Costco Wholesale (COST -0.24%) saw sales surge over the past two fiscal years, as subscribers flocked to the retailer's warehouses to satisfy their shopping needs. The stock has followed suit, up 55% since the start of 2020, compared to a 19% rise for the S&P 500 over the same timeframe.
Given the recent strong performance, many investors are trying to figure out what's next for Costco. The start of a new year is a good time for shareholders to reassess why they like this business. Let's take a closer look at both sides of the investment argument for this top retail stock.
Costco bulls make a valid point...
A top reason to like Costco as an investor involves the resilience of the business model. During the Great Recession more than a decade ago, the company's net sales declined by only 1.5% in fiscal 2009, its only down revenue year in at least the past 21 fiscal years. What's more, Costco really shined during the coronavirus pandemic, with annual revenue growth exceeding 15% in the past two fiscal years. Customers turn to Costco and its 847 warehouses to find the lowest prices around on a range of product categories, all in a no-frills environment. And this relentless focus on value will never go out of style.
Costco has a key competitive advantage that stems from its massive scale. By only focusing on a limited number of stock-keeping units, it can buy merchandise in huge quantities, thus negotiating favorable terms with its suppliers. This has helped expand the operating margin over time. Costco could easily boost its profits by keeping the savings for itself. But management is keen on continuously sharing its scale benefits with its loyal customer base.
Lastly, Costco's membership model has been incredibly successful. Attempting to provide the lowest prices by sharing cost savings with consumers wouldn't normally be a profitable strategy. But Costco requires shoppers to be members, creating a lucrative high-margin revenue stream for the business. In fact, the company made $4.3 billion in membership fee revenue over the last 12 months, with net income totaling $5.9 billion in the same period.
The membership renewal rate in the U.S. and Canada was 92.5% in the most recent quarter, and it was 90.4% worldwide. This stickiness affords Costco the ability to periodically raise prices on these memberships, which should mainly flow straight to the bottom line.
Responding to an analyst question about raising the membership price, CFO Richard Galanti said, "It's a question of when, not if" on the December earnings call for the first quarter of Costco's fiscal 2023.
...But so do the Costco bears
Costco's demand surge during the depths of the pandemic seems to have faded. In the latest fiscal quarter, net revenue and same-store sales increased 8.1% and 6.6%, respectively, compared to the year-ago period. Figures for December were even lower. It's probably safe to assume that growth going forward is likely to revert toward historical averages in the high single digits.
And while Costco proved to be a resilient enterprise in the past, it isn't entirely immune to the macroeconomic environment. How inflation affects businesses has been on investors' minds for over a year now. Costco's management is seeing some weakness with big-ticket items, particularly in furniture, electronics, and appliances. And the operating margin contracted in every quarter since the fiscal fourth quarter of 2021.
Investors might quickly point to BJ's Wholesale Club and Walmart's Sam's Club as Costco's most formidable opponents. But there's another important rival in the ring, and that's Amazon and its Prime membership offering. For only $14.99 per month or $139 per year, Prime customers have access to free shipping on a wide range of items sold on the e-commerce site, among other benefits.
A Costco membership and an Amazon Prime subscription are incredibly valuable to consumers. But there are currently over 200 million Prime members worldwide compared to 67 million membership households for Costco. To be fair, Costco is known for having a wonderful shopping experience, something that will certainly be attractive for customers. However, it's hard to ignore Amazon's dominance.
And finally, a prominent bear argument is that Costco's valuation is on the expensive side. This should hardly be a surprise, given how predictable, reliable, and successful the business has been historically. As of Jan. 17, the stock trades at a price-to-earnings ratio of 37, which is about a 15% premium to where shares traded over the past 10 years. This limits the upside potential shareholders have.
