Costco: Same Membership Fee For More Than Six Years; It Is Time Now (NASDAQ:COST)

Costco (NASDAQ:COST) does not make very high profit margin directly from its merchandise; however, it generates close 60% of operating profits from membership fees. Member loyalty and growth are crucial for the company’s earnings growth. Costco hasn’t raised its membership fees since June 2017, and historically, Costco raises its membership fee every five years. I believe a potential increase in membership fees could be a meaningful catalyst for their stock price. I initiate with a “Buy” rating at a fair value of $620 per share.

Importance of Costco’s Membership and Fee Growth

Costco’s revenue comprises two components: membership fees and net revenue from merchandise. If we exclude their membership fees, the operating margin only reflects the profitability from the merchandise sold to their customers. As illustrated in the chart below, their merchandise operating margin is quite stable and remains around the 1.5% level. While this is decent for a grocery retailer, it may not contribute significantly to generating direct profits for Costco.

The chart below illustrates Costco’s membership growth and the average fee per membership growth. Costco offers various membership types, including Gold Star, Business, and Household cards. Paid cardholders have the option to upgrade to an Executive membership in the U.S., for an additional annual fee of $60. Over the past decade, Costco has experienced significant growth in both membership numbers and the average fee per member.

I think there are several factors to explain their success.

Firstly, Costco has successfully increased member loyalty by skillfully negotiating with suppliers to control costs and subsequently reducing merchandise prices for consumers. This strategy has made Costco membership exceptionally valuable to consumers.

Secondly, there has been a notable increase in the number of consumers opting for Executive memberships at Costco. According to their FY23 annual report, Executive members totaled 32.3 million, representing 45.4% of paid members in FY23. This marks a significant growth compared to the 39% of paid members in FY16. Executive members not only pay an additional annual fee, but they also tend to spend more than other members.

Lastly, Costco has historically raised its membership fees approximately every five years. In June 2017, they increased the individual membership fee from $55 per year to $60 and the Executive membership fee from $110 to $120. This periodic adjustment in membership fees has contributed to the company’s overall revenue growth and financial stability.

Additional Profit Growth from Membership Fee Raise

The chart below illustrates the membership revenue as a percentage of total operating profits. This ratio has been declining in recent years as Costco has achieved higher margins from direct merchandise sales. The supply chain disruptions during the pandemic played a crucial role in boosting merchandise margins, as retailers raised prices due to the massive surge in demand. The supply-demand mismatch contributed to a higher gross margin for merchandise sales. Furthermore, it has been more than six years since Costco last raised its membership fee.

During their Q4 FY23 earnings call, Costco’s management indicated a fee increase at some point, expressing confidence in their member loyalty and continued membership growth. While they did not provide a specific timeline for the fee adjustment, their message strongly suggests that it is on the horizon, in my view.

The table below provides an estimate of the potential increase in membership revenue in the event of another price adjustment. Assuming a $10 increase for Executive membership and a $5 increase for other memberships, mirroring the adjustments made in 2017, the total membership revenue is projected to rise by $517 million. This fee increase alone could lead to a noteworthy 6.1% year-over-year increase in earnings before tax for FY24, a substantial impact as per my calculation.

Historical Financial Analysis

Costco is effectively managed, and its business exhibits a stable nature. Over the past five years, their same-store sales growth has averaged 10%, with the current high inflation contributing to some of this growth. The free cash flow margin has been consistently around 2.8%, and working capital stands at approximately 5% of total sales. In general, Costco demonstrates stable profitability with steady growth.

Furthermore, Costco engages in shareholder-friendly practices by paying dividends and repurchasing their own shares, mitigating the impact of stock option dilutions.

On the balance sheet, Costco held $15.2 billion in cash and cash equivalents in FY23, with a modest debt of only $6.4 billion. This results in a net cash position, reflecting a remarkably robust balance sheet.

Excluding the current high inflation period, Costco has achieved approximately 6% same-store sales growth and 3% new store sales growth on average. Notably, even during the global financial crisis in FY09, Costco’s same-store sales only experienced a marginal decline of 1.1%.

Recent Financial Results and Outlook

In Q4 FY23, excluding the impacts from changes in gasoline prices and foreign exchange, Costco’s same-store sales experienced a year-over-year growth of 3.8%, while their e-commerce declined by 0.6% for reasons previously discussed. During the earnings call, it was revealed that worldwide traffic or shopping frequency increased by 5.2%, with a similar increase of 5.0% in the United States. However, the average transaction or ticket was down 3.9% worldwide and 4.5% in the U.S. This decline was largely attributed to weakness in larger-ticket non-food discretionary items, as well as the deflation in gas prices.

Importantly, Costco’s membership continued to grow in the quarter, reaching 71 million paid household members, reflecting a robust year-over-year increase of 7.9%. I believe the quarter’s earnings are quite solid, especially considering the prevailing high inflation environment.

Costco’s adjusted same-store sales were up 3.7% in September and 3.4% in October. I anticipate that the current weakness in large-ticket merchandise sales could continue to exert pressure on Costco’s adjusted same-store sales growth in the near term. However, I also expect that Costco will soon raise their membership fee, and the current high inflation provides a compelling reason for such an increase.

Key Risks

Weakness in big-ticket non-food discretionary items: During the Q4 FY23 earnings call, Costco’s management highlighted a downturn in certain departments over the past two quarters. Specifically, home furnishings, small electrics, jewelry, and hardware experienced declines of 15% and 20% year-over-year, respectively. In Q4 FY23, the decline moderated to 5% year-over-year. Notably, these significant departments collectively contribute to over half of their e-commerce sales. The persistent weakness in these areas has resulted in a four-quarter consecutive drop in e-commerce comparable sales growth. However, I believe this weakness is macro-driven rather than stemming from changes in the competitive landscape, as other e-commerce companies have also reported challenges in large-ticket merchandise sales.

High Level of Inventories: Costco’s inventory increased to $17.9 billion in FY22 and subsequently decreased to $16.6 billion in FY23. Notably, the current inventory level is higher than historical norms. I believe this surge in inventory is a common occurrence for retailers and distributors in the post-pandemic era. Many merchants overpurchased their inventories during the pandemic due to supply-chain disruptions. As the economy transitioned into the post-pandemic period, these merchants, including Costco, had to work through the challenge of managing the elevated inventory levels. However, Costco is actively taking measures to address this situation, and I don’t perceive a significant issue with their current inventory management efforts.

Valuation

The model assumes that normalized same-store sales will grow at 6%, with an additional 2.8% contribution from new store openings in the near term. These assumptions closely align with historical averages. For FY24, I anticipate that the growth in membership fees will contribute to some same-store sales growth, although this may be offset by the weakness in large-ticket merchandise sales. The operating margin expansion in the model is primarily attributed to the growth in membership fees and improvements in operating margins.

The model utilizes a 10% discount rate, a 6% terminal growth rate, and a 27% tax rate. Based on my estimates, the fair value of their stock price is calculated to be $620 per share.

Conclusion

I am inclined to believe that Costco will raise their membership fee soon, especially given the significant time lapse since their last increase—more than six years. The substantial profit contribution from such a fee hike serves as a clear catalyst for their stock price. With this perspective, I initiate a “Buy” rating, estimating a fair value of $620 per share.