On Costco Wholesale Corp. (NGS: COST) is BUY. We put Costco on our BUY list in October 2008 at a price of $58.
If investors are looking for clues to our future ratings or target changes, these two measures of member engagement are likely to be important indicators because they are drivers of earnings growth and earnings stability.
While Amazon offers the world’s biggest selection, Costco sells a smaller, curated selection of items that enables it to both save money for customers and make a reasonable profit. We note, however, that Costco has greater pricing power on its narrower range of products as well as attractive private-label merchandise. In 2018, the company sold more than $39 billion of merchandise under its own Kirkland Signature brand, with growth of 11%. That is more than revenue at Coca-Cola, more than twice as much as Colgate-Palmolive, and about the same as Kraft Heinz and Kellogg combined. Kirkland products generally have higher margins than the company average, and the company expects private label products to become a bigger percentage of the company’s sales mix. Costco offers just 3,700 Shop-keeping Units (SKUs) in its stores while Amazon reportedly offers over 600 million, give or take a few hundred million.
On September 24, Costco reported EPS of $3.13 for the 16-week fiscal fourth quarter ended August 30. EPS rose 27%. Our estimate was $2.79 per share. There was a $0.15 per share tax benefit related to the partial reversal of a tax reserve in the prior-year quarter. While the tax benefit was not contemplated in our 4Q estimate, we had expected COVID-related expenses.
Fourth-quarter sales were strong, but they were already reported and factored into our model when we wrote our earnings preview. As a reminder, on September 2, Costco reported sales for August, the fourth quarter, and the full fiscal year. August sales rose 15% to $13.56 billion. Comparable sales, excluding changes in fuel prices and exchange rates, rose 14.5%. August e-commerce sales were up 102%.
For the fourth quarter, adjusted comps were up 14.1% and total sales were up $52 billion. Our estimate had been $50.16 billion. Adjusted 4Q comps, which exclude fluctuations in gasoline and foreign exchange, were up 13.6% in USA, 12.6% in Canada, and 18.8% in other international markets. Gasoline deflation was a 220-basis-point drag on total comps. The strong dollar had a negative 50-basis-point impact, which was sequentially smaller than 110 basis points of drag in 3Q. E-commerce sales grew 90% in the quarter. The company also saw a sales drag as the pandemic restricted business at food courts and some higher-margin ancillary businesses. Total revenue was $53.383 billion, including membership fees of $1.1 billion.
The expense rate was about 25 basis points higher than we expected because of COVID-related expenses. The consensus was 3.26% and the actual margin was 3.61%. Despite the strong EPS and better-than-expected profitability, the shares fell after the report. We believe that some investors were disappointed that there wasn’t better ‘flow through’ on such strong sales. Often companies will show big jumps in profitability when sales are very strong. This is because fixed costs are covered and a bigger portion of each sales dollar falls to the bottom line. Costco, like many other retailers, had high COVID expenses along with strong demand. This doesn’t alter our thesis.
Among the metrics that are important to us, global traffic was down 1.2% in 4Q but up 1.2% in the U.S. That was an improvement from a sequential traffic decline of 4.1% in 3Q, with a 2% decline in the U.S. Renewals remained very strong at 91% in the U.S. and Canada – another extraordinary performance that underscores the company’s relevance to its paying members. The overall renewal rate remained at 88.4%. The total number of cardholders increased by 3.7 million to 105.5 million.
EARNINGS & GROWTH ANALYSIS
We think the company’s financial strength gives it the opportunity to either repurchase shares more aggressively or pay another special dividend.
This assumes approximately 7% sales growth and a relatively flat share count. We see the potential for stronger sales growth and significant share repurchases; however, we also recognize that the company is coming off very strong results and still faces considerable economic and COVID-related uncertainty.
FINANCIAL STRENGTH & DIVIDEND
Within our now broader consumer universe, Procter & Gamble has a High rating. P&G’s balance sheet metrics aren’t that different from Costco’s, but P&G has substantially higher margins.
In assessing financial strength, we believe it’s important to consider how much debt a business has, how capital-intensive it is, and how cyclical it is.
We don’t expect the dividend to be constrained by the Costco’s considerable financial strength, rather the company is likely to use cash to open productive new stores.
We will update this after we review the annual report. The share count rose slightly from 3Q20 to 4Q20, so we don’t expect to see much repurchase activity.
MANAGEMENT & RISKS
The crisis has also closed some of the company’s ancillary businesses and forced it to restrict sales at its snack bars.
The company reported a material weakness in internal control in its 2018 annual report because of insufficient controls over user access and management of program changes. Costco put tighter restrictions on access to certain financial and reporting systems. Management said that they had not identified any financial misstatements as a result of these deficiencies. The company said that the weakness would not be considered as remediated until the new controls have been thoroughly tested. The remediation was completed and once again deemed effective at the end of fiscal 2019.
While this has been a challenge for management, we think the company has been successful in managing these expenses and that it has deservedly won praise for its efforts to provide employees with healthcare and good pay.
In January of 2014, we attended a lecture that co-founder and former CEO Jim Sinegal gave for students at Villanova University, near Philadelphia. He is a retail-sector legend and he isn’t in the press very often. His talk focused on fair business practices. He emphasized the importance of company culture.
Another benefit of stocking relatively few SKUs in high-volume warehouses is that it gives the company more bargaining power with suppliers than many of its rivals have.
The high valuation is based on a rare combination of growth potential and financial strength. Costco is one of the very rare U.S. retailers that has been successful in opening international stores.
While the shares trade at a premium multiple, it is important to consider the recurring revenue from membership fees, 90% renewal rates in North America, some of the strongest traffic in retail, a growing $40 billion private-brand business, more cash than debt, full ownership of 620 sites and warehouses, and financial strength that supports double-digit dividend growth and buybacks.