Costco Comps Expected to Accelerate in 2H17, but Will Competition Catch Up?

A former Wall Street analyst discloses the topics that equity analysts and hedge fund managers are currently talking about. 

Costco has largely traded sideways over the last year after a 92% run between April 2012 and December 2015. The stock's upward trajectory slowed as the company's core comps began to slow amid increasing food deflation, the removal of tobacco products, and an increasingly competitive retail environment. Today, the key question revolves around where same store sales will move from here - will they return to COST's historical mid-single-digit growth, or will they continue to remain pressured as competitors increasingly encroach on their territory?

Source: Google Finance

Source: Google Finance

Bulls believe Costco comps will return to mid-single digits

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

Near-term tailwinds

Bulls primarily believe that, in the near-term, comps will return to its mid-single digit history, driven largely by several tailwinds. 

Removal of tobacco headwind

Costco began slowly removing tobacco products from its stores over the last several years. Tobacco products are low margin, labor-intensive, and are often the target of thefts. Around this time last year, Costco noted that tobacco was running in the negative double digits, which likely pressured overall company comps meaningfully (by perhaps 1-2%) last year.  Going forward, the headwind is expected to ease, which should help comps.

Food deflation easing

Like the tobacco headwind, Costco comps have been negatively impacted for the last several quarters by food deflation. However, management expects these headwinds to ease as they enter the summer of 2017. CPI data suggests that already the headwinds are easing, as food deflation has become less negative over the last four months. Many other retailers have echoed this sentiment as well and expect inflation in 2H17.

Credit card change

Costco switched over to a Citi Visa credit card (from their previous American Express card) in mid-2016 and expects this to provide a benefit to comps and to margins. The card is expected to drive additional sales due to better cash back rewards. Additionally, margin should benefit as Costco pays less to Visa than to American Express. In F1Q17, Costco's first full quarter with the credit card change, the company saw a 40 basis point improvement in operating margin expansion from the card.

Membership price increase

Effective June 1st, Costco will be raising the price of a basic membership from $55 to $60. Costco's executive memberships will increase from $110 to $120. While some investors are fearful that such an increase could hurt renewal rates (see bearish segment later in the article),  bulls believe renewal rates will not be hurt too significantly; 37% of users (and 65% of revenue) is tied to Costco's loyal executive members.

The increase is expected to benefit EPS by $0.30-$0.40 on an annualized basis (but will be spread out over the course of ~2 years as members gradually renew), and are now largely baked into estimates as management has noted plans for some time now.

Easing comparisons

Comp comparisons will ease for Costco in both 3Q and 4Q. Last year, comps were flat in 3Q and 4Q when including gas and FX. Excluding gas and FX, comps decelerated from 6% and 5% in 1Q and 2Q to 3% in 3Q and 4Q. This year, Costco should get some benefit as they grow off of a lower base.

Source: Company filings

Source: Company filings

 

Costco reported March monthly sales that showed improvement

On Wednesday night, Costco also reported March monthly sales that showed that comp trends are improving as bulls hoped. The company reported a March comp of 6% including gas and FX, and 5% excluding gas and FX. As of right now, the stock is up 2% in response to the positive report.

Source: Company filings

Source: Company filings

There were several moving pieces from the report:

  • March sales were positively impacted by one more selling day than the previous March period due to the Easter shift this year from March to April. Easter is on April 16 this year vs. March 27 last year. Costco closes on Easter, so a month without Easter will be getting a benefit from the prior year's month with Easter. Management noted that the Easter shift helped comps by 1-1.5%. Even accounting for the shift, March comps were better than expected. Note that April comps are expected to be lower by the Street due to the Easter shift.
  • Management noted that weather negatively impacted total comps by 0.5%.
  • Average transaction was +2.5% (which includes a negative impact of -0.5% from FX and a positive impact of +1.5% from gas). Importantly, comp traffic was +3.75%, suggesting that traffic trends are improving.

 

Longer-term tailwinds

Longer-term, bulls see a number of favorable business characteristics that will allow them to sustain mid-single digit comps over the next several years. These factors should support Costco's high valuation as well given the more stable profile for earnings.

International growth

Costco's international growth opportunity is often cited as justification for the company's multiple and higher earnings expectations. The company currently owns 728 warehouses, with 508 in the US and 220 internationally (94 of which are in Canada).

Going forward, investors believe that the company will open more international stores with roughly half of the 29 planned store openings in 2017 going towards international openings, and potentially growing over time

In addition to the obvious sales benefits, international stores are also expected to contribute to margin expansion as international stores have higher margins than US stores. International stores have higher margins due to less competition and a lower mix of gas sales (which have low margins).

While the margin expansion is not expected to be very meaningful in the short-term, it could grow over time as international stores make up a larger part of the company's new store openings.

Source: Company filings, brokerage estimates Note: I thought I'd try out different colors. Let me know if this makes you want to throw up.

Source: Company filings, brokerage estimates

Note: I thought I'd try out different colors. Let me know if this makes you want to throw up.

Protective moat from online

Costco is seen as a company that is more insulated from the online threat than other retailers for several reasons.

The company's business model is to offer low product prices and an additional bulk product discount. The company saves in other areas that other stores might not traditionally receive savings in, including real estate (as the "stores" are warehouses), advertising (almost no advertising spend, relying on word of mouth and local community outreach), limited SKU assortments, and bulk purchasing. As a result, while gross margins are lower than other stores, operating margins are more in line with competitors. Additionally, the company sells at a higher turnover than other competitors since they sell in higher volumes. As a result of this business model, Costco's prices are very competitive against other retailers, including Amazon's. In fact, several price studies conducted by banks have suggested that their prices are lower on key items.

As a result of the lower prices and unique store format, Costco has a highly loyal customer base with above average incomes. Their membership has had historically high renewal rates at roughly 90%. The company is often seen positively by the local community as well, as the company pays its employees generously. 

Finally, ~57% of sales are in food-related categories, which online has not historically penetrated very deeply.

As a result, investors believe Costco is better insulated from the online threat than other retailers that offer similar products. However, Costco admits that online is still a threat, and they are making efforts to grow their online site and presence. Currently, roughly 4% of sales come from the online channel, and management plans to continue to invest in this channel.

The appliance category presents another opportunity for growth

Costco is adding appliance brands Samsung, LG, and Whirlpool to stores. While the category is in its nascent stages, management believes there is an opportunity to grow the category and potentially become a major player over time. The biggest competitors here include Sears (which has been bleeding share for many years now), Best Buy, Home Depot, and Lowe's.

If the category can grow meaningfully in size, appliances could add as much as half a point to comps.

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

 

Multiple is justified by stability of business and visibility of earnings growth

There has been some discussion on Costco's high multiple compared to other retailers, as it trades in the high 20s on a PE NTM basis despite low earnings growth. Bulls would largely point to the company's unique business model which provides further insulation than other retailers from competition, and therefore more stability and predictability in their outlook. After flat earnings growth in 2016, consensus estimates show that bulls believe the factors mentioned above will drive earnings to 9% growth in 2017 and 14% growth in 2018. 

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

 

Bears see increasingly competitive environment

Bears believe mid-single digit growth, while perhaps achievable in the short-run, will likely not be sustainable going forward due to the following factors.

Growing competition

The slowdown in comps over the last two years was largely attributed to cyclical factors and one-time headwinds. However, the bear case is that competition has also eaten away at Costco's traffic trends, and as a result, trends may not return to mid-single digits.

Competition continues to mount for Costco. Walmart continues to make investments in fresh food. Sam's Club's sales are improving as well, as comps have now improved sequentially for the last four quarters. The company is increasing its tobacco offerings in response to Costco lowering exposure to the category, and is getting more aggressive with price investments as well.

Source: Company filings

Source: Company filings

Additionally, other types of retailers are becoming aggressive as well. Hard discounters are entering the space (i.e. Aldi, Lidl). Specialty players like Whole Foods remain focused on organic, and while their results suggest they have lost share to Costco, they remain committed to recapturing their share.

Can online players penetrate the food category?

As is now common among retailers, Costco faces the question of just how insulated they are from the online threat. We've seen this play out in all areas of retail, even the areas that were once thought untouchable by the online players such as mattress players (competition from Casper) and auto part retailers (competition from Amazon).

While bulls might claim that Costco has a price advantage and a treasure hunt experience that can't be replicated, consumer surveys suggest that consumers view Amazon to be just as competitive on price as Costco. 

Additionally, although online has yet to penetrate the food space, Amazon has been making serious efforts to enter the space, and many people believe it will only be a matter of time until they are successful.

Furthermore, while 57% of their sales have yet to be fully impacted, 43% is still open to online, including areas with high online penetration such as consumer electronics.

Finally, bears have noted that Costco's higher-end customer base makes them particularly susceptible to online players, given their propensity to shop there. 

Member price increases could hurt renewal rates

As noted above, bulls point to Costco's historically high renewal rates as evidence of Costco's loyal customer base, and the high likelihood that customers will renew after the price increase goes into effect.

However, bears believe that the competitive environment has drastically changed, and that other memberships such as Amazon Prime deliver just as much value (if not more) with streaming videos and other services. Customers may decide on just one membership, and they could choose other competitors'. Also note that Costco's renewal rates have historically been negatively impacted during price increases in the past.

Margin flow through may not be high due to competition

As noted above, bulls believe that card benefits and member price increases could both drive higher margins. However, given the competitive environment, there is a risk that management will choose to reinvest those savings back into lower prices, and therefore would not see the margin benefits that investors might be expecting. So long as traffic and comps hold up, this may not be an issue. But if they begin to deteriorate, management may choose to give up margin expansion to remain competitive with the other players.

 

Comps a key factor moving forward

Ultimately comps will be a major factor of where the stock moves from here. If the company is able to generate mid-single digit comps as its unique model separates itself from the pack, the stock will likely move higher. However, if comps struggle to stay there as consumers flock to other memberships, Costco will likely face sales struggles, margin pressure, and multiple contraction. Given where valuation and consensus estimates are, most investors are betting on the former scenario.