Few large companies have embodied the resilience of brick-and-mortar retail amid the transition to the digital age quite like Costco Wholesale (COST -0.67%), which hit an all-time high on May 10.
The stock is up a mind-numbing 576% over the last decade. It is now the third-most-valuable U.S. consumer staples company behind Walmart (WMT 1.34%) and Procter & Gamble, and ahead of giants like Coca-Cola and PepsiCo.
Costco has done an excellent job building a brand that exudes customer loyalty. But the stock price has grown at a much faster rate than important metrics like sales, earnings, and operating cash flow.
Here's what makes Costco such a phenomenal business, and whether or not the blue-chip stock is a buy now.
Image source: Getty Images.
Costco is in a league of its own
Costco has an effective and unique business model with a clearly defined customer value proposition.
Costco will charge an annual membership fee ($60 for Gold Star, $60 for Business, $120 for Executive) but will offer compelling prices, a variety of consumer discretionary and staples goods, and services from tires and auto to eye exams and more. There's really no other business quite like Costco in this regard, and the data shows that Costco is giving customers a great deal.
Here are some key metrics from Costco's latest income statement for the first two quarters of fiscal 2024, or the 24 weeks ended Feb. 18, 2024.
| Revenue Metrics | 1H Fiscal 2024 | Operating Expenses Metrics | 1H Fiscal 2024 |
|---|---|---|---|
| Net sales | $114.05 billion | Merchandise costs | $101.6 billion |
| Membership fees | $2.19 billion | Selling, general, and Administrative (SG&A) | $10.6 billion |
| Total revenue | $116.24 billion | Operating income | $4.05 billion |
Data source: Costco.
Net sales dominate Costco's overall revenue, but membership fees are essentially pure profit. In this vein, membership fees make up a little more than half of Costco's operating income.
With $4.05 billion in operating income from $116.24 billion in sales, Costco has an operating margin of just 3.6%. But it gets even more razor-thin if you remove membership fees from operating income. Subtracting merchandise costs and SG&A expenses from net sales, Costco would have an operating margin of just 1.6% on its merchandise. That means that for every dollar a customer spends, Costco only makes $1.60 in operating income. For context, Walmart is making $4.20 on the dollar in operating income.
Normally, a higher operating margin is better. But retail is a bit different. You have higher-end outlets that rely on lower volumes and higher margins, and then there's the discount retail companies like Walmart that have higher revenue and low margins. Costco can create an excellent customer experience and value for its customers thanks to its hybrid model of membership fees and sales on goods and services.
Once customers sign up for a membership, there's an incentive to shop at Costco more to make the fee worthwhile. Costco pulls on multiple levers to get customers to come in as much as possible by offering a variety of discretionary goods like consumer electronics, appliances, clothing -- even gold bars, $1.50 hot dogs, and the services mentioned before. Costco provides a lot of value to its customers, and it doesn't overcharge, which is evident in the margins. And yet it can still grow profits because it is an extremely efficient business.
Going back to the table above, the two big operating expenses are merchandise costs and SG&A expenses. Costco does very little marketing, and that helps the business operate efficiently. Costco's SG&A expense as a percentage of revenue for the last four quarters has been just 9%, compared to over 20% for Walmart and Target. Costco's low SG&A expenses are another example of why it is a well-run business.
Another benefit of the membership model is how it affects Costco's predictability and recession resilience. With a little over half of operating income already accounted for thanks to membership fees, a dip in sales or pullbacks in consumer spending won't affect Costco as much as a competitor that doesn't have a steady stream of membership fee income. In its Q2 fiscal 2024 earnings presentation, Costco said that it had 73.4 million household members, 132 million cardholders, a 92.9% renewal rate in the U.S. and Canada, and $4.7 billion on membership fees over its last 12 months. That's an incredibly base and high renewal rate in what has been a challenging time for many retailers.
The problem isn't Costco as a business, it's Costco as an investment opportunity.
More expensive than Nvidia
The price-to-earnings (P/E) ratio is one of the most common valuation metrics. It is simply a stock's price divided by earnings per share over the last 12 months. So a 20 P/E ratio means that the current valuation of a company is 20 times a year's earnings. The current P/E of the S&P 500 is 27.1.
The forward P/E is also important, particularly for growth stocks. For example, Nvidia (NVDA -0.79%) has a 75.3 P/E, compared to Costco's 49.2 P/E. But Nvidia's earnings are expected to double over the next year, while Costco's are expected to increase at a mid-single-digit growth rate. Thanks to the implied growth, Nvidia's forward P/E is just 35.7, compared to 49.3 for Costco.
Costco deserves a premium valuation due to the strength of its business model. And it has, historically, traded at a high multiple. The following chart shows that Costco's median P/E has gradually increased over time, with the three-year median higher than the five-year median -- and so forth.
COST PE Ratio (Forward) data by YCharts
But Costco's current P/E is reaching nosebleed levels, especially because Costco isn't growing as fast as it used to.
Cheery consensus
Costco is arguably the best-run value-orientated retailer on the planet. But the stock is expensive, it doesn't pay a high ordinary dividend (although it does occasionally pay special dividends), it doesn't buy back a lot of its own stock, and it isn't growing that quickly anymore.
One of my favorite Warren Buffett quotes is "You pay a very high price in the stock market for a cheery consensus." Which basically means if there's widespread agreement that a company is great, then the stock will not be cheap.
Costco takes cheery consensus to an extreme level, and it is a good example of why a great business is not always worth investing in.
Nvidia showcases why a company that is expensive now can grow into a more reasonable valuation over time if it is growing earnings at a breakneck rate. But Costco isn't doing that, so it doesn't have a clear path toward reaching a fair valuation unless the stock price comes down. Even a return to a 35 P/E would mean nearly a 30% decline in the stock price.
It's a tough one to pass on, but Costco is just too expensive to consider now.
