Looking for Value From Costco? Buy a Membership, Skip the Shares

While a Costco COST membership is a passport to 72-pound cheese wheels and 8-foot-tall stuffed plush toys at low prices, the bargains do not extend to the shares, in our view. Our lack of enthusiasm for the current stock price doesn’t indicate an unfavorable attitude toward the company, though. We comfortably award Costco a wide economic moat rating, and our short-term forecasts are actually above FactSet consensus. The source of the discrepancy likely lies with our long-term top-line and margin forecasts, or the expected durability of economic profits.

We grant that Costco enjoys durable competitive advantages that other retailers dream about, with purchasing power, brand strength, and cost leverage that are difficult to replicate. But while Costco is poised to combat digitization and enjoys scale-based benefits that should allow it to defend its value proposition, intense competition requires aggressive merchandise pricing to maintain the perceived value of a membership. Also, with Costco increasingly reliant on less-developed foreign markets for expansion, we expect some of the densification benefit that it has enjoyed to subside, exerting some pressure on sales and margins.

Our Near-Term Outlook Isn’t Out of Step With the Market

Like most sellers of essentials and home-related discretionary items, Costco has seen its top line surge during the pandemic, with in-store and online sales spiking as Americans redirected spending from travel, restaurant dining, and other lockdown-unfriendly categories. We expect the trend to continue until the pandemic eases, although comparable sales growth rates should ebb as persistently high comparisons in calendar 2020 and 2021 are lapped. While some sales in categories like electronics and home decor were probably pulled forward as shoppers used newly uncommitted dollars to make the world’s transformation into a lazaretto more bearable, rebounding performance in areas like apparel, travel, optical, and fuel has helped soften the blow.

We do not expect accelerated growth in certain categories, or declines in categories like fuel and travel, to be followed by a countervailing move in the opposite direction as the pandemic ends. This is because Costco’s assortment can be tailored somewhat to meet trends, many consumables spoil (limiting the duration over which consumers’ stocks can be used), and much of pandemic-era shopping has come in unexpected categories as expenditures have shifted, as at-home work and activities became customers’ focus.

Furthermore, Costco’s reliance on membership fees for roughly 60% of its yearly adjusted EBIT mitigates the margin impact of sales normalization. Renewal rates have held steady and membership fee income has risen through the crisis. Members have also bought more. We believe customers’ focus on value amid an inflationary environment should continue to benefit Costco, as should lingering shopping habits developed during the pandemic as shoppers turned to the chain for more of their needs.

Although the sharply higher sales and redirected spending should support some operating margin expansion despite COVID-19-related costs and ongoing cost inflation, we suspect Costco will continue to focus on delivering value to members by pricing merchandise aggressively. Our near-term adjusted operating margin forecast is elevated relative to prepandemic levels, though not considerably so, particularly given the dramatic sales expansion.

None of our near-term targets are particularly out of step with market sentiment. Despite our below-market valuation, our expectations for fiscal 2022 are somewhat higher than consensus. We believe it is our longer-term expectations that are the wellspring of the difference between our valuation and the shares’ current trading price.

Our Long-Term Forecast Doesn’t Assume Perfection

In our long-term forecasts, we see the following as contributors to the discrepancy between our fair value estimate and the stock price:

• Our expectation that U.S. corporate income taxes will rise in 2022.
• Our postpandemic expectations for top-line growth and profitability from fiscal 2023 to 2030.
• Our expectations for the period over which Costco's economic profits wither under the weight of competitive pressure.

In May, we raised our U.S. statutory corporate tax rate assumption for the companies we cover to a probability-weighted 26% effective in 2022. We have incorporated this assumption into our valuation of Costco, which derives about 75% of its revenue from its home market. Our long-term corporate tax rate assumption for the company is slightly more than 28%; absent a change, we would expect Costco's normalized rate is around 24%. This differential reduces our valuation by around 5%.

Our Store Expansion and Membership Income Targets Differ Costco's top-line prospects rest on its comparable sales and membership fee revenue, for which we expect mid-single-digit annual growth in the long term, as well as its ongoing store count (we foresee roughly 3% gains yearly). Together, they result in our overall top-line targets of mid- to high-single-digit growth.

Of these factors, we suspect that our mid-single-digit expectations for comparable sales growth are least likely to be materially different from analysts’ targets. However, we believe our expectations for Costco’s store count growth could lag market perceptions.

Although Costco has room to expand its domestic store count, management has indicated its attention will increasingly turn outside the country for unit count growth, expecting more than half of units built long term to be outside the company’s home market. While one might argue that increasing comfort with international markets could allow Costco to eventually accelerate its pace, we contend that management’s long history of cautious expansion will hold for some time.

We do not believe the measured cadence is entirely management’s decision. Costco’s international warehouses average more than 140,000 square feet of operating floor space, and once a suitable location is identified, a supply chain must be established or significantly enlarged for a product assortment that, while concentrated across less than 4,000 stock-keeping units, includes everything from raspberries to refrigerators to razors to rugs, in addition to a sizable private-label assortment. All of this must be achieved with a level of operational efficiency that can enable aggressive pricing, and low-single-digit operating margins leave little room for error.

Via expansion at a fairly steady percentage of an increasing store base, we already assume Costco’s opening cadence accelerates somewhat over the next decade on a unit basis. However, we suspect market sentiment underappreciates the difficulties associated with more rapid expansion for a chain like Costco.

Investors may also expect more than we do from Costco’s membership fee income. Our long-term forecast is not far from Costco’s recent historical performance. This line item is particularly critical for Costco, as it contributes roughly 60% of annual EBIT.

Membership income largely depends on customer acquisition, retention, and fee increases. Costco’s cardholder growth is driven by warehouse openings and increased member density within existing units, and our estimates for member count growth are split between these two categories. Warehouse openings have a disproportionately large impact outside the United States and Canada, where new locations often unlock access to new markets and groups of customers.

We believe the unit count story is the most likely source of a difference between our expectations and those implied by Costco’s current market price, rather than the prospect of adding incrementally more members in mature warehouses. Costco’s performance by the latter metric has held fairly steady over the last several years, with the exception of a surge during the pandemic as shoppers flocked to the chain.

In terms of renewals, Costco’s retention rates in the U.S. and Canada have held steady for years, as have its marks internationally. The metronomic performance extends through the financial crisis, the maturation of digital general merchandise retail, the expansion of Amazon’s Prime offering, a credit card provider switch, a robust prepandemic economy, two meaningful fee increases, and the COVID-19 outbreak. Although we expect the worldwide number to gradually converge toward the U.S. and Canadian mark in mature international markets as Costco reaches its ideal customer base over time, we anticipate the benefit of the reduced churn will be offset by the ongoing addition of stores in other geographies. Furthermore, with more than 800 warehouses and growing, Costco’s implied renewal rate outside the U.S. and Canada is still likely healthy at more than 70%, limiting the upside.

From a fee increase standpoint, we anticipate Costco successfully raises its tariffs from its current $60 ask (for a basic membership) in line with historical patterns. We forecast two mid-single-digit dollar price increases over our 10-year explicit forecast, without much change in the roughly 40% penetration seen for executive memberships (which cost twice as much but include an annual reward equal to 2% of the year’s qualifying purchases). In contrast, we suspect current sentiment assumes more sizable or more frequent fee increases over the next decade. However, we believe this is unlikely.

While a $5 increase on the $60 current fee (8%) is not the same as the $5 increase on a $45 tariff executed in 2006 (11%), the percentage difference is not yet large. We believe Costco is more likely to seek modest increases that do not give customers a reason to doubt the value that they receive. We believe this is the reason that membership renewal rates have not changed after past increases. Additionally, retention is not as high internationally as it is in the U.S. and Canada, likely suggesting greater sensitivity that would lead Costco to maintain a conservative approach as it increasingly depends on foreign markets for growth.

Profits Constrained by Pricing Strategy and Competition Costco has relentlessly used its scale to drive membership value and enhance its value proposition. This strategy has Costco relying on member fees for around 60% of adjusted EBIT, enabling the company to sell merchandise at aggressive prices. The need to keep prices low relative to alternative channels for similar products comes as online retailers provide price transparency, scaled brick-and-mortar general merchandise sellers become more aggressive in utilizing cost leverage to fuel aggressive pricing, and retail customers face greater choice in a world with negligible switching costs. We believe Costco's trading price suggests profitability improvements that would usually come with scale. While we allow for meaningful profitability improvement, particularly as international operations mature, we believe the pricing strategy and environment cap the ultimate benefit.

With sales and profitability linked by cost leverage, we explored the likely degree of difference between our expectations and those implied by Costco shares’ current trading price. We believe our forecasts are more consistent with the competitive environment and Costco’s approach, and we suggest investors avoid assuming materially different long-term results in a challenging retail landscape with less runway for growth in the company’s core markets.

We Expect Excess Returns for a Long Time, but Not Forever Another possible contributor to the difference in our long-term expectations and those implied by the shares' trading price is the period over which Costco's returns on invested capital are expected to exceed its estimated 7% weighted average capital cost. Morningstar values equities based on a three-stage discounted cash flow model: an explicit forecast, a period over which expected returns on invested capital begin to fade toward the weighted average capital cost, and a terminal stage. We believe wide-moat companies like Costco will outearn their cost of capital for at least 20 years. Only around 15% of the companies we cover earn a wide moat rating.

However, we admit the possibility that Costco could exist in even more rarified air than many of its wide-moat peers, with the strength of its business model so formidable that it can comfortably outearn its capital costs for even longer than our 20-year threshold. Extending the period of excess returns to around 35 years from 20 years (assuming near-term results meet consensus, holding our other long-term assumptions constant, and assuming no change to U.S. corporate tax rates) explains the difference between our fair value estimate and the shares’ current trading price, even accounting for our above-market near-term expectations.

We do not discount this possibility, but we caution investors about making the assumption. Even 20 years ago, an American could have found himself driving a new Hummer (shut down 2010) to the airport for a flight on TWA (bankrupt 2001 and folded into American Airlines, which itself went bankrupt in 2011) to a meeting required by his employer, Lehman Brothers (bankrupt 2008), with the management of MCI Worldcom (bankrupt 2002) and auditor Arthur Andersen (effectively defunct 2002). Although he was unlikely to have shopped at leading department store Sears (bankrupt 2018) for the fashionable monochromatic satin tie he would wear to the meeting, he may well have bought it at Neiman Marcus (bankrupt 2020), where he could have also stopped to recharge his phone at an outlet powered by Enron (bankrupt 2001) or PG&E (bankrupt 2001 and 2019).

At the time, Google was known mostly as the search provider for Yahoo (acquired by Verizon in 2017, sold to Apollo in 2021), Amazon was negotiating a new partnership agreement with Borders bookstores (bankrupt 2011), Mark Zuckerberg was captaining his prep school fencing team, the top-selling Nokia 3310 cellphone advertised innovative smart features like a calculator and a chat function, and until September 2001, the U.S. government’s top concern had been what to do with a budget surplus.

A lot can change in 20 years, even for titans that once had strong market positions, which is why we are as judicious as we are about awarding wide moat ratings across our coverage universe. While we are not suggesting that Costco’s standing will completely erode right after that time frame, we would avoid assuming that its strengths will endure into what approaches perpetuity, particularly as the pandemic alters retail’s long-term trajectory and as game-changing concepts like mobile commerce and omnichannel fulfillment are in their infancy.