Sam's Club is an American chain of membership-only retail warehouse clubs owned and operated by Walmart (NYSE: WMT). On Jan. 11, 2018, Walmart announced its plans to close 63 Sam's Club in various locations. Costco (NASDAQ: COST), the main competitor of Sam's Club that has a similar membership-only business model, witnessed its stock rose more than 2% after the announcement.
Costco and its unique business model
As one of World's largest retail chain with 741 warehouses, Costco Wholesale Corp. adopts a unique business model which comprises of two different memberships. Its basic membership sells at $60/year, while the "Executive" membership costs $120/year and gives customers a 2% reward from purchases. Customers need to purchase a membership plan for shopping at Costco warehouses, allowing them to buy large quantity at a low price. Costco is geographically concentrated in the U.S. (73%) and Canada (15%), with only 12% of its revenues from other regions. What distinguishes Costco from other retailers is its lower level of stock keeping units (SKUs). A typical Costco warehouse carries only 3,800 distinct products, while a typical Walmart carries 140,000 products. As of March 9, Costco stock is trading at $188.6, with a market capitalization of $83 billion.
Such a unique business model drives its high P/E ratio of 30, dwarfing its competitors. Membership represents 70% of Costco's operating income. The renewal rate for membership is high: 90% in the U.S. and Canada. As the second largest retailer in the world after Walmart, Costco has a large market power: If Costco management feels the wholesale price of a product is too high, they could refuse to stock the product and turn to its competitors. It also pursue aggressive cost cutting measures: There is no department for Public Relations or Advertising.
Price drivers and implications of Sam's Club closures
Costco's price drivers come from its sales growth, particularly "comparable sales growth" (growth of sales from warehouses open for more than one year). With 63 Sam’s Clubs closing, there is large potential for attracting new members in nearby Costco warehouses. It is estimated that 2.5 million members have been affected. Even with a conservative estimate (only 50% of those affected will transfer to Costco), Costco's net income will increase by 1.3%.
Costco has also planned the opening of new warehouses. On its annual report, it discussed plans to open 20-25 new warehouses in 2018, which represents a 3% increase. Other price drivers include fast-growing online sales, which increased 33.3% in December 2017, and the development of its own-label brand, "Kirkland Signature", which increases the profit margin.
Valuation target and potential catalysts
With a 27-29 P/E Ratio and an EPS estimate of $7.2-7.5, valuation target for Costco stock will be within the range of $194.4 - $217.5 for the next 12 to 18 months. Its P/E ratio is mainly driven by the operating ability, growth prospects, and the valuations of other retailers. EPS (Current level: $6.9) will mainly be driven by the membership growth from the strengthening economy, online sales, the opening of new Stores and closure of competitors.
Catalysts which could trigger the price movement include the announcement of future monthly sales, comps, and quarterly earnings. Q2 2018 earnings results and February sales were announced on March 7, 2018, which reported that net sales for the first 24 weeks of fiscal 2018 increased by 12% from last year. It supports the further upside of the stock price.
In conclusion, Costco's unique business model of memberships contributed to its relative high valuation. With the opening of new warehouses and the closing of its competitor, Sam's Club, we believe there is still significant upside in Costco's stock, especially for long-term investors.