Built on Bulk: Costco Earns a Wide Moat

Ken Perkins: We recently upgraded Costco's economic moat to wide from narrow. We did this primarily to reflect what we consider to be a combination of cost advantages and brand equity. If you look at Costco's returns on invested capital, they are much higher than its peers; but its gross margins are much lower than its peers. If you compare it to Wal-Mart, Target, or Whole Foods, Costco's gross margins are about half of what the other competitors' [gross margins] are.

But if you look closely at Costco's cost structure, you actually can see that Costco has a pretty competitive cost structure relative to its peer base--despite being smaller in size than some firms like Wal-Mart. We think that Costco's profitability is lower because the company passes through its lower cost in the form of lower prices. Costco only marks up its products by about 12%, which is about half of what traditional grocers and Wal-Mart might mark up their products.

By doing this, Costco can actually increase the volume that it runs through its stores, which helps it to leverage its fixed-store base and, ultimately, run its operations very efficiently. By keeping its cost structure low, Costco can then keep passing through lower prices and, ultimately, develop a loyal membership base. This membership base is important for Costco because the company generates about 75% of its profits from membership fees.

Assuming conservative estimates for Costco's store growth, its members per store, and its fees per member, we still estimate that the company is worth about $125 per share, which is still a bit higher than the current share price of about $118.