Costco (NASDAQ:COST) reported second quarter 2016 earnings on March 2. The wholesale retailer makes up one of my largest positions, and these are three takeaways from the press release and management call that make me comfortable holding my shares for the long haul.
Net new warehouses
At first glance, net new warehouse growth during the quarter was anemic. The company added only one net new store, bringing its total to 698 globally. A deeper look into what that one new store is -- a different concept from the traditional warehouse -- and the growth plan for the rest of 2016 alleviated some of my concerns. The company opened 11 net new locations in the previous quarter and is on target for a total of 30 openings in fiscal 2016. The overwhelming majority of warehouses -- 614 of 698 -- are located in North America, and the bulk of expansion continues to be focused there as well with 24 of the 30 new locations in the U.S. and Canada.
The company added 23 net new locations in 2015, so it continues to grow its total warehouse count and increase the annual rate of new openings. However, at some point, growth opportunities in North America -- and especially in the U.S., home to 488 locations -- will dry up. Costco can become one of two companies at that point, both of which could prove lucrative to shareholders.
One is a mature business that's no longer expanding but takes in rich cash flows from membership fees. This is a slow growth, buyback and dividend paying machine. The other is one that figures out how to translate its domestic success around the globe and has a second act as a growth company. Costco has a small presence in six international markets, and I'll be curious to see if management sees opportunities for expansion elsewhere down the road.
Growth opportunity: business centers
The one net new location from the second quarter was a business center in Westminster, Calif. Many small business owners turn to Costco for supplies, and a Costco Executive Membership -- which costs $110 annually instead of the standard $55 but includes 2% cashback -- is a no-brainer for them as long as they spend at least $2,750 annually. These members make up around one-third of total membership but around two-thirds of total sales.
Costco business centers, of which there are now 12 in North America and two in the U.K., have some compelling economic advantages over regular Costco warehouses. They focus on small business customers -- although they are open to all members -- by excluding things like pharmacy and optical services. As a result, Costco can offer a wider selection of business-related goods and reduce consumer traffic.The hours -- 8 a.m. to 6 p.m. instead of 10 a.m. to 8 p.m. -- are also more appropriate for someone making business purchases.
The advantage for Costco is a smaller footprint: 115,000 square feet for business centers versus 150,000 square feet for traditional locations. The business centers also have half the number of parking spaces and generate higher check averages ($250 to $350 versus $100). I'm interested to see how many of the 30 net new stores to be opened in 2016 end up being business centers. This could be an interesting growth angle for the company and is something I'll be following up on in future quarters.
Time for a membership fee increase?
Costco runs on razor-thin margins. It doesn't mark any product up by more than 15%, and its net income margin has historically been below 2%. Compare this strategy with another famous discount retailer, Wal-Mart, whose net income margins have traditionally been in the mid-3% range. The mother's milk of Costco's business is its membership model. Shoppers pay an annual fee for the privilege of shopping there, and Costco sports a wonderful retention rate -- 91% in the U.S. and Canada, and 88% in the rest of the world.
The last price increase came in 2011,and before that, 2006.It would seem the company is almost due for another raise. I wonder at times if Costco has been too conservative with its member pricing. If raising the base price from $55 annually to $75 annually caused renewal rates to drop to 50%, that would be a deal breaker. But what if they only fell to 85% worldwide? This could be a huge boon for the business. It'll be interesting to see when the company increases the fee and if it jumps by more than the 10% the company announced in 2011.
This was not a blowout quarter, as reflected by the bearish trading that followed the release, but the business continues to push forward. Costco has abundant growth opportunities both at home and abroad. As it experiments with changes to its warehouses and shopping experience, the company has also shown the ability to consistently raise membership fees without hurting renewal rates.
This stock is unlikely to be a ten-bagger over the next decade, but it could get close over the next 20 years. According to Charlie Munger, Costco is "one of the most admirable capitalistic institutions in the world." With that kind of endorsement, I recommend you take a closer look at this company -- it may very well deserve a place in your portfolio.