The Membership Fee Investment Thesis

Costco Wholesale Corporation (NASDAQ: COST) is due for another membership fee raise in the short to intermediate term, due to the historical cadence at an average of five years and seven months over the last three hikes. Due to the uncertain macroeconomic outlook, a common question in its recent earnings call had been: When will the membership fees be raised?

The question was deftly answered by Richard Galanti, CFO of COST, in the FQ1’23 earnings call (and repeated in the FQ2’23 call):

Our view is all the parameters, as it relates to member loyalty and value proposition that we’ve improved to our members, we have no problem thinking about doing it and doing it ultimately. So it’s a question of when, not if. But we feel that we’re in a very strong competitive position right now. And if we have to wait a few months or several months, that’s fine. And I’ll be purposely coy on when that might be. (Seeking Alpha)

COST had also highlighted that the additional revenue will allow the company to become even more competitive, emphasizing its long-term mission thus far, “to continuously provide our members with quality goods and services at the lowest possible prices.”

COST’s Margins With & Without Membership Fees

If we were to omit its membership fees revenues of $4.33B over the last twelve months [LTM], its gross margins would have been at 10.41%, operating margins at 1.57%, and net income margins at 0.74%, instead of the current 12.07%, 3.39%, and 2.58%, respectively. It seems apparent that membership fees are highly critical to the company’s profitability, allowing it to operate with razor thin product margins.

Meanwhile, we posit that the company may be raising its annual fee by $5 for the basic Gold Star membership and by $10 for the Executive membership, similar to the previous hike in June 2017. This would result in improved membership revenue by $493.5M, or +11.3%, to $4.82B annually, based on FQ2’23 numbers of 30.6M in Executive members and 37.5M of basic Gold Star members.

For now, we are not concerned about its churn rate, since the increase would be miniscule compared to the average annual spending per paying member at $3.37K. This was based on the company’s net sales of $230.05B ​​over the LTM and total paid members of 68.1M in the latest quarter.

At the same time, COST has also shown growing deferred membership fees of $2.41B as of FQ2’23, growing by +11% QoQ and +7.5% YoY, to be recognized over the one-year membership period. This suggests improved consumer onboarding, triggered by the excellent value offered by the company at a time of tightened consumer spending, which will be discussed later.

Therefore, we reckon the raised annual fee may still be well embraced by existing members, allowing the company to further grow its top and bottom lines ahead.

The hike may also lead COST to record an improved operating margins of 3.5% and net income margins of 2.7% in FY2024, triggering expanded EPS of $15.60 then, on top of an organic growth in net sales by +6% YoY. This is assuming that the membership fee hike is implemented in FQ1’24 (CQ4’23) with COGS and operating expenses remaining stable.

These are impressive tailwinds for long-term appreciation, in our view, especially given our prudent estimates as the company has averaged higher organic same stores sales growth of 10.6% in FY2022, 13.4% in FY2021, and 6.1% in FY2019.

So, Is COST Stock A BuySell, or Hold During The Potential Economic Downturn?

COST 1Y EV/Revenue and P/E Valuations

COST is currently trading at an EV/NTM Revenue ratio of 0.83x and NTM P/E of 31.60x, higher than its 3Y pre-pandemic mean of 0.63x and 28.90x, respectively. Otherwise, it is lower than its 1Y mean of 0.93x and 35.80x, respectively.

Based on its projected FY2024 EPS of $15.84 and current P/E valuations, we are looking at a moderate price target of $500.54, suggesting minimal upside potential from current levels.

COST 1Y Stock Price

COST stock has also notably retraced by -17.5% from its heights of $588.68 in April 2022, which we believe is attributed to the economic downturn and the Fed’s continuous hikes thus far. Market analysts are already projecting a terminal rate of up to 6% by September 2023, suggesting elevated interest rates over the next few quarters.

This had also been commented on by COST’s management, with “big-ticket discretionary items” experiencing some weaknesses. This was attributed to the uncertain macroeconomic environment and tougher YoY comparison during the hyper-pandemic levels.

However, there have also been some excellent tailwinds for COST, such as the consumer’s accelerating tendency to “trade equal” to Kirkland Signature items over the last few months. It reported tremendous expansion in its store brand sales penetration by +1.5% YoY for food products in FQ2’23, against the historical increase of +0.5% annually over the past ten years.

We reckon these inflationary events may trigger improved Kirkland brand loyalty and consequently, growth in Costco memberships moving forward, due to its excellent branding and value-added offerings.

In addition, COST already reported moderating inflationary pressures, with prices declining to between 5% and 6% YoY as of FQ2’23, against 6% to 7% in FQ1’23 and 8% in FQ4’22. In particular, inflation for food products had moderated to its “lowest levels in nearly a year,” providing relief to its consumers.

In particular, the company was able to maintain consumer loyalty by passing on savings from its lower-priced high-quality store branded products. This was likely attributed to the strategic choice in outsourcing to manufacturers from lower-cost regions, such as Africa and Vietnam, where labor costs were dramatically lower compared to the US. Given the normalizing global supply chain and freight costs, we may see COST seize even more opportunities in offering better value to its members ahead.

Meanwhile, due to the tightened discretionary spending and intense competition from other warehouse clubs, COST has strived to provide competitive pricing and value for “exactly like-branded items,” such as Coke or Advil or Tide detergents.

We reckon these combined efforts may therefore drive more sales and maintain profit margins, all while offering excellent value to its consumers. This helps explain its excellent membership renewal rate of 92.6% in the US/Canada regions and 90.5% internationally by the latest quarter. Richard Galanti, CFO of COST, said:

We’re looking to use price to gain share, we’re continuing to do that… There have been times, when we might take a bigger hit on some expense in a given quarter. Many years ago, it was the rotisserie chicken example that we, frankly, I think, have more levers today to adjust things, which helps us… to drive the top line and being cognizant that we’re also a public company trying to earn money for our shareholders. (Seeking Alpha)

Therefore, given that the stock is trading below its 50-day moving averages, COST currently looks very attractive indeed, on top of being well-supported at the $450s levels. Nevertheless, the declining peak and trough stock price movement since its peak in April 2022 may suggest moderate volatility ahead.

Therefore, existing investors looking to nibble may consider doing so at those levels, only if the exercise consequently reduces or matches their dollar cost averages.