Costco’s International Expansion Plans Will Boost Growth

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In 2013 Costco (NASDAQ: COST) commenced its plan to expand its operations by opening 150 warehouse clubs globally, with a specific focus on previously untapped international markets. [1] This was an important strategic move to accelerate growth, given that initial customer response for Costco in international markets has been much better than in the U.S.

Membership signups in the first eight to twelve weeks of opening a warehouse internationally is typically much larger than in the US. For example, new warehouses in Asia typically see an average of 30,000-40,000 signups in the first eight to twelve weeks, while the same figure ranges between 3,000-12,000 in the US. [2] This large difference can primarily be attributed to the excitement associated with a fresh concept being introduced to consumers in a new market. This is a factor that will continue to sustain as Costco expands internationally in previously un-entered markets.

With its superior offerings at bargain prices, Costco is also able to retain these new members successfully. In the most recent earnings report, the international membership renewal rate for Costco grew to an impressive 87.9%. [3] Increased membership revenues and retention rates also contribute  to increasing overall net sales at Costco’s international stores.

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It is important to note that in FY 2013 and 2014, international net sales grew at an average of 8%, while domestic net sales grew at an average of 6%. This figure substantiates the fact that Costco’s aggressive international expansion plan is a great strategic move to drive growth. [4]

Our price estimate for Costco stands at $147, which is approximately in line with its current market price.

See our complete analysis for Costco

International Expansion Plans a Consequence of Consistent Growth

The international expansion, expected to conclude in 2017, is the result of Costco continually seeing positive growth. Net sales increased impressively by 45% between 2010 and 2014. This growth especially stands out when compared to Sam’s Club, the warehouse club chain run by Wal-Mart (NYSE:WMT), which witnessed comparatively slower net sales growth of 21% over the same period. [5]

Unlike most retailers, Costco’s plan to expand internationally is not a strategy to counter the slowdown in domestic sales. Costco’s average year-over-year growth in domestic net sales was 7% between 2010-2014. The plan to increase international presence is hence a strategic move to ramp up overall growth at Costco.

Between 2013 and 2014, Costco opened 29 of its planned 55 domestic warehouses in the US. On the other hand, only 26 of the planned 95 international warehouses were opened in the same time period. [4] We hence expect that the expansion will be more focused on international locations, especially where Costco has no presence currently, over the next three years.

Capital Expenditure Will Shoot Up

The first consequence of store expansion is increased capital expenditure. Prior to 2013, Costco’s annual capital expenditure ranged between $1-$1.5 billion. However, in 2013 and 2014, annual capital expenditure touched $2 billion.

Globally, warehouses operated by Costco are between 73,000-205,000 square feet in size. In 2014, Costco disclosed that its average warehouse size is 143,700 square feet. [6] However, Costco’s international warehouses are usually at or above the average warehouse size. For example, Costco Spain spans over more than 160,000 square feet, while Costco Australia has stores that have an area larger than 150,000 square feet. [7] [8]

In 2013, Costco opened 14 new warehouses internationally as compared to 12 in 2014. The number of warehouses opened in the US increased from 12 to 17 in the same period. However, capital expenditure reduced by 90 million between 2013 and 2014. [4] Hence, even as the number of new warehouses in the US increased, the slowdown international expansion led to a reduction in capital expenditure.

This suggests that international expansion comes at a higher cost than domestic expansion. Moving forward, as the expansion is more focused on international locations, we expect that capital expenditures will see a rise. Costco has already planned to increase its capital budget to $2.5-$2.7 billion for fiscal 2015. We anticipate that over the next three years, capital expenditures will range between $2.5-$3 billion. [9]

We Expect Gross Margin to Remain Stable

While costs have been rising marginally, the payoff of opening new warehouses in terms of net sales is also evident. As a result, gross margins at Costco have increased slightly from 10.55% in 2012 to 10.66% in 2014.

The marginal increase in operating expenses is expected to put downward pressure on the operating margin. However, historically, net sales increases from new warehouses has offset the impact of these incremental costs on the margin. As a result, we anticipate that margins will continue to rise slowly and move to 10.80%-10.90% by 2017.

Risks Accompanying International Expansion

An inherent risk in international retail expansion is the inability of the retailer to adjust to different socio-cultural environments. If the retailer fails to adapt to the sensibilities of new consumers, it might lose out on sales and customer retention. One of the reasons why Costco continues to see success in international markets is because it integrates itself into new markets seamlessly. Almost two-thirds of the products sold in an international Costco warehouse originate at the country where it is located, utilizing local suppliers. The company also sends very few employees from its home location to setup overseas operation, largely relying on locals familiar with the specific market and socio-cultural dynamics. [10] As a result, this risk will not be a big concern as Costco has already demonstrated its ability to handle international expansion successfully.

Real estate and land tend to be relatively cheaper in emerging markets. However, Costco also intends to build its presence in Europe. In countries like France and Germany, where leasing area to build warehouses will be expensive, the warehouses will have to be particularly aggressive with membership signups to ensure that store margins are not affected.

Financially, international operations are subject to a variety of risks. Currency exchange rate risks, among these, tend to have a direct impact on Costco’s reported net sales. This impact was evident in Costco’s performance in the first half of 2015 as well. Overall same-store growth remained at a healthy 7%. However, due to the impact of falling gas prices and currency rate fluctuations, reported same-store growth for this period was only 3%. [3] As the company expands into international markets, the impact of foreign exchange rates on reported results will become a bigger concern for the company. The company continues to hedge these risks with the use of a variety of derivative contracts.

The other concerns while expanding in international markets include political instability, economic conditions and regulatory issues, which the company has no control over, but could adversely affect Costco’s business in the future. This is a risk that the company will have to bear as it tries to increase its presence in international markets to accelerate growth.

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Notes:
  1. Costco Plans 150 New Stores in 5 Years, Supermarket News []
  2. Costco’s Global Expansion…With a Twist, The Motley Fool []
  3. Costco Wholesale (COST) Q2 2015 Results – Earnings Call Transcript, Seeking Alpha [] []
  4. Costco Wholesale Corporation 10K FY 2014, Costco Wholesale Corporation [] [] []
  5. Form 10K, Wal-Mart Stores Inc. []
  6. Corporate Profile, Costco Wholesale Corporation []
  7. US Wholesaler Costco Opens First Spanish Megastore in Seville, El Pais []
  8. US retail giant Costco opens Docklands store, The Sydney Morning Herald []
  9. How Costco Plans to Blow Past $100 Billion in Sales, The Motley Fool []
  10. Costco kicks off European drive in Spain, The Seattle Times []