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Why Costco stock is worth its 'fairly expensive' valuation, analyst explains

DA Davidson Senior Research Analyst Michael Baker and Cowen Senior Research Analyst Oliver Chen join Yahoo Finance Live to discuss Costco's performance over the past year and why they're bullish on the stock.

Video transcript

[MUSIC PLAYING]

- We announced our company of the year today. It is Costco. Despite the stock taking a hit year-to-date, the warehouse giant added consumers in a year of record inflation and saw sales rise 16% for its fiscal year ending in October. For more on the state of Costco, we're joined by DA Davidson Senior Research Analyst Michael Baker and Cowen Senior Research Analyst Oliver Chen. Great to have you both here with us today.

Oliver, I want to start off with you. When you think about what year this has been-- what a year it has been, especially for consumers who were looking for deals and perhaps buying in bulk-- the name "Costco" alone that stands out among this broader consumer environment right now.

OLIVER CHEN: Yeah, Brad, great to be here. Happy holidays, everybody. Costco screams value, treasure hunt, that $4.99 rotisserie chicken. I'm wearing Costco jewelry. It's a really unique business model. And being a member there enables you to buy goods at lower prices available than anywhere else.

It's a fixed low-markup model. So you're getting a great deal no matter what. And Kirkland's an iconic brand, too. So it checks many boxes for us.

We have more than ever before a consumer looking for value. It's one of the few global concepts that the US has exported. And also it's a net cash dividend yield, free cash flow yield is attractive as well. All these things make for a great story in our opinion.

The one disclaimer is the PE is 30 times. That's a fairly expensive stock. However, we think it's worth it, given what I mentioned.

- Michael, I talked to CEO Craig Jelinek as part of this Yahoo Finance Company of the Year package. And he said that he is seeing some signs of a recession-- a slowdown in jewelry, a slowdown in TVs. How do you think a stock like Costco will perform next year if we do, in fact, get a mild recession?

MICHAEL BAKER: Well, yeah, and I think we're starting to see that creep into the sales, a little bit with the last few months being strong, certainly relative to most retailers, but slowing a little bit for Costco. And as it relates to next year, if we do go into recession, we do think consumers will continue to shop at Costco. And we think their sales will hold up better.

As it relates to the stock, I think the key question, and Oliver touched on this and we agree with him, would depend a little bit on where the valuation is at that point. If the stock continues to come in a little bit and starts 2023 at a little bit more of an attractive valuation, if it does outperform on the top line at least in an environment of slowing consumer spending, there could be a case to be made for the stock. But we'd like to see the valuation still come in a little bit from here.

- Oliver, just to take a little bit of a backtrack, I don't think I've ever heard anyone say, "I'm wearing Costco jewelry right now." And I got to say, you're one of the best dressed analysts I know. So I'm assured that it is nice looking jewelry.

But I am curious, when we talk about the coming economic environment, in past economic pullbacks, do you have people who say, yes, I know Costco has things that are lower priced, but I don't want to pay the membership fee, for example? Do you have some attrition of members in economic periods like this?

OLIVER CHEN: Yeah, Julie, we're impressed with the renewal rates. They've been at 92%. And membership growth has also been impressive, above 5%. So those are key statistics that give us a lot of conviction.

Also, Julie, we have higher-income consumers trading down to Costco. And Costco is well positioned, with household income above other retailers as well. So those are two dynamics that work really well. And everybody loves a good value.

It's noteworthy that Costco only has about 3,000 to 4,000 items. So best of class across cashews, pearls, gold jewelry as well. You can really trust that their merchants have done a good job. And this is a key core competency. Being one of the biggest buyers of many categories, that's another positive, too.

And consumers will be looking for value, having this clarity of value. And don't forget, there's a treasure hunt experience in store. Consumers are going back to stores. That's a positive trend, too.

One of the big problems in retail has been negative traffic across the industry. Costco has distinguished itself by having positive traffic and positive momentum. That's very hard to get in this age of digital. And Costco's digital online product's getting better and better as well.

- Michael, one of the other major categories that everyone-- Costco, Sam's Club, BJ's-- they all compete on is the rewards that they give some of their members, especially in a time where they might be experiencing higher gas prices even. How much does that continue to be a competitive play that they continue to roll out, even going into 2023, or even just as some of those gas prices start to abate a little bit?

MICHAEL BAKER: Yeah, well gas has been a huge story for all the warehouse clubs this year, BJ's and Sam's included. And we think certainly it remains a positive for Costco. There is some risk, though, that if gas prices do continue to moderate, that will be less of a positive catalyst going forward because it's been such a strong catalyst in 2022. And they've made not only great top-line growth there, but also great profits on their gas business. And so there is the concern that that gas profit windfall might not repeat to the same extent next year and could end up being a little bit of a margin drag.

Now, typically I think analysts exclude that the gas price benefit from the top-line trends. But it is harder to disaggregate from the profitability. Again, one of the things that has led to really strong profitability this year might be a little bit less so next year.

- Oliver, is the Kirkland brand you mentioned, is that this company's secret weapon? And I bring this up because longtime CFO Richard Galanti told us last year for the fiscal year ended, they racked up about $50 billion in sales related to Kirkland alone. I mean, that's huge. It blew me away.

OLIVER CHEN: Yeah, Brad, the name of the game in retail is differentiated private label because you can get only Kirkland at Costco. And Kirkland has very powerful brand equity, in our opinion. I even bought a Kirkland sweatshirt.

Thinking about Kirkland, it really stands for quality. And it stands for great pricing, again. And it cuts across many categories. So it's a unique private label in that you can buy a sweatshirt, you can buy Kirkland chardonnay, you can buy a Kirkland chicken at many categories, which is quite unique, too.

What they've done is used private label strategically. Costco has a mixture of national brands as well as Kirkland. And it helps them get better deals as well on national brands. And it also really highlights Costco's ability to innovate product and offer you a great product at a great price that's well trusted as well. So lots of features, but the bottom line is the future of retail is offering proprietary private label as well. And Kirkland checks that box as well.

- Next thing, Oliver, you'll be telling us your suit is from Costco also. No, I was just kidding. Michael, one of the things that you point out in your latest note is-- and we saw this big time, especially earlier this year-- how much gasoline was driving traffic to Costco because of the differentiation that Costco offered on that front in terms of price. Gas price has been coming down everywhere, right? So is that less of a traffic driver for Costco now?

MICHAEL BAKER: Yeah, I think it probably will be. So still a great deal on gas at all the clubs, but maybe a little bit less of that panic buying that we saw back in February, March, and April, and even into June, when gas prices peaked at more than $5 a gallon. We'd go to Costco and see lines. It felt like the early '70s in terms of people lining up to get gas.

You still see a lot of people at the pump these days, but a little bit less so than we saw over the summer. And some high percent of those customers, in the 30% to even 50% range, when they go to fill up at the tank, they go into the store and pick up some items while we're there. So with all things Costco, it's still a positive, but maybe a little bit less of a positive than it was at the peak of this gas price situation earlier this summer.

- All right, a very helpful deep dive into our company of the year, Costco. DA Davidson Senior Research Analyst Michael Baker and Cowen Senior Research Analyst Oliver Chen, thanks, gents. Appreciate it.