the blow.
Takeaway
Costco is undoubtedly a very attractive business, one worthy of long-term ownership and a stock that should be considered a core holding. But it's very difficult at the current valuation to reasonably model a satisfactory long-term investment return. Conservative value-oriented investors should wait for a better price, and for me that is in the mid $400's range. What do you think? Let me know in the comments and thanks for reading!
For further details see:
Costco: Incredible Business, But Here Is Where I Would Buy The Stock