Costco’s Value-Oriented Offerings and Sticky Membership Should Help It Navigate Macro Uncertainties

Equity Analyst

Zain Akbari

Associate Equity Analyst

Grace Na

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With a besotted member base, low-frills warehouses, and growth opportunities at home and abroad, we expect Costco’s durable competitive advantages to lead to consistent, strong performance despite retail’s upheaval. The competitive environment is intense and becoming more challenging as Amazon scales and physical rivals deliver an omnichannel experience, but we believe the values that Costco offers (driven by cost leverage, procurement strength, and top-class store efficiency) should allow it to keep traffic high. With ample opportunity to expand globally, we expect Costco to post consistently strong returns even as it grows.

Through a financial crisis, the maturation of digital general merchandise retail, the expansion of Amazon’s Prime offering, a credit card provider switch, a robust pre-pandemic economy, two meaningful fee increases, and the COVID-19 outbreak, Costco’s membership renewal rates in the United States and Canada have remained at roughly 90%. We suspect that the traffic-driving values that Costco offers in its stores are fueled by cost leverage and procurement strength that, in turn, feeds additional store visits.

Despite its warehouses’ large size (roughly 146,000 square feet), Costco concentrates its buying power on a small number of items, featuring less than 4,000 stock-keeping units in store versus about 75,000 to 80,000 at Target or what we estimate as about 140,000 at Walmart supercenters. This magnifies purchasing leverage that we believe is a key ingredient in delivering the values Costco offers, augmented by a renowned private-label offering.

We believe the firm’s food and fuel offerings drive traffic and suspect that Costco is poised to thrive even as digital sellers expand. Although we expect it to keep pace with rivals by further developing its omnichannel offering (7% of fiscal 2022 sales, excluding same-day grocery and various other services, came from e-commerce), we believe that Costco’s value proposition should support continued member growth and in-store sales expansion.

Business Strategy & Outlook

While the retail sector’s lack of switching costs and intense competition make durable competitive advantages hard to develop, we believe Costco has achieved a wide economic moat based on its intangible assets and a cost advantage. With a membership model that features high renewal rates (nearly 90% globally) that have held steady through the financial crisis, the rise of Amazon and its Prime memberships, growth in the broader e-commerce sector, the pandemic, and ongoing high inflation, we contend that Costco, which relies on membership fees for nearly 55% of EBIT (in fiscal 2022), should be well positioned for decades to come. Our targets are consistent with this conclusion; we expect the firm’s return on invested capital to average in the mid-30s over the course of our explicit forecast, somewhat higher than the mark’s 24% five-year historical average and well ahead of our 7% weighted average cost of capital estimate.

Offering customers a select assortment of high-value merchandise in a low-frills environment delivers several benefits that allow Costco to continually hold prices down and leverage its warehouse infrastructure. The warehouse setup maximizes efficiency by allowing Costco to stock large quantities of goods at their point of sale (often stacked on pallets), reducing internal distribution costs. As the customer expects a low-frills environment and to buy in bulk to cut costs, Costco can hold store capital needs in check while reducing the number of times a product ready for an end user is handled from delivery to sale, contributing to industry-leading real estate efficiency. Costco posted over $1,800 in sales per square foot in fiscal 2022, dwarfing Walmart’s roughly $560 mark and Kroger’s approximately $765 (including fuel; the second-highest company-level mark in our defensive retail coverage universe) in their most recently completed fiscal years, despite the latter’s greater exposure to faster-turning grocery categories. Costco even comfortably exceeds rival Sam’s Club’s approximately $920 mark, which we believe reflects its greater scale and operating leverage.

In addition to cost management and distribution leverage, we believe Costco’s low prices are enabled by its procurement strength. While Costco’s U.S. top line ($165 billion in total revenue in fiscal 2022) is considerably smaller than Walmart’s namesake domestic operation ($393 billion in fiscal 2022 sales), we believe it achieves similar procurement strength by concentrating its assortment. Costco sells fewer than 4,000 different stock-keeping units in its stores, a fraction of the 75,000 to 80,000 at Target and roughly 140,000 at Walmart in the United States. Excluding e-commerce (where Walmart offers a significantly higher number of items via its marketplace), Costco’s U.S. sales per SKU were over $40 million, towering above Walmart’s roughly $3 million and Target’s $1 million, contributing to its procurement cost advantage. 

Costco benefits from a number of traffic drivers, particularly its food and sundries offerings (52% of fiscal 2022 sales, including fresh) and fuel (around 10% on a normalized basis), which we believe creates a steady stream of repeat visitors. Furthermore, we expect fuel sales to serve as a meaningful counterpoint to any traffic pressure from digital sellers. With in-store prepared food offerings and a well-developed private-label portfolio (including the Kirkland Signature brand, which accounts for around a quarter of Costco’s sales, excluding fuel, and is also margin-accretive), we believe Costco’s store offering is well differentiated.

Costco has long featured a high renewal rate for its memberships, which we believe is a function of the values offered and contributes to its intangible asset advantage. Gold Star (individual) and business memberships in North America cost $60, with around 45% of paid members globally upgrading to an executive membership (for an additional $60 in North America, in exchange for a 2% reward on most purchases and additional savings on insurance and other services). The membership structure enables Costco to price merchandise aggressively, shifting the focus from optimizing per-unit margins to driving member growth and retention. Costco has averaged a mid-single-digit member growth rate globally for the last decade, with more than 120 million cardholders worldwide. Growth (and retention) has held steady despite membership fee increases; the most recent domestic increase, which began to take effect in 2017 and was a roughly 10% uptick, resulted in virtually no change in the retention rate in fiscal 2018 (or beyond). After Costco raised U.S. membership fees in 2011, retention moved higher by roughly 100 basis points in fiscal 2012. The retention performance comes despite a membership fee that is higher than rival Sam’s Club’s charge ($60 versus $50 annually at the most basic level). The membership model (which involves controlling doorways with membership card and receipt checks) also likely reduces shrinkage, in our view.

While the digitization of retail has strained all traditional sellers, we believe Costco is better positioned than most considering its large product sizes and the shipping costs associated with delivering such items directly to homes. We believe that its e-commerce efforts (roughly 7% of sales, excluding same-day grocery and certain other services) have been prudent, focusing on items not available in stores (including travel and other services) and a differentiated product assortment. Although e-commerce took center stage in much of retail amid the pandemic (with Costco’s adjusted digital sales rising more than 65% and 90% in the third- and fourth quarters of fiscal 2020, respectively, and more than 40% in fiscal 2021), we expect the in-store experience to continue to be the dominant means of delivering Costco’s value proposition.

Wide

Economic Moat

Costco

"Kirkland Signature" is Costco's private label. It is sold by Costco at their website and warehouses, and is trademarked by the company. The name is derived from the location (from 1987 to 1996) of Costco's corporate headquarters, Kirkland, Washington. Costco introduced Kirkland Signature as its private label in 1992. The idea was to provide brand name quality products at discounted prices. To counteract the consumer confidence problem common in store branding, Kirkland Signature occasionally employs co-branding. According to Costco, while consumers may be wary of same-store-branding, they are less likely to be wary of brands that they are familiar with and trust.

Kirkland Signature

Costco Wholesale Corp. engages in the operation of membership warehouses through wholly owned subsidiaries. It operates through the following geographical segments: United States, Canada, and Other International Operations. The company was founded by James D. Sinegal and Jeffrey H. Brotman in 1983 and is headquartered in Issaquah, WA.

Earnings data Q2 2023

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Costco Wholesale Corporation (NASDAQ:COST ) Q3 2023 Earnings Conference Call May 25, 2023 5:00 PM ET Company Participants Richard Galanti - CFO Conference Call Participants Michael Lasser - UBS Simeon Gutman - Morgan Stanley Christopher Horvers - JPMorgan Scot Ciccarelli - Truist Securities Karen Short - Credit Suisse John Heinbockel - Guggenheim Securities Oliver Chen - TD Cowen Scott Mushkin - R5 Capital Brandon Cheatham - Citi Rupesh Parikh - Oppenheimer & Co Operator Ladies and gentlemen, thank you for standing by, and welcome to Costco Wholesale Corporation's Fiscal Q3 2023 Conference Call. All lines have been placed on mute to prevent any background noise.

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