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Costco's Long-Term Prospects Still Solid

Zain Akbari, CFA

Despite a somewhat soft start to fiscal 2017, we do not anticipate making a large change to our $149 per share valuation for wide moat-rated Costco (COST). In the first half, the company posted 4.5% net sales growth against a 3.0% operating margin, lagging our 6.7% and 3.2% full-year expectations, respectively. That said, we expect the company’s announced 9% membership fee increase will help close the gap somewhat after it takes effect in the fourth quarter (though the financial impacts take two years to be fully reflected). As a result of our expectation that much of Costco’s shortfall is due to transitory deflationary pressures, we do not expect to materially alter our long-term expectations, calling for mid-single-digit top-line growth and 3%-4% operating margins over the next decade. The shares trade higher than our valuation, likely due to our somewhat more conservative long-term margin growth view.

Costco recognized low-single-digit deflation on the quarter, driven by food and electronics. We believe the challenges are not idiosyncratic to the firm, and while the industrywide price compression erodes Costco’s price advantage against traditional retailers in the short-term, we do not anticipate a long-term change to the company’s competitive standing. Similarly, we do not expect the planned membership fee increase in the United States and Canada (which is effective June 1) will lead to a material change in renewal rates that remain near 90%, a view consistent with Costco’s historical performance in the wake of hikes. The company’s impressive scale-driven productivity (over $1,100 in sales per square foot, around 60% higher than Sam’s Club) and no-frills shopping environment allows it to deploy most of its lineup--particularly fresh food and gas--as a loss leader, with annual charges constituting most of Costco’s operating profits. As a result, the firm’s value proposition to customers should remain difficult to replicate.

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