Costco Stock: I Can’t Defend A 40x P/E (NASDAQ:COST)

Investment Thesis

Costco (NASDAQ:COST) has a wonderful business that is managed well. The only thing I don’t like about the stock is the price, which has kept me on the sidelines for the better part of the last 2 years.

For now, I’m (anxiously) sitting on my hands.

About Costco

Costco operates membership-based warehouses that sell branded and private-label products in a range of consumer categories. Costco has locations in the United States and internationally (Canada, Japan, UK, Australia, and more).

Shares are trading for $577.15.

Here’s a look at its 5-year price history:

One of my favorite stories about Costco, and one I believe sets the table for understanding Costco as an investment, is when Craig Jelinek (the current CEO) went to Jim Sinegal (a co-founder and Jelinek’s predecessor) about raising the price of the hot dogs. Here’s how Craig recalls the conversation:

‘Jim, we can’t sell this hot dog for $1.50. We’re losing our rear ends.’ And he said, ‘If you raise the f-ing hot dog price, I’ll kill you. Figure it out.’ That’s all I really needed. By the way, if you raised it to $1.75, it wouldn’t be that big of a deal. People would still buy it. But it’s the mindset that when you think of Costco, you think of the $1.50 hot dog.” – Craig Jelinek

This argument was about raising the price of the hot dog combo by 25 cents, and I believe it’s an illuminating example of why Costco has been so successful over the last 38 years. And it’s about a lot more than hot dogs.

Costco’s entire business model is centered around two pillars:

1. Stakeholder satisfaction. “Stakeholders” includes everybody the brand touches: customers, employees, and shareholders.

2. Operating efficiency. They sell relatively few SKUs directly off pallets in a giant, undecorated warehouse. This reaffirms #1 since every dollar saved is passed on to its members.

In addition to these pillars, Costco has also created a brand of excellent customer service, employee satisfaction, high-quality products, and unbeatable prices.

We’re not a margin company, we’re a volume company.” – Jim Sinegal, CNBC

Let’s dig into the membership model a bit deeper.

While the bulk of its revenue comes from its merchandise, the vast majority of its profits come from membership fees.

As of 2023, there are 867 warehouses worldwide (602 of which are in the US) and 127.9 million cardholders. Each of these cardholders is paying $60 (Gold Star membership) or $120 (Executive membership) per year.

In FY23, total revenue was $242.29 billion while revenue from membership fees was $4.58 billion, just 1.89% of sales.

Without diving into the weeds, let’s assume a 90% margin on membership fees (10% for maintaining the membership-system infrastructure). That equates to $4.12 billion in profit from membership fees, or ~65% of Costco’s total profit ($6.29 billion).

After subtracting the membership revenue and profit, only 0.9% of merchandise sales flow through to the company’s bottom line – a razor-thin margin.

This is a membership business, not a retailer.

Are these members happy? Let’s look at two pieces of data.

In Q3 2023, Costco reported a 92.6% membership renewal rate in the US and Canada (where ~82% of warehouses are located) and a 90.5% renewal rate globally, numbers which have been steadily increasing:

Remember, this is the renewal rate of people paying to shop in Costco warehouses.

Additionally, Costco warehouses continue to increase same-store sales:

This indicates 1) an increase in the number of members and/or 2) an increase in how much each member is purchasing. I’ll spare you the boring details: it’s both.

People love to shop at Costco.

Plus, as the business has grown, Costco has achieved significant negotiating leverage with suppliers and a growing mix of private-label products (namely the Kirkland Signature brand, which accounted for ~25% of sales in FY22). Both of these deepen the brand moat – stakeholder satisfaction and operating efficiencies.

Growth

Since 2000, Costco’s revenues have averaged a CAGR of 8.6%. This growth comes from 1) the number of members and 2) the average spend per member.

Given just ~1% of merchandise sales flows to the bottom line, I primarily view this revenue as a gauge of member satisfaction, not a key growth figure. Said another way, while I believe same-store sales growth is an important indicator for the Costco brand, increasing merchandise revenue will have a muted impact (relative to membership revenue) on the company’s bottom line.

If Costco added $100 billion in additional merchandise sales (41% growth), profits would increase by just ~$1 billion (~16% growth). On the other hand, a 20% increase in membership revenue (to just $5.5 billion, or 2.3% of total revenue) would increase total profits by 13.2%, a much better lever to pull.

Again, this reiterates the importance of growing memberships.

You can grow memberships by 1) increasing the number of memberships per warehouse and 2) increasing the number of warehouses.

While it will continue to pursue #1 (memberships per warehouse grew from ~68,000 in FY18 to ~83,000 in FY23), I expect Costco to begin to focus on #2 over the next 5-10 years, especially internationally. It’s also much easier to grow memberships by adding locations than by increasing the number of memberships per warehouse.

Here’s why:

Can the countries toward the top of this list (Mexico, Japan, and the UK) reach similar penetration rates as the US and Canada? Can France, China, and others reach penetration rates closer to Australia and Taiwan? Over time, I believe they can.

And if you agree with those assumptions it’s easy to see an additional 500 warehouses in these markets PLUS additional growth in the US, Canada, or expansion into countries where Costco doesn’t currently operate.

That said, Costco has been very disciplined with its unit growth over the last 10-15 years (averaging 26 net new locations per year). This is (purposefully) a slow grower, which is important to note as we get into the valuation section below.

Forecasts

Before we get into the valuation and my conclusion, let’s briefly look at how Wall Street is thinking about Costco’s growth over the next several years.

Revenue is projected to grow at mid-single digits while EPS is forecasted at ~11%:

In FY23, Costco spent $4.32 billion on CapEx, a large chunk of which is taken up by new warehouse builds. While there’s not enough granularity for me to find the specifics, I would estimate each new warehouse costs ~$100 million to build.

Given Costco’s net income of $6.29 billion, I believe 25-30 new warehouses per year as fast as it can safely grow without becoming too reliant on its balance sheet. Therefore, I find it highly improbable that Costco’s revenue will increase by more than 9% in any one year and will likely stay in the 5-7% range for the foreseeable future.

While I don’t think anyone would disagree too strongly with those assumptions, the valuation seems disconnected from this reality.

Valuation

I love everything about this business besides its valuation, which is what I see as its primary risk (and the reason I’m not a shareholder).

Here are a few figures:

• P/E: 40.8x

• PEG: 3.4x

• EV/EBITDA: 22.4x

• EV/FCF: 36.9x

• 5-year revenue growth forecast: 6.30%

• 5-year EPS growth forecast: 11.26%

And a quick look at a few of its peers:

These are extreme prices to pay. While Costco has an excellent business, I do not believe its growth prospects justify the cost – the expectations are too high.

Conclusion

I believe Costco has constructed a business model that will work in at least 15 countries around the world, and its current pace of growth is likely to be sustained for the next 20+ years.

That alone, coupled with the brand loyalty, moat, management team, and culture of the company makes for an incredibly rare business. If I owned 100% of it outright, I would be a happy man.

But the market’s consistent upward pressure on the stock has kept me from ever owning a share. The strength of Costco’s business and its long-term opportunity, for me, don’t justify the current price tag. I would need a significant pullback, to a P/E nearer 30x (~$425 per share), before entering.

That said, if I were already a shareholder, there’s no way I would sell a share.

For now, I’ll keep waiting for the market to present a better buying opportunity.