Value Investors Tribe

Analysis Date: March, 2024

For the analysis of any business, rely on the primary data which we gather from annual reports, earnings calls, company filings and other information which the business has shared firsthand.

We use the framework described by Warren Buffett in 2007 letter to shareholders. Warren Buffett looks for four parameters particularly: a) Understandable business economics b) Long-term growth prospects c) Able and trustworthy management d) A sensible price tag. These parameters for Costco Wholesale Corporation (referred as Costco now on) are discussed in detail below:

Business Economics and its Moat

Costco is a retailer primarily operating in United States with some presence globally. Costco provides yearly membership fees and with that fees, it gives access to its warehouses wherein they sell wide range of nationally branded and private-label products useful in day to day life. Costco has distribution through their warehouses and also operates in e-commerce platform.   

The operational model of Costco is its main moat. Costco purchases its merchandise from seller offering lowest prices. The seller benefits from the high volumes Costco purchases and in return Costco benefits from the low-cost merchandise. Costco conducts business in warehouses leading to low-cost operations. Combination of Costco’s volumes, its low cost operations via warehouses and rapid inventory turnover allows Costco to operate at lower gross margins. This provides customer with the low-cost, high quality product creating a win-win model. In fact, most of the inventory at Costco is sold off before they are required to pay for it; this leads to less working capital needs than most of the retailers. Additionally it requires very little capex to conduct its operations leading to high free cash flows.

Growth Prospects

At present, Costco has about 875 warehouses globally. It has about 603 warehouses in United States and other 272 warehouses in multiple countries globally with total 129.5 million memberships. The renewal rate of members is about 90% globally as well as in United States. The revenue for FY-23 was $238 billion with pre-tax earnings of $8.5 billion. The revenue for FY-13 was $105 billion with pre-tax earnings of $3 billion. This implies CAGR of 8.5% for revenues and 11% for the earnings. Memberships grew from 71.2 million in 2013 to 127.9 million in 2023 with CAGR of 6%.

Given the competitive advantage of being a low-cost retailer of globally-recognized brands, Costco can enjoy long runway with strong pricing power of its memberships. Costco has just scratched the surface when it comes to its global expansion and has potential to witness strong growth globally. Compared to its historical growth, Costco has potential to grow at about 10% – 12% for next 10 years.

Management Trustworthiness

In the annual reports and earnings call, the management has been candid with the shareholders. In the past, management has shared mistakes, errors and other irregularities occurred in the company. Management has shared its strategy to maintain lower gross margins so as to provide higher customer benefits; focusing on long-term growth prospects and not optimizing short-term gains. Additionally, management has shared all the critical and necessary figures in their annual reports and presentations which are necessary for shareholders to evaluate the business.

Valuation

Warren Buffett and Charlie Munger have state multiple times in their annual meetings, interviews and annual report that understanding moat and quality of business is far more important than quantitative calculation of intrinsic value. As a result, we use simple calculations to arrive at the intrinsic value.

For the valuation, a Discounted Cash Flow (DCF) model is used. In 2023, Costco had a free cash flow of $6.7 billion compared to free cash flow of $1.4 billion in 2013, implying a CAGR of 17%. It is critical to note that to obtain the free cash flow number, we subtract capex from the operating cash flow (Free Cash Flow = Operating Cash Flow – Capex). Assuming, historical membership growth of 6%, price increase of 2% and additional cash flow increases of 2% – 3% given its moat, it is a reasonable estimate that Costco will grow its free cash flow at about 11% for next 10 years. This is highly conservative estimate compared to 17% growth over the last 10 years. Terminal growth rate after 10 years is assumed to be 2%.

Additionally, Warren Buffett and Charlie Munger especially have encouraged to think about discount rates in terms of opportunity costs. The risk free rate during the analysis is about 5% and hence it is safe to assume discount rate of 5%. With these growth rates and assumptions, DCF analysis conducted is summarized below:

Year	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Growth Rate Assumed	–	11%	11%	11%	11%	11%	11%	11%	11%	11%	2%
Free Cash Flow (billion $)	6.7	7.4	8.3	9.2	10.2	11.3	12.5	13.9	15.4	17.1	17.5
Present Value Factor	–	1.05	1.10	1.16	1.22	1.28	1.34	1.41	1.48	1.55	1.63
Present Value of FCF (billion $)	–	7.1	7.5	7.9	8.4	8.8	9.4	9.9	10.5	11.0	10.7

• Sum of Present Value of FCF (billion $): 91.2
• Terminal Value (billion $): 582.7
• Present Value of Terminal Value (billion $): 357.7
• Total Equity (billion $): 448.9
• Shares Outstanding (millions): 442.74                                                                                                                          
• Intrinsic Value (per share): $1,014
• Current Trading Price: $755
• Margin of Safety: 26%

What does this mean? This implies that based on our DCF assumptions, Costco is currently undervalued with its intrinsic price somewhere around $1,000.

Disclaimer: This fundamental analysis of Costco is primarily for educational purposes so as to help value investors learn core concepts. This is not a buy or sell recommendation of any form whatsoever. Reader discretion is advised.