Rising Food Prices And Razer Thin Margins Are A Bad Combination For Costco

-10.80%
Downside
732
Market
653
Trefis
COST: Costco logo
COST
Costco

The Midwestern drought and global food inflation have resulted in a significant increase in food prices that will likely persist for some time. Retailers such as Costco (NASDAQ: COST), Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) could be affected since a significant portion of their revenues comes from the grocery sales. Among these retailers, the effect on Costco could be greater than its competitors as a warehouse club and so Costco’s margins are lower than Wal-Mart and Target’s. We believe that the weak U.S. economy has made consumers cautious about their spending and so retailers might have to absorb a portion of the higher costs by compromising on their margins. Given that Costco’s margins are already quite low, if it looks to pass on these prices to customers, it could lose them to other retailers such as Wal-Mart.

See our complete analysis for Costco

Costco May Have To Pass On The Price Increase

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Besides the global food inflation, the food prices in the U.S. have shown an upward trend since the food riots in 2008. The U.S. Department of Agriculture forecasts an increase of 2.5-3.5 % in the food prices in 2012, and another 3-4% increase in 2013. [1] However, the figure for 2012 might rise further by the end of the year owing mainly to the Midwestern drought. The wholesale food prices in the U.S. rose by 1% within the two months of June and July. [2]

With the increase in the cost of goods, Costco will either have to pass on the burden to its customers or accommodate it in its margins. Since Costco already has very low margins, absorbing the prices and taking a margin hit may not be a viable option. We believe that the retailer, like others, is more likely to pass on the price increase to its customers.

However, This May Prompt Customer Shift.

The U.S. economy is still under the phase of slow growth. The Q2 2012 GDP growth, which was expected to be around 1.7%, was recorded to be 1.3%. [3] One of the reasons behind this was the Midwestern drought.

The majority of Costco’s customers are families, small business owners and consumers who buy in bulk. With the sluggish growth in the economy, these customers might be reluctant in buying the same volumes as before. Moreover, the customers often buy food items in wholesale. As the prices increase, they might consider buying less or switching to other alternatives such as Wal-Mart where they can still get value but in smaller quantities.

Costco’s main counterpart is Wal-Mart’s Sam’s Club. While Costco’s entire business is confined to warehouse stores, Sam’s Club only contributes about 5% to Wal-Mart’s value. Wal-Mart can utilize its sheer size, higher gross margins and efficient supply chain to better absorb the food inflation. This will put Wal-Mart in a position to offer food products at attractive prices, which may result in a shift of customers from Costco to Wal-Mart.

Groceries constitute 55% of the total Costco revenues. [4] Therefore, the rise in the food prices will certainly have a negative impact on the retailer.

Our price estimate for Costco stands at $101, roughly same as the market price.

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Notes:
  1. WRAPUP 2 U.S. Midwest drought worsens, food inflation to rise, Reuters, Jul 25 2012 []
  2. Supermarkets face tough choices if food costs rise, Forbes, Aug 15 2012 []
  3. Second-quarter GDP cut to 1.3% on drought, Reuters, Sept 27 2012 []
  4. Costco’s SEC filings []