Costco (NASDAQ:COST) is a big-box retailer that blends defensive and growth appeal, thanks to its ability to remain profitable even during tough economic times. This is achieved through a low-cost, high-volume approach. As of now, Costco's shares are at an all-time high, with its stock continuing to rise amid seemingly unstoppable bullish momentum. Looking at Costco's chart, it's clear that the stock has taken on a exponential rise since 2023.
How Costco's Membership Fees and High ROIC Justify Its Elevated Valuation
Despite widespread concerns about consumer spending this year, retailers like Costco have navigated these headwinds effectively, expanding comparable sales and increasing traffic. While many competitors have struggled, Costco has managed to absorb market share. Thanks to its subscription-based business model, Costco today returns capital at significantly higher levels than its industry peers, making this efficiency a key asset in the long-term bullish investment thesis that justifies its premium valuation.
Costco: A Standout Subscription Model Beyond the Tech Sector
Successful companies always have a great and often unique strategy behind them. This is exactly the case with Costco in the retail space.
The giant big-box retailer Costco is unique in many ways. But the main one is certainly its membership-based model, which generates a predictable revenue stream through annual fees, separate from product sales. This approach not only makes the company more immune to economic cycles but also creates great competitive advantages over its competitors with regard to price.
For example, focusing on bulk purchases and discounted prices creates an exclusive shopping experience, differentiating it from traditional retailers that rely on single-item sales and varied pricing. Costco thus manages to negotiate its merchandise with minimal margins, stifling any other competitor exercising similar margins, and achieving a high return on margins from subscriber fees.
Although subscriber fees represent less than 2% of the company's total revenues, they contribute to about 52% of the operating income due to their assumed full profit margins. But perhaps more importantly, this membership base has become extremely loyal to this model. Costco boasts around 76.2 million active members and an impressive 90.5% renewal rate globally.
So far, so good. As long as Costco's membership fees continue to grow, the company's bottom line should remain strong, likely pleasing shareholders.
How Costco's Membership Fees and High ROIC Justify Its Elevated Valuation
Source: Costco's IR
These figures have logically been achieved after years of high-quality management. The strategy of focusing on high volume and low margins is extremely challenging because it requires tight control of operating costs and an efficient infrastructure to handle large amounts of sales. And I believe that there is no one in the retail space who does this better than Costco.
Why Membership Fee Increases Are Great News for Costco
In early September of this year, Costco made an important announcement to investors: the company raised its membership fees for the first time since 2017. Historically, Costco tends to increase its fees approximately once every five and a half years, making this the longest gap between hikes.
The new fees consists in a $5 increase for U.S. and Canadian Gold Star, Business, and Business Add-on members. Executive membership fees will rise from $120 to $130 annually in both the U.S. and Canada, bringing the total cost to $65 for the standard membership and an additional $65 for the upgrade.
So, how much could this fee increase impact Costco's profitability going forward?
Well, with around 26 million standard memberships affected by the $5 increase and 26 million executive memberships impacted by the $10 rise, the total impact is estimated at $30 million from standard memberships and $260 million from executive memberships, adding a combined $290 million to Costco's operating income. Of course, there may be some cancellations, although Costco's renewal rate is an impressive 90.5%.
For context, Costco reported an operating income of $9.28 billion in Fiscal 2024. Given this, the membership fee increase could represent a modest 2% to 4% boost to Costco's annual operating income for Fiscal 2025. Considering Costco operates on such tight margins, this increase could have a significant impact on its bottom line.
Costco's Valuation Concerns
Costco's recent membership fee hike helped push its stock to all-time highs, reached in late November. While Costco's membership-based, recurring revenue model and its countercyclical nature make it a defensive stock, it now trades at valuations typically associated with growth stocks.
The company is expected to grow its EPS by 10.7% in Fiscal 2025, while its top line is projected to increase by only 7.5%. As a result, Costco is currently trading at a forward P/E ratio of 59x, which is approximately 42% higher than its average over the past five years. Additionally, its price-to-sales (P/S) ratio stands at 1.68, roughly 56% above its historical average.
When Valuations Are Justified on Above Industry Returns
However, assessing whether Costco's steady, reliable growth in membership revenues and its unique business model are adequately reflected in traditional metrics like the P/E or PEG ratio can be complex. From a fundamental perspective, one way to evaluate how well Costco justifies its current valuation is by looking at its return on invested capital (ROIC).
To calculate ROIC, we use NOPAT (Net Operating Profit After Tax), which for Costco in Fiscal 2024 was $7.022 billion, assuming an effective tax rate of 24.4%. The second component of ROIC is invested capital, which includes the total capital Costco has deployed to generate profits.
Its fixed assetswhich include property, equipment, operating leases, and other long-term assetstotaled $35.585 billion.
Net working capital was a negative $1.2 billion, which likely results from Costco's just-in-time inventory model and its ability to negotiate favorable payment terms with suppliers. This allows the company to carry substantial accounts payable (money owed to suppliers) while not having to pay those bills immediately, creating a temporary situation where liabilities are high, but Costco can manage them without issue.
Intangibles and goodwill, added up to $994 million.
When we calculate Costco's ROIC for fiscal 2024, we find that it reached 19.95%, which is impressive. Even assuming a modest cost of capitalsay, 8%or a more aggressive 15%, Costco continues to demonstrate high efficiency in generating value for its stakeholders, particularly its shareholders.
It's also important to recognize that in the retail industry, particularly within sectors like grocery and food, companies typically see lower ROICs compared to industries with higher capital intensity, such as technology or pharmaceuticals. For reference, the average ROIC in the retail sector is around 11%. Competitors like Target (NYSE:TGT) and Walmart (NYSE:WMT) have a ROIC of about 11%, while Amazon, a notable player in the retail space, achieves a ROIC of 14%.
In this context, Costco's 19.95% ROIC stands out as nearly double the industry average and significantly higher than its closest competitors. This impressive figure reflects the strength of Costco's membership-based model combined with its efficient supply chain management.
Risks to the Thesis
Ultimately, a company's share price is driven by what investors are willing to pay. As long as membership fees continue to rise, COST shares are likely to remain near their highs. However, my main concern lies in the potential impact of a slowdown in membership fee growth. As mentioned earlier in this article, membership revenue is a critical metric for Costco's bottom line. While price hikes can help increase revenue, a significant drop in renewal rates (to around 80%, for example) could have serious negative consequences for Costco's stock price.
Final Remarks
Costco is arguably the best-in-class business within its industry. In my opinion, there is no other retailer that can execute the high-volume, low-margin strategy as effectively as Costco, particularly with the support of membership fees that provide full profitability. This model allows Costco to outperform competitors while maintaining a counter-cyclical, resilient investment thesis.
Although many investors are concerned about paying 52x earnings for a business with these attributes, the stock's performancereaching all-time highsindicates that stretched valuations have not been a problem so far.
In my view, Costco deserves recognition for delivering superior returns to shareholders, particularly when considering metrics like ROIC, which far exceed those of its peers. A business that consistently earns high ROIC is typically very effective at converting investments into lasting profits. This is evident when we look at Wall Street analysts' projections for bottom-line growth over the next eight years, which have consistently been revised upward.
How Costco's Membership Fees and High ROIC Justify Its Elevated Valuation
Source: SeekingAlpha
As long as this competitive moat remains intact, I see no valuation issue that could prevent Costco's share price to continue climbing to new highs.
