Pocket Change is a newsletter where Tony + Karine keep track of and analyze stocks we think are noteworthy (and whether we should invest pocket change into). We’ve been friends since 2013, and have been sending each other stock suggestions and portfolio screenshots over the years. Pocket Change is our way of opening up the conversation and sharing these ideas more publicly. This newsletter goes out every weekend with our analysis and decision for a new stock.
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Summary
Costco Wholesale Corporation is among America’s favorite retailers, high up on the list with Trader Joe’s and HEB. Started in 1976, the concept of Costco actually began as a membership-based discount department store called Price Club in San Diego, and was only available to business members at a $25 annual membership fee. In 1983, the first “Costco” opened in Seattle. However, it wasn’t 1993 when Costco and Price Club agreed to merge together as PriceCostco, when things really started to scale for the business, reaching sales of over $16 billion by 1995.
Fast forward to today, Costco currently operates 795 membership warehouses worldwide, with the majority in the US and Canada. Consistent with its founding principles, Costco continues to provide its members low prices on a limited selection of nationally-branded and private-label products in a wide range of categories (groceries, electronics, apparel, gas/pharmacy, and etc.). The average store has 3,700 active SKUs in-store and 8-10k SKUs online, which is significantly lower than retailers like Walmart which have ~120,000 SKUs, or the average grocery retailer which has >32,000 SKUs. This limited SKU catalog enables Costco to generate high sales volumes and rapid inventory turnover.
As people have been stockpiling for COVID at Costco, net sales increased 12.5%, to $52.28 billion from $46.45 billion, and e-commerce sales have soared +101.9% in the month of August alone. As expected, the frozen foods, liquor and cooler categories demonstrated the strongest sales growth. In this post, we’ll walk through Costco’s business and where we think the business could fit in the long term in the retail landscape.
Did you know?
Costco could’ve merged with Walmart in 1993 😮
Price Club agreed to merge with Costco only after the founder, Sol Price declined an offer from Sam Walton and Walmart to merge Price Club with their warehouse store chain, Sam's Club. At the time, Costco's business model and size were similar to those of Price Club, which made the merger more natural for both companies.
Another random fun fact: Did you know that Costco hasn’t changed the price of its $1.50 quarter-pound 100% beef hot dog and 590 ml drink in 34 years?
Fundamentals
58.1M Household Members
Membership Stats: 91% renewal rate in US & Canada
$3.5B membership fee income (FY20)
Financials:
Annual Net Sales: $163B, +9.3% YoY (FY20, ending Aug 30 2020)
11.2% Gross Margin
EV/EBIDTA: 21.2x (NTM)
How Costco Makes Money
In 2019, the annual net sales was $163B, up 9.3% compared to the last year. 98% of the sales comes from merchandise such as food, sundries, appliances in a warehouse format. The remaining 2% of the sales come from memberships.
Costco requires a membership to shop at its store. There are three options. Individuals can choose Gold Star ($60) or Executive memberships ($120), and businesses can get Business memberships ($60). Executive memberships earn additional savings and benefits for car/home insurance, and a 2% reward on qualified purchases. In 2019, there are 58.1M paid members with Executive Members making up 39% of its paid members. Membership drives greater customer loyalty and average sales. Furthermore, Costco has been able to raise membership fees consistently in the past three years, increasing 6% in 2020 and 7% in 2019.
Growth opportunities
E-Commerce - In 2019, only 4% of its total revenue came from e-commerce. However, the recent growth in e-commerce (+101% in August compared to last year) represents a huge opportunity to expand its reach beyond its physical stores and also attract new, younger shoppers.
International Growth - Of 795 warehouses worldwide, 31% are international. There is only 1 store in China but they plan to open a second location in the upcoming year. The first location has exceeded management expectations on membership sign ups and sales. However, each new region requires new supply-chain and introduces currency exchange risks.
Greater Executive Membership Penetration - Executive memberships are $60 higher than the Gold Star but its members have higher renewals and spend more each year. Membership expects the penetration rate of Executive Membership to increase over time, with U.S./Canada in the mid-70s and other regions in the 50s and growing.
Competitors / Risks
Retailers (Walmart, Kroger, Target, Amazon) - Walmart operates Sam’s Club, which grew faster during COVID, with comparable sales increase of 17.3% (excluding fuel which tends to be volatile). They also saw historically high membership signups and penetration into higher membership tiers. Walmart is also taking elements of Sam’s Club into their regular big-box retail stores by introducing Walmart+, an $98 per year membership. Walmart could deter potential customers from trying Costco.
COVID-19 Durability - The bulk of the growth during the pandemic comes from customers stocking up for their quarantine at home. As we mentioned earlier, net sales grew 12.5% in August, and as a result the share price multiple on an EBITDA-basis has reached all-time high. If growth slows, we could see multiple shrink, and making a decent price return more difficult.
Limited Product Selection: Part of Costco’s competitive advantage is its limited product selection, but this may be limiting for Costco to appeal to all types of customers.
Key Questions to Ask Yourself (before we think you should buy...)
Can Costco sustain its double-digit same store comparable growth (via higher Executive membership penetration, international growth?)
Our Take
We recommend waiting for a drop in the share price before buying because the share prices are trading at record valuations, and we see greater risk that sales trend revert to pre-COVID levels.
Note this is not investment advice. Please consider doing your own research before making any investments!
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