Cash Flow and Growth Prospects Give This Retailer a Rare Wide Moat

Bucking the trend of most of our retail coverage universe,  Costco (COST) has improved its competitive position in recent years and now stands on the short list of retailers with wide economic moats, joining  Wal-Mart (WMT),  Amazon (AMZN),  Home Depot (HD), and  Lowe's (LOW). We believe that the competitive environment will remain intense, but Costco's membership and traffic trends remain solid, and we think the firm's long-term growth potential still appears compelling. Combining all these factors, we value Costco at $125 per share, which implies a forward price/fiscal 2015 earnings ratio of 25 and an enterprise value/EBITDA ratio of 11. While Costco's current multiple of 23 times fiscal 2015 earnings per share may be keeping investors on the sidelines, we believe the firm's cash flow generation and growth potential justify a premium multiple. With the shares trading at a modest discount to our fair value estimate, we think investors should keep this quality name on their radars.

Costco's Cost Advantages and Brand Equity Make Excess ROICs Sustainable
We assign Costco a wide moat because we believe its per-unit costs are structurally lower than those of most other retailers. Selling a narrow range of fast-turning products in bulk quantities allows Costco to maximize the benefits of volume purchasing and run operations very efficiently. By passing cost savings on to customers, Costco strengthens its perceived cost leadership, increases customer loyalty and spending, and bolsters its ability to charge membership fees, which help drive asset turnover and returns on invested capital higher.

We have compared the returns on invested capital for some of the largest defensive retailers in the U.S. The group average return on invested capital (adjusted to exclude excess cash and include capitalized operating leases) is 13.4%, which we believe is higher than the industry average as a whole (we assume that the average firm's returns approximate its cost of capital over the long term) because these large firms tend to drive exceptional volume through their stores, allowing them to sustain above-average sales productivity and scale advantages that smaller firms lack. However, even when stacking the strongest competitors against one another, Costco still generates returns on invested capital that are well ahead of the group average.

We estimate that Costco has a very competitive cost structure, and its below-average gross margins are due primarily to exceptionally low markups. To analyze gross-margin differences among firms, we first estimated each retailer's average markup, which we triangulated from management commentary and gross margins. For example, Costco's gross margin (excluding membership fees) implies an average markup of about 12%, much lower than other firms' markups. This estimate is broadly consistent with Costco CFO Richard Galanti's comments that Costco's "average markup is 11% and supermarkets' average markup is in the mid-20s, and Wal-Mart's, depending on the format--not Sam's, but the Wal-Mart stores--are probably somewhere in the high teens to the low 20s, depending on the format and the departments."

We combined these markup estimates with a price index that we developed by comparing prices for more than 50 items in each store. We then indexed these prices relative to the group average, allowing us to delineate how much price differences and cost (dis)advantages contribute to gross-margin differences among firms. We note that our price sample is subject to considerable bias, as geographic region, stock-keeping unit selection/comparability, timing of promotional pricing evident on shelves, and private-label alternatives can vary quite substantially among retailers at any given time.

Regarding the drivers (cost and price) of relative gross-margin differences among several major defensive retailers that we evaluated, Costco's gross margin is by far the lowest. Wal-Mart's U.S. gross margin (which we've estimated) is higher than Costco's, due to a combination of lower costs and higher average markups. While Wal-Mart could theoretically lower its prices in an attempt to take market share from Costco, we don't believe such initiatives would guarantee the desired outcome because shopping at a warehouse club is quite a bit different (with regard to SKU selection, package sizes, location, and so on) from shopping at a supercenter; these two formats are not direct substitutes. Target has an even higher gross margin, but we estimate that it has higher costs than Wal-Mart and Costco; the company generates higher gross margins than these two firms primarily because of higher markups. Whole Foods generates the highest gross margins, predominantly as a result of higher markups for its products.

What Costco gives up in margin, it more than makes up for in above-average asset turnover. Strategically, each firm attempts to maximize sales per square foot, primarily because the ratio of sales per square foot is positively related to asset turnover, which in turn drives return on invested capital.

A firm attempts to maximize sales per square foot by emphasizing some aspects of the customer proposition (assortment, quality, and price) and de-emphasizing others. There are trade-offs to pursuing one strategy over another, and firms must weigh the costs and benefits to differentiation, or lack thereof. We've also looked at the strategic differences among the firms' product offerings and how these differences drive differences in unit productivity (as measured by sales per square foot). We've already established that Costco's markup is the lowest in the group. We've also seen that Costco's product assortment is much narrower than those of competitors (as measured by SKUs/square foot), which is consistent with the firm's focus on stocking only the highest-velocity items in a category. Costco focuses its inventory purchases on about 3,300-3,800 active SKUs, which compares with tens of thousands of SKUs in traditional grocery stores and supercenters and about 10,000 SKUs in dollar stores. (To be conservative, we've used 3,800 SKUs to calculate Costco's ratios.) With a much narrower product range and lower markups, Costco still generates the highest sales per square foot in the group because the size of its inventory purchases and the velocity at which its inventory turns over are multiple times higher than at any of the other firms.

Costco's inventory days are lower (inventory turnover is higher) than those of other defensive retailers in the peer group, with the exception of Whole Foods and Kroger; those two turn inventory faster in part because they generate a greater proportion of sales from perishables than Costco does. By contrast, the dollar stores hold inventory longer than other defensive retailers, largely because of the economics of smaller store formats.

However, Costco doesn't just turn inventory over quickly; it turns a large amount of inventory over quickly. When we compared the amount of inventory per SKU per store each firm has, we found that Costco holds a significantly greater amount of inventory/SKU/store than other firms. This also suggests that Costco commands disproportionate purchasing power for a firm of its size. Maintaining competitive velocity (as measured by inventory turnover) on higher purchasing levels allows Costco to generate the highest levels of sales per square foot in the peer group.

The ratio of sales per square foot is important to moat analysis for defensive retailers because it is directly related to fixed-asset turnover and return on invested capital. The substantial gap between Costco's sales per square foot and those of competitors explains why Costco's fixed-asset turnover and return on invested capital ratios are higher than those of other firms.

The aforementioned advantages have helped Costco grow a loyal member base, and we think the combination of two mutually reinforcing competitive advantages (cost advantage and brand intangible asset) is worthy of a wide economic moat. The member base remains a key driver of the firm's profit and cash-flow generation; Costco generates about 75% of its operating profit from membership fees. The percentage has decreased over time, primarily because the company has been able to leverage fixed selling, general, and administrative expenses while keeping merchandise gross margins flat, but membership revenue has increased about 9% annually for several years. Part of this growth was fueled by a 10% membership fee increase that Costco implemented in 2012; despite the difficult economic environment, the firm was able to increase its membership fee without a negative impact to renewal rates or membership growth. These results suggest that Costco's brand equity remains strong in an industry where loyalty is very difficult to maintain. So long as Costco is able to keep renewal rates high, its sales velocity should remain strong and returns on invested capital high.

Costco Still Has a Long Runway to Add More Units and Increase Membership Revenue
We estimate that Costco can increase square footage roughly 4% annually over the next decade. We believe that the U.S. could support about 600-650 Costco warehouses (versus about 450 at the end of fiscal 2013), assuming that the warehouses average about 140,000 square feet and that there are about 525,000 people per warehouse on a nationwide basis. We also believe that the company could nearly double its international store base over the long term, bringing its total store count to around 1,000 (from about 630 at the end of fiscal 2013). We believe these forecasts are roughly in line with management's unit count expectations over the very long term.

Costco already operates many warehouses across the U.S. Costco’s presence is most established along the East and West coasts, and a majority of the firm’s more recent growth has come from adding stores in the Midwest. Identifying domestic store growth opportunities requires estimating store saturation levels. We've used population per store as a general measure of saturation, as we assume that growth opportunities are higher in regions with fewer stores per capita than in regions with more stores per capita, all else equal.

Costco's Solid National Presence, Opportunity to Further Expand Inward From the U.S. Coasts

Source: Census data, Company filings, Morningstar

​

While population per store is useful as an aggregate measure of penetration, it can be misleading on its own. For example, population-dense areas such as New York may appear underpenetrated on a population/store basis, but growth opportunities may be inherently limited by the challenges associated with securing urban sites that are large enough to house Costco's physical real estate. Because of these limitations to the population/store count ratio, we broke the metric into two subcomponents: population density (people per square mile) and store coverage (square miles per store).

Existing Domestic Markets
With this framework for estimating Costco's total store growth opportunity, we looked at the firm's potential to grow in existing markets and to expand into new territories separately. We first analyzed the firm's penetration in more than 150 of the nation's largest metropolitan statistical areas (MSAs), which cover around two thirds of the U.S. population. To do so, we located Costco's U.S. stores and identified the closest metropolitan statistical area to each store in order to assess store coverage and population density of each MSA.

To estimate growth potential in these markets, we assumed that Costco is, for the most part, already saturated in many of these regions. We identified a region as underpenetrated if its square miles per store and population density were higher than the average of all existing markets. Only a few markets appear underpenetrated when looking at both store coverage and population density. With this model, we don't expect Costco to add more than 20 stores in existing MSAs; this is a very conservative estimate when considering that the average level of square miles per store decreases as more stores are added (for example, with multiple iterations). However, our estimate for store growth isn't materially higher even after running multiple iterations.

New Domestic Markets
To estimate the number of new stores Costco could add in regions where it doesn't currently have a presence, we first estimated the number of stores Costco could add assuming no competition from warehouse club rival Sam's Club; we then adjusted this figure to incorporate competitive dynamics. We derived our initial (no-competition) store estimate from a regression analysis of existing markets, whereby we regressed Costco's store count against standardized values for population and land area.

We found that about 63% of the variation in Costco's store count (in existing markets) is explained by variation in the standardized values for population and land area. That said, it's worth noting that population has a larger impact on store count than does land area.

Competition is a real deterrent to growth, so we adjusted our store count estimate downward to account for competition from Sam's Club in new markets. We did so by assuming that Costco will not open a store if Sam's Club has more than one store in an area in which Costco does not currently operate. Changing this filter can have a large impact on the final store count estimate; however, we think that using one Sam's Club store is conservative, yet it still doesn't preclude Costco from opening stores in markets where Sam's Club operates. Overall, we estimate that Costco could operate with about 650 stores in the U.S. over the very long term, implying 3% unit growth over the next decade (roughly in line with historical rates).

International Markets
On the international front, where about 30% of Costco's warehouses are located and 30% of revenue (including membership fees) is generated, we think Costco has room to grow. We believe that Costco's international markets can grow at a slightly faster rate than the domestic business. This view is based on the fact that Costco's international store base is smaller than the domestic store base, so each new store addition contributes more to the international segment's growth rate. Overall, we anticipate mid- to high-single-digit square footage growth in international markets, driven by our assumptions that the international store base grows to about 35%-40% of total stores and international revenue represents more than 35% of total revenue by 2023.

Costco's Multiples Appear Reasonable Once Cash Flow, Growth Potential Are Factored In
Costco shares trade at a slight discount to our $125 fair value estimate, and we think investors should keep the company atop their list of potential purchases despite what appear to be lofty valuation multiples. Our fair value estimate implies a forward price/earnings ratio of 25 times, an enterprise value/EBITDA ratio of 11 times, and a free cash-flow yield approximating 3%. While these valuation multiples may seem rich for a defensive retailer, we think Costco's growth prospects and meaningful cash-flow generation warrant a premium valuation multiple.

Because Costco's membership fees are a big driver of profits and cash flows, our estimates for store growth, members per store, and average fees per member are important to our valuation. Over the next 10 years, we expect warehouse growth to have the largest impact, while we believe membership fees (expected to increase a conservative 1% annually, or 10% over the decade) are also a large driver. Finally, we believe increases in members per warehouse will be driven largely by international stores, although we also expect this figure to increase in underpenetrated U.S. markets.

We forecast Costco's net sales per square foot to increase about 3% annually over the next decade, reflecting modest inflation and mix changes (partially offset by price investments), more traffic, and greater average basket size. These sales forecasts, combined with our membership growth forecast, imply that net sales per member will increase about 2% annually.

We expect that Costco will reinvest most of its cost savings in price investments, so we don't anticipate material improvement in the gross margin over the long term. However, we do think the firm could still leverage its selling, general, and administrative expenses and drive 10-20 basis points of operating margin expansion over the next decade. Moreover, scaling operations should allow Costco to operate even more efficiently, and given that the firm already operates with negative working capital, we think it should be able to drive free cash-flow margins slightly higher as its revenue base grows. We think free cash-flow margins could steadily increase to around 1.5%, and when combined with our revenue growth projections and our 8.5% weighted average cost of capital estimate, these forecasts imply that Costco's intrinsic value stands at about $125 per share.