How Costco’s membership fees and high ROIC justify its increased valuation

Costco (NASDAQ:COST) is a large retailer that combines defensive and growth appeal thanks to its ability to remain profitable even in difficult economic times. This is achieved through a low-cost, high-volume approach. Currently, Costco shares are at an all-time high and the stock continues to rise amid seemingly unstoppable upward momentum. Looking at Costco’s chart, it is clear that the stock has seen an exponential rise since 2023.

Despite widespread concerns about consumer spending this year, retailers like Costco have effectively navigated these headwinds by increasing comparable sales and increasing traffic. While many competitors have struggled, Costco has managed to gain market share. Today, thanks to its subscription-based business model, Costco returns capital at significantly higher levels than its industry peers, making this efficiency a key factor in the long-term bullish investing thesis that justifies its premium valuation.

Successful companies always have a great and often unique strategy behind them. That’s exactly what Costco does in retail.

The giant wholesaler Costco is unique in many ways. However, the most important advantage is certainly the membership-based model, which generates a predictable revenue stream through annual fees, regardless of product sales. This approach not only makes the company immune to economic cycles, but also creates major price competitive advantages over its competitors.

For example, focusing on bulk purchases and discounted prices creates an exclusive shopping experience that differs from traditional retailers that rely on selling individual items and varying prices. This allows Costco to negotiate its goods at minimal margins, crush all other competitors with similar margins, and generate a high margin return on subscriber fees.

Although subscriber fees represent less than 2% of the company’s total revenue, based on their assumed full profit margin, they contribute to approximately 52% of operating income. But perhaps more importantly, this membership base has become fiercely loyal to this model. Costco has around 76.2 million active members and an impressive 90.5% renewal rate worldwide.

So far, so good. As long as Costco’s membership fees continue to rise, the company’s bottom line should remain strong and likely please shareholders.

These figures were logically achieved after years of high quality management. The strategy of focusing on high volumes and low margins is a major challenge as it requires tight control of operating costs and an efficient infrastructure to handle large volumes of sales. And I don’t think there’s anyone in retail who can do that better than Costco.

In early September of this year, Costco made a major announcement to investors: The company increased its membership fees for the first time since 2017. In the past, Costco typically increased its fees about every five and a half years, which is the longest gap between hikes.

The new fees include a $5 increase for Gold Star, Business and Business Add-on members in the US and Canada. Executive membership fees will increase from $120 to $130 annually in both the U.S. and Canada, bringing the total cost to $65 for the standard membership and an additional $65 for the upgrade.

So how much impact could this fee increase have on Costco’s future profitability?

Now, with approximately 26 million standard memberships affected by the $5 increase and 26 million leadership memberships affected by the $10 increase, the total impact is $30 million through standard memberships and $260 million through Executive memberships are estimated to add a total of $290 million to Costco’s operating income. Of course, some cancellations may occur, although Costco’s renewal rate is an impressive 90.5%.

For comparison, Costco reported operating income of $9.28 billion for fiscal year 2024. Given this, the increase in membership fees could represent a modest 2% to 4% increase in Costco’s annual operating income for fiscal year 2025. Considering Costco operates on such thin margins, this increase could have a significant impact on its bottom line.

Costco’s recent membership fee increase helped push the stock to an all-time high in late November. Despite being a defensive stock due to its membership-based, recurring revenue model and countercyclical nature, Costco is now trading at valuations typically associated with growth stocks.

The company is expected to grow its earnings per share by 10.7% in fiscal 2025, while its revenue is expected to grow by just 7.5%. As a result, Costco is currently trading at a forward P/E ratio of 59x, which is about 42% higher than the average over the last five years. Additionally, the price-to-sales (P/S) ratio is 1.68, about 56% above the historical average.

However, it can be complex to assess whether Costco’s consistent, reliable membership revenue growth and unique business model are adequately reflected in traditional metrics such as P/E or PEG ratios. From a fundamental perspective, one way to assess how well Costco justifies its current valuation is to look at its return on invested capital (ROIC).

To calculate ROIC, we use NOPAT (Net Operating Profit After Tax), which was $7.022 billion for Costco in fiscal 2024, assuming an effective tax rate of 24.4%. The second component of ROIC is invested capital, which includes the total capital that Costco has used to generate profits.

Looking at Costco’s invested capital:

Its fixed assets, which include real estate, equipment, operating leases and other long-term assets, totaled $35.585 billion.

Net working capital was negative $1.2 billion, likely due to Costco’s just-in-time inventory model and its ability to negotiate favorable payment terms with suppliers. This allows the company to carry significant liabilities (supplier debt) without having to pay those bills immediately, creating a temporary situation where liabilities are high but Costco can easily handle them.

Intangible assets and goodwill amounted to $994 million.

If we calculate Costco’s ROIC for fiscal year 2024, we find that it reached 19.95%, which is impressive. Even assuming a modest cost of capital of, say, 8% or a more aggressive 15%, Costco continues to demonstrate high efficiency in generating value for its stakeholders, particularly its shareholders.

It is also important to recognize that companies in retail, particularly in sectors such as food and grocery, typically experience lower ROICs compared to higher capital intensity industries such as technology or pharmaceuticals. For reference, the average ROIC in the retail sector is around 11%. Competitors like Target (NYSE:TGT) and Walmart (NYSE:WMT) have an ROIC of around 11%, while Amazon, a notable player in the retail space, has an ROIC of 14%.

What stands out in this context is Costco’s ROIC of 19.95%, which is almost twice the industry average and significantly higher than its closest competitors. This impressive number reflects the strength of Costco’s membership-based model combined with its efficient supply chain management.

Ultimately, a company’s share price is determined by investors’ willingness to pay. As long as membership fees continue to rise, COST shares should remain near their highs. My biggest concern, however, is the potential impact of a slowdown in membership fee growth. As mentioned earlier in this article, member revenue is a critical metric to Costco’s bottom line. While price increases can help increase sales, a significant drop in renewal rates (to around 80%, for example) could have serious negative consequences for Costco’s stock price.

Costco is arguably the best company in its industry. In my opinion, there is no other retailer that can execute the high volume, low margin strategy as effectively as Costco, especially with the support of membership fees that provide full profitability. This model allows Costco to outperform competitors while maintaining a countercyclical, resilient investment thesis.

Although many investors fear paying 52 times earnings for a company with these characteristics, the stock’s performance, which is at an all-time high, suggests stretched valuations have not been a problem so far.

In my opinion, Costco deserves credit for delivering superior returns to shareholders, especially when you consider metrics like ROIC that far exceed those of its peers. A company that consistently generates high ROIC is usually very effective at converting investments into lasting profits. This becomes clear when we look at Wall Street analysts’ earnings growth forecasts over the next eight years, which have been repeatedly revised upwards.

How Costco's membership fees and high ROIC justify its increased valuation — How Costco’s membership fees and high ROIC justify its increased valuation

Source: SeekingAlpha

As long as this competitive advantage remains intact, I don’t see any valuation issue preventing Costco’s stock price from continuing to rise to new highs.

This article first appeared on GuruFocus.