Here’s Why We Believe That Costco Is Fairly Valued At $121
Largest warehouse club in the U.S., Costco (NASDAQ:COST), has grown at a steady pace over the past several years irrespective of the state of the economy. While most retailers have struggled to attract customers due to low consumer confidence lately, Costco has had no problems in driving store traffic. With its unwavering financial performance, the retailer’s stock has been somewhat stable, rising only 5% over the last year. However, we believe that there is still some value to be unlocked in the company and our price estimate for Costco at $121 is about 10% premium to the current market price.
The retailer can maintain a steady growth momentum in the U.S. going forward, due to increasing adoption of warehouse shopping and Costco’s appealing bargains. Historically, Costco’s international growth has exceed its domestic growth by a long margin, which is likely to continue in the future with the retailer’s persistent expansion in lucrative markets. Another bankable factor that is likely to add significant value to Costco in the long run is its growing e-commerce channel. However, rising competition from Wal-Mart‘s (NYSE:WMT) warehouse model Sam’s Club and online giant Amazon (NASDAQ:AMZN) pose some serious threats for the company. While Amazon’s rapid growth and showrooming are causes for worry to a number of retailers, including Costco, Sam’s Club’s lower membership fee and wider customer reach can hurt the warehouse giant.
See our complete analysis for Costco
Strong Industry Growth & Costco’s Core Value Propositions
A warehouse retailer charges an annual membership fee to its customers and provides a wide variety of merchandise at discounted prices. The U.S. warehouse club industry comprises of three main players – Costco, Wal-Mart’s Sam’s Club and BJ’s Wholesale Club – with Costco being the strongest of the lot. Some consumer reports suggest that buyers can save up to 55% while shopping at warehouse clubs. [1] Due to these bargains, the warehouse club industry sales have grown at a higher rate than general merchandise store sales over the last decade. Costco’s annual comparable store sales growth has averaged around 6% for the past three years, thanks to new membership signups. We do not expect any significant slowdown in the industry growth in the future as pricing benefit is something that buyers will always welcome, as long as they are offered good quality products.
As a warehouse retailer, Costco offers products at lower prices than its competitors. It does so by keeping the product markups low at 15% while most supermarkets and department stores markup their goods by more than 25%. [2] The retailer displays its products in simple boxes and shelves on concrete floors to keep the costs to minimum. Also, it changes the brands it offers regularly, and therefore, customers always find something new at its stores and get a ‘treasure hunt’ experience. To add more appeal, the retailer from time-to-time offers high-end products such as Coach (NYSE:COH) purses and Dom Perignon champagne. [2] Costco is also focused on serving its customers based on the local tastes and demand. It grants its local store managers some discretion over the products that are kept in stores. For instance, demand for salsa is highest in the Southwest region, as compared to other U.S. markets. [3]
Several Opportunities In International Markets
Over the past four years, while Costco’s revenues in the U.S. have grown at an average annual rate of 5%, its international revenues have increased by almost 15% annually. It appears that consumers in international markets are welcoming the retailer’s business model, which promotes cost saving. In fact, early signups in Asia and Australia have been very strong, which is encouraging Costco to continue its expansion in these regions. The company opened two stores in Australia in the first quarter and plans to add another two by the end of fiscal 2014. Also, Costco will open two locations in Japan and Korea during the next six months. [4] Currently, the company operates just 173 stores in seven countries, out of which 120 are in Canada and Mexico. Therefore, Costco has a strong opportunity to increase its reach in Japan, Taiwan, Korea, Australia and the U.K, and also enter other lucrative markets. In Mexico, the retailer has enough room for growth, despite the recent economic slowdown. [Read: Costco Has Room For Growth In Mexico]
This spring, the company will be opening its first store in Spain, where the prevailing economic weakness can work in its favor. [4] We believe that given the right marketing, Costco can acquire a strong customer base in the region by offering cost saving options. Demand for essential items such as groceries in Spain is quite strong despite the overall retail weakness. [5] This should assist the retailer’s growth since it generates more than half of its revenues from groceries.
Growing Online Business
Over the past several quarters, Costco’s online business has grown at a robust pace, backed by its website re-platforming, several new mobile apps and the launch of new product categories. Following 24% growth during the first quarter of fiscal 2014, the retailer’s e-commerce revenue rose by 20% in Q2 fiscal 2014. [4] We believe that this growth is likely to continue in the future as Costco’s online channel is at a nascent stage and accounts for just 2.5% of its net sales. Furthermore, the company’s e-commerce strategy, increased product categories and better inventory management will assist its online growth. About 80%-90% of products offered on Costco’s website are different from its store inventory. This prevents self-cannibalization between these two channels. Over the last year, Costco has added new product categories such as apparel, health and beauty aid. The retailer has also improved its delivery times by shipping from three depots instead of one. [4] Costco currently operates its e-commerce operations in three international geographies – Canada, the U.K. and Mexico. As the company enters new markets such as Japan, Australia, Korea etc. in the future, its online business will get bigger and start making material contribution to its sales.
Key Risks To Consider – Sam’s Club & Amazon
Although Costco is the leading warehouse retailer in the U.S., it faces stiff competition from its closest competitor, Sam’s Club. While Costco has a larger customer base, there are some factors that make Sam’s Club a more attractive choice for customers, thus making it a potential threat for the warehouse giant. Compared to an annual membership fee of $55 at Costco, Sam’s Club charges only $40 from its members. While an executive member at Costco pays $110 per year, Sam’s Club’s plus members pay only $100. It appears that Sam’s Club has a clear competitive advantage in terms of membership fee. Costco operates 450 stores in 40 states of the U.S. and Puerto Rico, with high concentration around California. The retailer earns about 24% of its domestic revenues from the region. On the other hand, Sam’s club is evenly spread across the U.S. with over 630 stores in 47 states and Puerto Rico. Additionally, Sam’s Club is the only warehouse club that offers Apple (NASDAQ:AAPL) products, which gives it a slight edge over Costco. [1] Sam’s Club also provides excellent services for delivery, installation and technical support. When it comes to groceries, which is the largest product category sold by both warehouse retailers, Sam’s Club is found to be cheaper than Costco. [1]
In case of Amazon, showrooming (a phenomenon where shoppers visit physical stores to find products, compare their prices on different websites and buy them cheaper online) is the biggest threat for Costco. Amazon offers and promotes free mobile apps to encourage its customers to compare prices of various products while walking in different stores. According to a survey conducted by a Seattle based startup Placed, apart from retailers such as Target (NYSE:TGT), Best Buy (NYSE:BBY) and Bed Bath & Beyond (NASDAQ:BBBY), showrooming can also impact the warehouse giant Costco. This study included the response of 15,000 customers as well as their movement analysis through the physical world. According to the study, about 45% of Amazon’s prime customers (who pay $79/year for free two-day shipping) will more likely shop at Costco than an average shopper. Moreover, there is 38% more chance for Amazon’s showroomers to visit Costco as compared to other showroomers. [6] This indicates a big overlap between Amazon’s and Costco’s customers, which could be problematic for Costco. Considering the rapid growth of Amazon’s product categories, showrooming becomes an even greater threat. The company has demonstrated the ability to quickly grow its product portfolio, modify it to remain in line with Costco’s products and deliver merchandise within two days. Amazon offers a compelling range of consumer electronics and jewelry items – categories which have been important for Costco’s growth. In addition, Amazon is also taking on Costco in the grocery space with its local grocery-delivery service known as AmazonFresh.
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Notes:- Best Warehouse Store: BJ’s, Costco or Sam’s Club?, Yahoo Finance, Jan 6 2013 [↩] [↩] [↩]
- Costco’s Unorthodox Strategy To survive The Big Box Apocalypse, Business Insider, Mar 7 2013 [↩] [↩]
- Why Costco And Other Warehouse Club Retailers Matter, L.E.K Consulting [↩]
- Costco’s Q2 fiscal 2014 earnings transcript, Mar 6 2014 [↩] [↩] [↩] [↩]
- Retailing in Spain, Euromonitor International, Mar 2013 [↩]
- Survey: Showrooming a threat to Costco, too, The Seattle Times, Feb 27 2013 [↩]