Why Costco, Seemingly Overvalued, Should Climb Further (2024)

Costco (NASDAQ:COST) (NEOE:COST:CA), one of the most misunderstood stocks in the market, is down 9% from the pre-earnings all-time high of nearly $800 per share — although it is still up 50% over the past 12 months. This, I believe, is a great buying opportunity for those seeking a long-term investment in one of the best business models in the US retail space.

Below, I use discounted cash flow to explain why COST, generally considered a very expensive stock at a 2024 P/E of 44.7x against only 8% expected EPS growth next year for a PEG of 5.5x, will likely continue to climb until or unless its market cap approaches $500 billion.

Costco's Secret Sauce

There isn't much to be excited about Costco's core big-box retail business. In fiscal 2023, the Issaquah, Washington-based company reported tiny operating margins of only 3.3% and op profits that grew by only 4% YOY. This was no fluke, mind you, as margins in the prior fiscal year had landed at an equally dismal 3.4%.

Take a close look at Costco's earnings call transcripts and notice how obsessed the company's management team is with controlling costs. Anecdotally, I find it entertaining how margins are presented and discussed in two decimals (e.g., gross margin "coming in at 10.80% compared to 10.72% last year") and how YOY improvements to the tune of a few single-digit basis points (i.e., 0.09% or less) are often celebrated. One might wonder: how can such tight margins and slow growth be rewarded with well-above-market valuation multiples?

Costco's secret sauce is not its signature rotisserie chicken promotions (although they do serve as a stimulant to foot traffic), but its membership fees instead. While representing only 1.9% of total revenues in fiscal 2023, I estimate fees to represent nearly pure profit for the retailer. For simplicity, if I assume membership fees to flow straight down to operating income — not a terrible assumption — they account for an astounding 56% of this important P&L line.

Costco, therefore, is a very rare instance of a recurring-revenue, subscription-like business model outside the tech and software world. That, in my view, is the reason why COST deserves to trade, and will likely continue to trade, at super-premium valuation multiples (see chart below).

DCF Explains COST's Appeal

Membership fee growth is driven primarily by two factors: (1) net new members joining the club and (2) membership price hikes. A secondary factor is the mix of executive-to-gold star memberships, with the former providing Costco with twice the annual per-member revenues compared to the latter.

The metrics below on Costco's membership base are quite impressive:

• At the end of fiscal 2023, the total number of paid household members, 71 million, was up 7.9% YOY. Nearly half of them were executive members who paid $120 per year for the mere right to step into a Costco store.
• Membership renewal rates in the US and Canada, Costco's largest markets, stood at an impressive 92.7%. Even better, this already high rate improved YOY, albeit by a small 10 bps.
• With a large membership base that continues to grow and renew at a stratospheric rate, Costco is still able to raise membership fees. Hikes of around 10% tend to happen every six or seven years, for a rough average fee increase of 1.2% annualized.

Now, for a moment, forget Costco's revenues and profits generated from its core brick-and-mortar, bulk retail business (keep in mind that e-commerce is a very small chunk of Costco's revenues and has been shrinking lately). I would argue that:

• Costco's $4.58 billion in membership fees generated in fiscal 2023 could continue to grow indefinitely at a rate of 5% per year. This number assumes (1) continued price hikes, (2) footprint expansion within and outside the US and Canada, partially offset by (3) a slowdown in the growth rate over time as Costco gains scale, influenced in part by (4) slightly lower renewal rates that tend to be a norm in markets outside North America.
• Such a steady, predictable inflow of cash presents relatively little risk for an investor. Considering the current yield on the 30-year US government bond at 4.2%, I believe that discounting Costco's future membership fees to present value using a rate of 6% is reasonable.

A quick back-of-the-envelope DCF calculation helps to explain the appeal of owning COST stock. Let's use the perpetuity formula below:

Plug in the variables presented above, and I would argue that Costco's future membership fees alone might be worth $460 billion today. Overlay a very slow-growing, thin-margin retail business that generates over $200 billion in annual revenues, and I could very conservatively round COST's fair market cap up to $500 billion vs. the current equity value of $315 billion.

In Conclusion

In my view, for as long as COST continues to trade at a discount to $500 billion in market cap, the stock will continue to rise. This would happen while side-lined investors and analysts continue to underappreciate Costco's reliable, steady, decent-growing membership revenues that are certainly not properly reflected in traditional valuation metrics like P/E or PEG.

DM Martins Research