Worried About Retail; Try Wholesale - The Case for COSTCO

Worried About Retail; Try Wholesale - The Case for COSTCO by G. M. Fyden

     Investor concern over the viability of brick & mortar retail is prevalent, persistent, and well founded. While reports of the death of retail are probably (at-least somewhat) premature, the challenges that continue to face traditional retailers are real. It’s hardly necessary to enumerate the difficulties inherent in competing against the internet. It’s enough to point out that the cost structure of a physical storefront operation is highly unfavorable, and the pricing pressure from online giants is monumental. 

     None-the-less, opportunities in the space still exist. Nimble, well managed companies that can adapt and capitalize on competitive advantages they still have (and they do still have a few) will reward investors who have the insight to recognize them.  

     Costco Wholesale Corporation (NASDAQ: COST) warrants consideration as just such a company. Wall Street analysists are lined up solidly behind COST. Of the twenty-some-odd analysts who cover the firm sixteen rate it “Strong Buy” or “Buy, none have it rated lower than “Hold”. There are several compelling reasons for this institutional support.

Valuation

     The current stock price of around $197.00 is roughly 26x (F19) the consensus EPS forecast of $7.68. Considering COST’s recent and seemingly sustainable 22% ROIC (return on invested capital), COST equity is attractive from a valuation standpoint. A PE ratio anywhere in the low thirties – not an unreasonable assumption – would result in a stock price over $238 (+20%) if the consensus EPS is realized. 

Discounters will Remain in Favor

     Aggressive pricing and effective marketing have cemented COST’s image as a discount store. Discounters have, of course, been en-vogue since the turn of the century. As the more agile among their competitors make necessary adjustments and the less agile die away, equilibrium will eventually be achieved. Until that time – perhaps a decade hence – the era of the discounter will prevail. As long as COST continues to compete on price and maintains its “wholesale club” image, the warehouse giant will benefit from the publics ongoing distain of MSRP.

The Membership Model   

     In defiance of conventional wisdom, membership growth at COST is accelerating. The company recently reported the best sequential growth in member households per store since F17. Further, renewal rates, which had been in decline for several years, have stabilized and are growing once-again. Good news on the membership front gives COST the confidence to raise membership fees when necessary. It’s an extraordinary and impressive fact that fully 45% of COST revenues now come from membership fees.  

Competing Without Cannibalizing  

     Much needed upgrades in website functionality are contributing to notable growth in e-commerce sales at COST. User experience has been enhanced, order fulfilment is faster, and online merchandizing is much improved. The growing list of non-perishables eligible for two-day delivery now exceeds 500 items. The rollout of Instacart (grocery delivery system) continues apace, and the system - currently in 450 warehouses - will be nationwide by the end of the year. After an initial and expected period of “cannibalization”, which-is-to-say growth of e-commerce at the expense of physical locations, we are seeing a notable easing of that dangerous phenomenon.     

Buy on the Pullback

     On 5/31/2018 COST reported a consensus beating EPS of $1.70/share on top and bottom line growth. The stock retreated, however, on news of fairly aggressive price cutting by the firm. Even in light of continued price cuts, the comps and the earnings outlook for the big box chain is well supported. COST is effectively competing on the strength of its core value proposition (price, quality, & selection). Investors should consider buying on this pullback.