Costco: The Multiple Expansion Train Marches On (Rating Downgrade) (NASDAQ:COST) (2024)

Costco (NASDAQ:COST), a simple old-fashioned business, continues to shine in a tech-driven market. Somehow, Costco has figured out the recipe for high-single-digit growth in almost every environment. That, combined with dedicated members and extraordinary management, results in one of the most predictable and resilient companies in the world.

Still, at some point, the multiple expansion story will have to come to an end.

What will that look like? let's dive in.

Revisiting Costco's Recipe For Market-Beating Returns

In October of last year, I published an article under the title 'Here's Why Costco Can Continue To Beat The Market Despite Rich Valuation'.

I had a long discussion about Costco's elevated multiple, which stood at 40x on a forward basis back then.

In short, there are two reasons a company should justifiably trade in such a high multiple. It either has a very compelling growth story, or it has an extremely predictable and resilient business model, or, a combination of both.

In Costco's case, the predictable part is a much larger portion of the pie, and yet, its growth prospects should not be overlooked.

For the last 10 years, Costco grew revenues and EPS at 8.8% and 13.1% CAGRs. With its unique focus on the customer, a combination of traffic growth, tailored price increases, a growing membership base, and market-share gains, I see nothing that suggests Costco won't continue to do the same for the next 10 years as well.

So, back in October, I found Costco's multiple justified. As we can see, the multiple continued to grow, almost surpassing 50x. As such, we need to take a second look.

Footprint & Memberships

As of the end of Costco's fiscal Q2, which ended on February 16th, Costco had 73,400 household members, up 3.4% from the end of 2023. Costco reached a run-rate of $4.9 billion in membership fees, which reflects an increase of more than 8%.

Costco serves its members primarily in its physical locations, which amounted to 875 at the end of the quarter, and 876 as of April, including 604 in the United States and Puerto Rico, 108 in Canada, 40 in Mexico, 33 in Japan, 29 in the United Kingdom, 18 in Korea, 15 in Australia, 14 in Taiwan, six in China, four in Spain, two in France, and one each in Iceland, New Zealand, and Sweden.

Although Costco has no shortage of capital or demand, the company maintains a slow expansion pace, primarily due to its own high standards for opening a store. This means that they want to bring in experienced managers from other stores, train employees, build the right inventory and awareness, and have a sufficient managerial focus on each new warehouse.

As we can see, they open between 20–30 locations each year, which means the expansion pace gradually declines because of scale. In 2024, they expect to open 31 stores.

Despite the growing footprint, we can clearly see there's no cannibalization nor saturation, as the average revenue per house has been growing almost every year of the company's existence, reaching $252 million in 2023. In addition, we can see that the ramp-up stage becomes better and better each year.

I encourage you to take a look at the above charts and try to find a single flaw in the company's operational progress. I don't think you'll be able to find one. The company continues to grow memberships and its footprint while seeing improved unit economics each year.

Financial Brief & Why Costco Won't Raise Membership Fees Soon

The next step is seeing how the company's exceptional operational metrics translate into profits. As I wrote above, Costco has been growing revenues at a high-single-digit pace for a long time.

Even in 2022 and 2023, during which many of Costco's rivals struggled, the company was able to sustain high growth. And, according to their April sales release, this trend continues, with net sales being up 7.0%, and comparable sales up 5.2%.

Costco makes sure to surpass any price benefit it gets to its customers. This means that its members know they probably won't be able to find a cheaper option outside of Costco. As such, Costco is able to surpass any cost increase to its customers as well, without seeing significant pushback.

This is best reflected in the company's gross merchandise profit, which remains steady in the 10.5%-11.5% range, disregarding the macro environment.

With steady gross margins and consistent revenue growth, Costco's operational leverage flows through the P&L. Although it seems small, on Costco's revenue base, the 30 bps improvement in operating margins results in quite a significant increase in profits.

Again, there's nothing to suggest this trend will stop in the foreseeable future, and this is why Costco won't raise its fees so quickly. During what is still a tougher consumer backdrop, there's no reason for a customer-oriented management like Costco to raise its fees when they have no actual reason to do so when margins are at all-time highs.

So, near-perfect both operationally and financially. The last hurdle is valuation, and it's a big one.

Valuation

Over the past five years, Costco shares are up a little over 220%, while EPS is projected to only be up approximately 130%. Therefore, the rest of the increase is attributed to multiple expansion, which more than doubled.

Costco's fiscal year is not aligned with the calendar year, and it's roughly two quarters ahead, which means the forward P/E you see in places like Seeking Alpha is a bit higher than the calendar 2024 P/E.

Still, it's quite high, sitting at 48.9x, compared to the S&P 500's 21.6x, and the Nasdaq's 27.4x. Interestingly, Costco's premium over the S&P 500 expanded in the last year, as it stood at slightly below 2x a year ago, and is now above that.

Looking ahead, if we assume Costco grows EPS by 10.5% annually (significantly higher than estimates, but those don't reflect membership fee increases), we'll get the following:

And, if we assume an exit multiple of 40x, which is obviously quite high, we'll get to a 7.9% annual return, excluding special dividends and buybacks.

Clearly, this isn't a very high return considering the market averages around 7%, and a 40x exit multiple is quite ambitious. On the flip side, Costco tends to surprise to the upside when it comes to growth and profitability, and I'd say our EPS outlook is reasonable.

The bottom line is, at the current valuation, I can no longer rate Costco as a Buy.

Conclusion

Costco is an exceptional business. With this company, the arguments always revolve around valuation.

In the past, I dismissed valuation worries, as I viewed the company's multiple in the reasonable range, due to Costco's unparalleled resiliency and above-market growth prospects.

At today's levels, I can no longer do so. At a 49x P/E over 2024 EPS, Costco is trading at a historically high premium over the market, historically high PEG, and outside of its elevated trading range.

With that said, I don't see extreme downside in the foreseeable future, as I expect Costco to maintain business as usual.

Therefore, I downgraded Costco to a Hold.

Yuval Rotem