Costco Q3: Strong E-Commerce Growth Driven by Discretionary Shopping (NASDAQ:COST)

I presented my bullish view on the topic Costco Wholesale Corporation (NASDAQ: COST) in my previous article published in March 2024, in which I argued for strong membership growth and the potential to increase membership fees. The company has published its report for the third quarter of FY24 result as of May 30 after the bell, with adjusted same-store sales growth of 6.5% and membership dues growth of 8%. I maintain a “Buy” rating at a fair value of $870 per share.

Strong e-commerce growth driven by discretionary purchases

The biggest takeaway I can take from this quarter is the strong e-commerce growth, which was 20.7% this quarter, as shown in the table below. The strong growth is due to two main factors:

• Costco’s e-commerce business was weak throughout fiscal 2023 due to weak sales of big-ticket discretionary items. As a result, the company faced weak peers in FY24.
• As reported on earnings call, Costco saw strong growth in gold and silver bullion, gift cards and appliances. More specifically, home appliance sales increased by 30% year-on-year. Costco has done an impressive job of lowering product prices to provide added value to its members.

The strong growth in e-commerce is quite noticeable for Costco as the digital channel provides much better margins for Costco. The rapid growth of e-commerce has the potential to increase Costco’s margins over time.

Collaboration with Uber Eats

Costco is available on the Uber Technologies, Inc. website. (UBER) Eats in select locations in the U.S., Canada, Mexico and Japan, and Costco will expand the partnership to additional regions in the coming months. A partnership can be a win-win situation for both companies. The key reasons are:

• At the end of the fiscal first quarter, Uber One had 19 million members and Costco had 34.5 million paid executive memberships. The partnership could potentially cross-sell gift cards and other products on both platforms.
• Costco is testing grocery delivery through Uber Eats in some regions, such as Texas. Once certain conditions were met, the ordered groceries could be delivered within a few hours. Uber One members have access to Costco merchandise even without a Costco membership. The grocery delivery service could potentially help Costco gain more customers, especially among younger customers who prefer grocery delivery.

Outlook for 25

After the growth instability caused by the global pandemic, I anticipate that Costco will gradually normalize its growth, as I have discussed in my previous coverage. When considering FY25 growth, I consider the following factors:

• I predict that as inflation begins to decline, the Fed will begin lowering interest rates this year, which could benefit consumer consumption. Costco uses its Kirkland brand to lower the prices of goods. As suggested during Tin terms of earnings, the Kirkland brand aims to achieve at least 20% in value compared to branded products. When interest rates begin to decline, Costco will most likely benefit from improved consumption.
• I predict Costco’s e-commerce business will grow at a double-digit rate. Costco has the advantage of offering online and offline channels. Additionally, their partnership with Uber has the potential to accelerate their e-commerce business in the near future.

Therefore, I continue to expect that Costco can deliver comparable sales growth of 6% in the near future, assuming 5% growth for retail stores and 1% growth for e-commerce. Additionally, as I mentioned in my previous story, Costco has not raised membership fees for several years. A potential fee increase could translate into additional profits for the company.

Quotation

Costco anticipates reaching 890 stores by the end of FY24, and my calculations are that the warehouse expansion could contribute an additional 2% to revenue growth.

As previously mentioned, I anticipate Costco to generate comparable sales growth of 6%. Therefore, the model assumes a total growth rate of 8%.

Costco’s margin increase is due to several factors:

Membership fee increase: Membership fee increased by 8% in the quarter. Because most of the revenue from incremental fees will fall to the bottom line of the income statement, leading to a significant increase in the company’s margin. I anticipate that strong membership growth will continue in the future given the value it adds to members.

Additionally, Costco may benefit from operating leverage from gross profits and selling, general and administrative expenses. I calculate that Costco will increase its operating margin by 10 basis points per year, driven by 5 basis points from gross margin and 5 basis points from selling, general and administrative expenses.

The calculated WACC is 9.1% assuming:

• -Risk-free rate: 4.25% (yield on US 10-year treasury bonds).
• -Beta: 0.84 (SA).
• -capital risk premium 7%; cost of debt 7%.
• -debt balance: $6.4 billion; equity capital of $25 billion.
• -tax rate: 26.5%.

After discounting all future free cash flow and adjusting for net debt, Costco’s fair value is estimated at $870 per share.

Risk

I don’t think Costco’s business has any significant risk factors. Instead, a high share price multiple could create concerns in the market. However, I want to point out that the traditional P/E multiple may not be a good indicator of its intrinsic value for the following reasons:

• Costco is a fairly low volatility stock with a beta of 0.84. A lower beta value would result in a low discount rate in stock price calculations.
• Costco performed well during the last recession in 2009, reducing total revenues by only 1.1%. Institutional investors benefit from improved business performance during a recession.
• Competitors would have a hard time replicating Costco’s business model, and in fact Costco’s biggest competitor is themselves.

Application

I support Costco’s strong membership and the expansion of e-commerce. The company’s ongoing efforts to lower the price of goods make it unique in the retail industry. I maintain a “Buy” rating at a fair value of $870 per share.