Costco: I love the company, I can’t rationalize the rating (NASDAQ: COST)

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Investment thesis

Most investors are familiar with Costco Wholesale Corporation (NASDAQ: COST) operates as a membership warehouse and offers, at wholesale prices, just about anything you might want or need. They have an exceptional business model. Costco is unique in that its dues account for almost 80% of its net income. Costco would probably be profitable even if it sold goods at cost. I don’t know many companies that could make that statement. In financial year 2021Costco’s membership fees totaled $3.9 billion, all of which was reflected in the bottom line.

Over the past few years and likely exacerbated by Covid-19, the market has taken note of Costco’s unique operating model and put a premium on the stock. Since 2018, Costco’s P/E has always been above 30 and often above 40. As of this writing, Costco’s P/E is 43. However, from 2012 to 2017, the P/E from Costco generally ranged between their mid to late twenties. What has changed in the company to justify such a leap?

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Historical P/E COST (Quickfs.com)

As a value investor, I simply cannot rationalize Costco’s valuation from a P/E or DCF perspective. I’m also having trouble rationalizing the additional multiple expansion. How far higher could he go? Will a short squeeze push the P/E to 80? I don’t count on it. For me, multiple compression is a higher probability than multiple expansion. Therefore, I think investors are better off putting their money elsewhere or waiting to take a new position. I would be interested in less than $500, but $560, no thanks.

A snap of the fingers

Costco could increase revenue by $325 million to $650 million a year with the snap of a finger. They could achieve this by increasing annual membership fees from $5 to $10 per year per household. Currently, Costco has 64.4 million household members, increasing $5 net to $325 million and increasing $10 net to $650 million. It’s kind of crazy if you think about it. Costco management might wake up tomorrow and say, “Sure, let’s add another half a billion to the income statement.” If that isn’t earning power, I don’t know what is.

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COST data by YCharts

In the past, Costco has increased its annual membership fees roughly every 5 years or so, the last of which was in June 2017. So Costco is just over 5 years since its last increase and management has hinted another potential upside. During their third quarter 2022 earnings call, Bob Nelson, senior vice president of treasury, planning and investor relations, said:

Historically, we have increased fees every five to six years, with the last three increases occurring on average over the 5.5 year period,

And that …

there would be more discussion.

Personally, I don’t think Costco members would mind a $5 to $10 increase. In fact, they’re probably wondering why they haven’t already or why they aren’t raising fees more frequently. Realistically, a member will save well over $5-$10 on a single grocery trip while shopping at Costco. Did I mention that Costco also sells fuel at wholesale prices? The return on investment is obvious to members.

But is it worth the premium?

Yes, I believe a bounty is warranted due to income and stamina, but how much bounty is the question. Over the past 10 years, Costco has grown EPS to a respectable 13.1%. If you’re in the camp that thinks a stock should trade at double its earnings growth, that puts Costco’s target P/E at 26. And that’s generous because the 33 analysts covering Costco are just asking EPS growth of 9% in 2023, so a realistic P/E may be closer to 20.

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Financial history of COST (Quickfs.com)

Personally, I could justify a P/E in the low 30s. That would be about a 60% premium to the S&P 500, which seems reasonable given the phenomenal economy. But at a P/E of 43, I just can’t rationalize it, no matter how badly I want to.

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S&P 500 Price/Earnings Ratio (Yardeni Research)

So what is fair value?

Using the Market Multiple (P/E) approach, I arrive at a fair value of $565 for Costco in 2029, which coincidentally is only slightly higher than the current price of $560. For the valuation, I included dividends, assumed a revenue CAGR of 5.8%, net margins of 2.4% (5-year average), no outstanding stock dilution and a P/E of long term of 31.

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Multiple market assessment (personal data of the author)

Using the DCF approach, I arrive at an intrinsic value of $487 for Costco. I used a discount rate of 8% and a terminal growth rate of 3%. I assumed a CAGR of 7.2% FCF, slightly below the 10-year average of 10%, and no dilution of outstanding shares. From the DCF’s perspective, Costco appears to be overvalued by 15% at current prices.

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DCF valuation (Personal data of the author)

Both valuations reach the same conclusion, Costco is simply too expensive at $560 per share and leaves little meat on the bone for investors, in my opinion.

What would change your mind?

For me, the low-hanging fruit that I would like to see Costco incorporate into its capital allocation strategy is stock buybacks. Over the past 10 years, Costco has actually diluted shareholders, if ever so slightly. Costco has nearly $12 billion in cash and cash equivalents on the balance sheet and regularly generates more than $3 billion in annual FCF. If there is nowhere else to invest, why not invest in their own stocks?

If Costco invested $3 billion in stock buybacks every year, that would put an additional 7% in shareholders’ pockets on top of organic EPS growth. I’d like to see Costco look into stock buybacks like Apple (AAPL), Walmart (WMT) or Lowe’s (LOW). It would make Costco much more appealing to me.

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Circulating COST Shares (Quickfs.com)

Conclusion

Costco is a phenomenal company, there’s no doubt about it, but I just can’t rationalize its current valuation given my value-driven approach. In my view, EPS growth is not significant enough to warrant a P/E of 43 and I cannot justify taking a position based on a stock buyback program that does not exist. At current levels, multiple compression is a real risk and probably a higher probability than multiple expansion. At $560, I think investors better steer clear of Costco. If you hold a position, you can consider taking profits or closing out completely. Maybe a pullback is in the cards where you’ll have a chance to buy back stocks for less than $500.

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