Costco: High Volume Consumer-Centric Business with Steady Growth.
Costco Overview
Based in Issaquah, Washington, Costco Wholesale Corporation sells high volumes of foods and general merchandise (including household products and appliances) at discounted prices through membership warehouses. It is one of the largest warehouse club operators in the United States. The company also operates e-commerce websites in the United States, Canada, the United Kingdom, Mexico, Korea, Taiwan, Japan and Australia.
The company’s warehouses offer an array of low-priced nationally branded and select private labelled products in a wide range of merchandise categories. Costco offers three types of memberships to its customers: Business, Gold Star (individual), and Executive.
As of Sept 2, 2020, Costco operates 795 warehouses, comprising 552 in the United States and Puerto Rico, 101 in Canada, 39 in Mexico, 29 in the United Kingdom, 27 in Japan, 16 in Korea, 13 in Taiwan, 12 in Australia, three in Spain, and one each in Iceland, France and China.
Costco generates revenue from two sources: 1) Store sales (Net sales; 97.8% of fiscal 2019 total revenue) and 2) Membership fees (MFI; 2.2% of fiscal 2019 total revenue).
Costco offers myriad varieties of food products as well as a vast range of household and lifestyle products, stationeries and appliances. The company also sells gasoline to customers at cheap prices and offers merchandise in the following categories:
1) Food and Sundries (including dry foods, packaged foods, groceries, snack foods, candy, alcoholic and nonalcoholic beverages, and
cleaning supplies)
2) Hardlines (including major appliances, electronics, health and beauty aids, hardware, and garden and patio)
3) Fresh Foods (including meat, produce, deli, and bakery)
4) Softline’s (including apparel and small appliances)
5) Ancillary (including gasoline and pharmacy businesses).
Costco Buy Side
Costco’s strategy to sell products at heavily discounted prices has helped it to remain on a growth track as cash-strapped customers continue to reckon Costco as a viable option for low-cost necessities.
- Decent Comps Performance: In the evolving retail ecosystem, Costco has been able to create a niche for itself on the back of growth strategies, better price management, strong membership trends and increasing penetration of e-commerce business. Certainly, these helped the company to continue with its decent comparable sales run. Comparable sales for third-quarter fiscal 2020 improved 4.8%, reflecting an increase of 5.9% and 6.2% in the United States and Other International locations, respectively, partially offset by 2.5% decline in Canada. Average transaction improved 9.3% on a year-over-year basis. I note that Costco’s comparable sales for August rose 13.2%. This followed an increase of 13.2% and 11.5% in July and June, respectively. Markedly, shares of the company have increased by 17.9% so far in the year compared with the industry’s gain of 6.8%.
- A Dominant Warehouse Retailer: I believe that Costco continues to be one of the dominant retail wholesalers based on the breadth and quality of merchandise offered. The company’s strategy to sell products at heavily discounted prices has helped it to remain on a growth track as cash-strapped customers continue to reckon Costco as a viable option for low-cost necessities. In the wake of the fast-spreading coronavirus, the company has been witnessing increasing demand for toilet paper, disinfectants, packaged water and related food staples. A differentiated product range enables Costco to provide an upscale shopping experience for its members, resulting in market share gains and higher sales per square foot. The company has been employing the Zest Fresh solution to augment its Fresh Food Supply Chain. Zest Fresh lower waste by 50%, increase shelf life of the food and allows the company to offer low prices on fresh food.
- Increasing E-Commerce Penetration: The company is also gradually expanding its e-commerce capabilities in the United States, Canada, the U.K., Mexico, Korea, Taiwan, Japan and Australia. To drive its online sales, the company launched CostcoGrocery to deliver non-perishable items to the buyer’s home and expanded same-day grocery delivery service in collaboration with Instacart. These delivery systems have been yielding favourably and driving more traffic. The company has also launched same-day prescription Rx delivery and same-day alcohol delivery through Instacart. Also, Costco acquired Innovel Solutions, a leading provider of third-party end-to-end logistics solutions, for a purchase price of $1 billion from Transform Holdco. The buyout boosts Costco’s e-commerce capabilities and facilitates it to sell “big and bulky” items such as appliances, furniture, mattresses, televisions, grills, patio, fitness equipment and wine cellars. I note that e-commerce comparable sales advanced 64.5% year over year during the quarter under review. Excluding the effect of gasoline prices and foreign exchange, the same exhibited an improvement of 66.1% year over year. The company’s e-commerce sales have been showcasing a sharp increase, courtesy of a loyal customer base who have been shopping for essentials from home amid the lockdown. E-commerce comparable sales soared 101.9% during August. This followed an increase of 75.3%, 85.8% and 106.2% in July, June and May, respectively.
- Concentrating on Enhancing Global Footprint: I remain encouraged by Costco’s expansion strategy. The company has one of the highest square footage growth in the industry and remains committed to opening new clubs in the domestic and international markets. In our view, the company’s diversification strategy is a natural hedge against risks that may arise in specific markets. The company opened 23, 29, 26, 21 and 25 locations in fiscal 2015, 2016, 2017, 2018 and 2019, respectively. Management expects to open net 13 units during fiscal 2020. There were two new openings during the third quarter. During the final quarter, the company plans to open 10 units, including two relocations.
Costco Sell Side
Stiff competition from both brick-and-mortar stores and online retailers and cautious consumer spending may hurt Costco’s performance. Moreover, it remains prone to currency fluctuations.
- Stiff Competition: Costco faces stiff competition from BJ’s Wholesale Club and Sam’s Club, a division of Wal-Mart Stores. These two rivals follow similar business models as they market high volumes of merchandise at low prices in membership-only warehouse clubs. Sam’s Club, in particular, poses the biggest threat to Costco as both primary target professionals and small-business owners who typically make bulk purchases. Analysts pointed out that any incremental investments or aggressive pricing strategy may hurt margins.
- Rising SG&A Expenses May Strain Margins: I note that SG&A expenses and merchandise costs increased 13.6% and 6.7%, respectively, during the third quarter of fiscal 2020, following an increase of 8.1% and 10.9%, and 7.4% and 5.3% in the preceding two quarters. In the first, second, third and fourth quarters of fiscal 2019, SG&A expenses rose 7.8%, 7.1%, 6.8% and 9.9%, while merchandise costs rose 10.9%, 6.9%, 7.5% and 6.8%, respectively.
- Macroeconomic Headwinds: The company’s customers are very sensitive to macroeconomic factors including interest rate hikes, increase in fuel and energy costs, sluggishness in the housing market, unemployment levels, and high household debt levels, which may affect their spending levels. Moreover, due to exposure to international markets, Costco remains prone to currency fluctuations. Management stated that foreign currencies relative to the U.S. dollar adversely impacted sales by roughly 110 basis points and gasoline price deflation negatively impacted sales by about 190 basis points during the third quarter of fiscal 2020. Additionally, gasoline volumes or gallons were down about 20% year over year in the quarter as a result of less driving due to the pandemic.
Valuation Metrics of Costco
Costco’s Long Term Outlook
Costco is a true consumer-centric volume business. Many times, the CEO of Costco, Craig Jalenik reiterated their emphasis on better employee satisfaction and better consumer satisfaction as a catalyst to their success. This is dependent on them making as little as possible on a product and still deliver value to shareholders by retaining customers and maintaining low prices with high-quality products driving volume.
With E-commerce booming for Costco, I expect more sales in bulk to impact Costco’s bottom line positively. Since the pandemic began Costco’s e-commerce sales have been consistently above 70% and for comparison, e-commerce sales for Costco in September 2019 sat at 17.8%. Now, e-commerce sales for September 2020 sit at 90.3%. I expect this trend to continue and compete with the likes of Amazon and Walmart.
Summary
Shares of Costco have risen and outpaced the industry so far in the year. The company’s growth strategies, better price management and strong membership trends reinforce its position. Notably, top-line grew year over year and the company logged a decent comparable sales growth during third-quarter fiscal 2020. The company’s e-commerce sales surged during the quarter. Yet I note that Costco’s bottom line came under pressure. Management highlighted that incremental wage and sanitation costs owing to the coronavirus outbreak hurt the company’s quarterly earnings. Also, any higher investments or aggressive pricing strategy may hurt margins. Again, rising SG&A expenses and stiff competition pose concerns.
Referred Sources:
Costco’s FY 2020 Results, Costco’s 2019 10-K, Zacks.com and predictions made by the Author’s understanding of the company.
Disclosures:
This report contains independent commentary to be used for informational purposes only. The analyst/author contributing to this report does not hold any shares of this stock at the time of writing. The analyst/author contributing to this report does not serve on the board of the company that issued this stock. Additionally, the analyst/author contributing to this report certify that the views expressed herein accurately reflect the analyst’s/author’s personal views as to the subject securities and issuers.
