Costco Wholesale Corp (COST)

[msmithgold]

Case Study of Costco Valuations and Right Entry Point

Summary of case study and good read on common valuation pitfalls

Costco (COST) Case Study:
Over the past two decades, COST generated a cumulative return of 1790% vs 337% in the S&P – probably safe to say that COST was not overvalued over this period
Costco membership costs about $45/yr and in exchange, people shop at Costco because goods are priced at a fixed 14% markup over cost
Costco’s operating costs are extremely low and this makes it difficult for even WalMart to compete as they can’t make money pricing goods as low as Costco
In order to make money selling at 14% above cost, revenues need to be very high
Competitive advantage is derived from what management does with this revenue advantage – passes efficiency gains back to consumer to drive more growth
Consumers benefit from firm’s expansion which drives supplier prices down
Over the past two decades, traded on average at 24x forward earnings estimates (stock looked always expensive)
We estimate steady state value for COST around $74/share which is nearly half of COST’s recent stock price – but this is conservative due to a number of factors temporarily depressing current profitability
COST stores are immature – newer stores only generating $80-100MM in sales vs $160MM on average and $180MM for stores open for 10+ years
Assuming new stores eventually ramp up to average, newer stores are under-earning by $8.7B
If you consider likelihood for a near-term hike in membership fees and maturation of existing store base, normalized steady state value increases to $80/share (60% of today’s value)
Costco is profitable enough to self-fund growth and has done so throughout history; so growth has been more measured in pace and more sustainable as COST is not dependent on capital markets
5-year average ROIC stood around 13% vs. long-term average of 12%; despite the recent increase, believe normalized returns are greater than indicated by reported financials – assuming maturation of existing stores, estimated normalized ROIC of 16%
Assuming 16% returns, company’s earnings multiple should fall somewhere in the range of 15.7x to 25.5x depending on one’s expectation for earnings growth (4% to 10%)
Management appears comfortable with current pace of square footage growth – assuming 4-5% annual growth, equates to 1050 to 1150 stores in ten years
For perspective, HD and LOW have 4,000 combined stores in the US alone
In summary, future value for COST might be in the area of $40-80 per share – adding steady-state value of $80-90/share, puts fair value in the range of $120 to $170
Bottom line, would be happy to own COST at a 25% discount to our estimate of intrinsic value or roughly $100/share
At an entry point of $100/share, assuming mid-single digit comps and store growth, would expect to generate ~20% annual returns

Full case study and read on common pitfalls of valuation: https://investoralmanac.com/2017/03/02/multiples-vs-valuation-growth-vs-returns-cheap-vs-value-drivers-of-value-creation-costco-case-study/