Investment thesis

Costco Wholesale Corporation (NASDAQ:COST) is an operator of discount stores known as wholesale clubs. I first became interested in Costco after Charlie Munger expressed interest in the company and spoke very positively about their operations. He was the second largest single shareholder after former CEO Craig Jelinek. Despite COST’s incredible moat and growth, I thought Charlie paid a very high multiple for COST. Over the last 18 years, the company has been able to grow at a fairly impressive rate, but I think that will come to an end and the multiple is not justified. A company the size of COST can grow at these rates up to a point – and that point has already been reached.

COST is a fairly expensive company. Sell-side analysts expect the The company is earning just over $16 per share this year and is trading for over $800 per share – that’s 50 times this year’s earnings. The company has always had an immense P/E ratio, even Charlie paid a pretty expensive multiple, but it has worked out very well for him so far. However, according to all of my valuation models below, COST should not be trading in the $800 range. I don’t think paying a high multiple is justified when the company hasn’t been able to grow its operating profit for a long time.

COST operates in an industry characterized by low single-digit margins. From an economic perspective, they don’t make money on price, but on volume. The company has been able to operate with EBIT margins of 3 to 4 percent for a long time, but has not been able to increase them significantly to 6 percent and I don’t think they will be able to do so in the near future unless they start raising prices on their products and services. This could lead to a decline in customer numbers as shopping at Costco becomes more expensive.

The company recently announced that it will increase its annual membership fees for the first time in 7 years. While this would bring in additional revenue, it would not have a major impact on growth as membership fees only represent 2% of total revenue. In my opinion, management is anticipating a possible decline in purchases and has therefore increased membership fees to generate additional revenue.

The consumer

Costco customers are becoming more “price conscious,” which has led to a decline in sales of expensive items (where demand is very elastic) such as high-end TVs, computers, etc. According to the sales breakdown above, sales of non-food items have slowed since 2021, and I expect these to continue to decline as a percentage of total sales. It is very true that COST has loyal customers throughout the U.S. and Canada (who account for more than 80% of its sales), however, there are better places to shop and consumers want to get more value from the products they buy.

Not to mention, COST is not well positioned in online shopping (e-commerce accounted for about 6% of total net sales in 2023), while competitors like Walmart and Amazon dominate the online shopping market and offer great alternative prices. In the next few years, we will see a decline in traditional shopping that will impact Costco stores.

Ali Hortaçsu and Chad Syverson have put together a research paper called “The Progressive Evolution of U.S. Retail: A Tug of War over Formats” which essentially looks at the changes in the way people shop over the past 15 years and the future prospects. Given the slowdown in traditional shopping (as per the chart on page 99), the multiple of COST is not justified. I think the company is a SELL and worth about half of its current value, so about $450 per share.

Evaluation

My 20-year DCF model discounts COST’s future cash flows to arrive at a company valuation. Using the following assumptions starting in 2024, I expect the company to grow its revenue to nearly a trillion dollars by 2043 (if the company grows its revenue by 7% each year). COST is a low-single-digit EBIT margin company. I expect the company to plateau at 5% by the end of 2043. Taxes have been held at 21% over time, in line with the U.S. corporate tax rate. COST has a current market cap of $368.3 billion ($830.74 per share) and trades at a premium to my DCF model’s implied equity value of $224.6 billion, or $506.65 per share.

In addition, COST trades at a premium to its peers – Walmart (WMT), Target (TGT), Kroger (KR), Dollar General (DG), Albertsons (ACI). According to my trading comparison analysis, COST should trade in the $400 range at the current revenue multiple and between $250 and $350 at EBIT and net income. As mentioned earlier, the company operates in an industry characterized by very low and consistent margins. COST does not have the growth and operating margins of a technology company, so it should not trade at a technology multiple.

My exit multiple method and the Gordon Growth method also show downside to the stock. Assuming an exit multiple of 12 (which is the industry average), we see an equity value of $234.8 billion, or $529.71/share, down 36.2% from $830.74. The implied stock price will show even more downside if a lower exit multiple is applied. The Gordon Growth model, on the other hand, shows an equity value of $216.3 billion, or $487.98/share, down 41.3% from current levels.

Possible risks

Short interest for COST stock is 1.6%, showing strong sentiment for the bull side. There could be a potential risk as investors are leaning more towards the bull side and are not willing to sell. Most of the outstanding shares are held by large passive asset managers (Fidelity, Northern Trust, Wells Fargo); therefore, there will be less interest in selling a large portion of the shares, and this may not push the price of COST down to my price target of $450 per share.

Economically speaking, memberships should fall as annual fees rise. The same is true for demand-elastic products that Costco sells. However, economic theory doesn’t always hold true.

Diploma

Costco has been one of the best players in consumer goods distribution and retail. Its price has tripled since 2019 and has done very well during the COVID pandemic. However, I believe this will come to an end and the current P/E of 50 is not justified, especially given the company’s long-standing inability to grow its operating profit. COST has EBIT margins between 3% and 4% and has not been able to significantly increase them to 6%. Unless they start charging more for their products and services, I don’t think they ever will. This could provoke customer attrition as shopping at Costco becomes more expensive.

E-commerce accounted for 6% of total net sales in 2023; the company does not have a well-developed online business. The majority of its revenue comes from traditional shopping. The company is poorly positioned in online shopping, while Walmart and Amazon, which offer great alternatives at competitive prices, dominate the market. Costco stores will be affected by a slowdown in traditional shopping in the next few years. The slowdown in traditional shopping was made clear in the work of Hortaçsu and Syverson.

Shoppers are becoming more “value conscious,” which has slowed sales of expensive items like high-end TVs, computers, and other products where demand is very elastic. Sales of non-food items have declined since 2021, and I expect these to continue to decline as a percentage of total sales. While COST has a moat and a loyal customer base in the United States and Canada, consumers are looking for more value in their purchases, and there are better alternatives elsewhere. I believe the company is worth about half of its current value.