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Stock Strategist

Discounter Costco Deserves Premium Valuation

We see near-term visibility and long-term market share gains.


Warehouse club operator  Costco Wholesale (COST) warrants a premium to the retail defensive sector, in our view. Its shares currently trade at a healthy discount to our fair value estimate, which implies a forward multiple of roughly 23 and 8 times on a price/earnings and enterprise value/EBITDA basis, respectively. The valuation multiples that our fair value estimate assumes are essentially consistent with five-year historical averages. Still, that puts Costco at a premium to nearly all of the other companies we cover. Moreover, we expect the combination of rising food prices and federal fiscal contraction to cause a consumer pullback in 2013, which should pressure all stocks in our sector, including Costco.

Membership Means High Near-Term Cash Flow Visibility
Costco books nearly all of its profits in 12 months in advance. Membership revenue, although deferred over the life of the annual membership, is paid at the beginning and accounts for nearly all of Costco's operating profits. Furthermore, even after fee increases and during recessions, member renewal rates have remained steady. Costco cardholders renewed their membership at an 86% rate during and after the Great Recession. Therefore, we have a very high level of certainty in our near-term financial forecast. Moreover, cash, a debit card, or an American Express charge card are the only forms of payments accepted at the warehouses. In our view, this indicates a high-credit-quality customer base, which we believe can better withstand economic downturns. For these reasons, as well as being free cash flow positive and in a net cash position, Costco trades at premium valuation to nearly all of the other companies in our retail defensive coverage.

Renewal Rates Have Remained Consistent During Economic Cycles, Rate Increases

Source: Company reports, Morningstar estimates.

Loss-Leader Business Model Should Continue to Drive Market Share Gains
Costco sells the two basic inelastic consumer needs, food and fuel, at zero economic profit or a loss. The company has the ability to deploy these inelastic products as category loss leaders because it derives virtually all of its profits from membership fees. The ability to be a price leader on these items drives customer traffic and market share gains, especially in inflationary environments when food and gas consume a greater share of household budgets. Costco is now the third-largest food retailer in the United States on just over 400 units. Higher customer counts in the warehouses then create greater sell-through opportunities for better-margin discretionary products. Still, Costco marks up nonessential items by only about 10%-11% or so, which effectively offset the costs of running the business. The company delivers one of the most consistent two-year comp rates (excluding gas revenue) in our coverage universe.

Annual Fuel Savings of $150-$300 Pays for $55 Base or $110 Executive Membership

Source: Company reports, Morningstar estimates.

Concentrating on fewer stock-keeping units generates buying power for Costco on par with, or perhaps even greater than, larger mass merchants. At first glance, at about $60 billion in U.S. sales (excluding gasoline), Costco seems at a scale disadvantage to Wal-Mart's (WMT) $265 billion domestic purchasing power. However, Costco concentrates its merchandise purchases on only about 3,600 active SKUs, compared with the average 50,000-75,000 SKUs at a Wal-Mart superstore. If we assume a straight average, that calculates to more than $16 million in sales per SKU at Costco, compared to just over $3.5 million-$5 million per SKU at Wal-Mart. Moreover, Costco limits its buys to specific, faster-selling items; it turns its inventories in less than 30 days. This variable-cost parity with larger mass merchants, along with the little or zero markup requirement of its membership business model, produces price leadership for Costco on the products it chooses to sell.

Costco's SKU Velocity Offsets Wal-Mart's Size Advantage

Source: Company reports, Morningstar estimates.

We believe Costco offers consumer defensive investors the least relative downside risk to sales, earnings, and cash flow, because it derives virtually all of its profits from membership fees. So over the near term, the company has the highest cash flow visibility in the sector. We think Costco's long-term durable competitive advantages should deliver sustained double-digit earnings per share growth and drive the share price toward our $116 fair value estimate.

Morningstar Analysts does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.