Business Model Risks Could Undercut Costco Stock Price

  • Costco needs to do something about speed of service to its customers. If if just wants customers looking for "bargains", they will forego customers who want to spend more.
  • Up to now, its narrow portfolio of products has been an asset to its business model. It may not be such an advantage going forward.
  • Same store sales will eventually flatten out because of overcrowding issues. Company needs new stores to adapt its current model.
  • The visa deal will definitely help numbers in the near term but analysts will have these savings priced into future earnings projections.

Costco (NASDAQ:COST) announces earnings on 8th of December next and the consensus EPS forecast is $1.16 a share. The company has beaten estimates pretty convincingly in the past and an earnings beat looks to be on the cards once again. The business model of this company is one of beauty but I believe the company might soon be facing an an inflection point regarding how it wants to grow going forward. Why you may ask? Well, I just feel that the retailer's main weapon in this ultra competitive market will be speed of delivery going forward. We can already see it with Amazon (NASDAQ:AMZN) prime program, which in some cases offers free of your goods within one hour of ordering them as long as the order is over a certain amount. Now compare this with Costco's business model in which you also pay a membership fee, but generally customers are advised to shop in-store (because Costco's e-commerce service can't yet compete with Amazon's).

Also read: Costco stock remains one of the best retail stock picks for 2016.

This is where Costco starts to lose in my opinion against prolific online retailers and here is why. A Costco store opened near me recently in Europe and they have been attracting customers in hoards mainly due to them selling diesel at a 10%+ discount compared to the rest of the market. This has caused huge delays at the new superstore which definitely has caused some motorists and consumers to stop doing business there. Discounts are one thing but anyone that values their time would prefer not to be there at on-peak hours. One thing to me is clear after visiting their store. If the company wants to achieve faster growth rates by using the existing model, it needs to roll out more infrastructure at a faster rate because same store sales growth is not going to cut it because their stores are maxed out as they are. The demand is definitely there but presently the company runs the risk of being a company that offers slow service which would be detrimental to its future growth.

Note: You might also be interested in this Costco Stock analysis video.

One of the main reasons this business model does so well is because Costco only relies on about 3,500 active stock picking units. Narrowing the inventory has enabled the company to really concentrate on volume with its suppliers (which gets it better discounts over time) and streamline the operations of the business. Costco has focused on the mainstay products such as food and gas but I just feel that volume of products sold will be the defining factor on whether retailers succeed or fail going forward. Therefore, if Costco is offering approximately 3,500 unique products compared to millions of different items being sold by other retailers, you would feel that its volume growth would definitely be limited. If the retailing industry trend is more sustained online growth and if online retailers will reward you for shopping exclusively with them, it stands to reason that the companies with larger portfolio of products will do better over the long term. I understand that bulls may question my bearish argument by stating that Costco's business is on the ground and face to face service is still wanted by consumers. However, investors need to have an open mind with regards to technological advances in the next few years. In 2005, we would never have thought that e-commerce could have grown so rapidly in 10 years. I think its growth (both in volume and service) will grow even more in years to come which will leave brick and mortar retailers in the dust unless they adapt quickly.

The faster and cheaper online retailers can provide services to its customers, the more it will put pressure on the likes of Costco. If you include a 20 km round trip into a Costco experience, you are probably spending on fuel to get there and then spending your time. This is the conundrum Costco is in. It wants more people in the door but on the other hand doesn't want to vacate them either (through over-crowding). I just think, based on my own experience, that same store sales won't continue to increase over time. No matter how efficient you make the super stores, you are dealing with a business which is operated under space and time rules (not like a strict online retailer).  I just think the company's same-store sales growth rate (7% in fiscal 2015) is due to a strengthening US economy where unemployment is decreasing and interest rates are extremely low which is bolstering credit demand. International economies are not doing as well as the US presently and we can see this with Costco having a higher attrition rate (less membership renewal rates) internationally. The question that has to be asked is would Costco's membership renewal rates hold up if the US entered a recession. Bulls would undoubtedly state yes because they remained strong in the recession of 2008. However, in 2008 consumers didn't have access to the quality of products and services they have access to today (primarily online).

To sum up, Costco stock now has a P/E ratio of over 30 meaning that the street believes that earnings growth will be strong over the next few years. Personally I feel that the biggest threat Costco will face going forward is the online shopping, which is still projected to grow by leaps and bounds. Costco (although being very cheap for mainstay products) has a service problem in that it is trying to service too many customers. I have no doubt that when some customers see the queues, they will prefer to walk way.

Jack Foley Jack Foley   on Amigobulls :
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  • I do not have any business relationship with the companies mentioned in this post.
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