The COST of wholesale and membership

Costco(COST) is a wholesale club, allowing its members to buy in bulk at wholesale prices.  This strategy helps customers save money, but doesn’t really generate high profit margins for COST.  Where Costco generates the bulk of its revenue is through its annual membership fee.  COST offers four membership types, a regular membership (gold star level) for business and personal use at $55 and an executive level membership, both business and personal, for $110 a month. My wife and I shop at Costco almost every month, but we would do what most people we know did, and that’s use other people’s membership cards.  It wasn’t until recently that Costco began checking to make sure the membership card matched the customer, at least at the location we would go to. Most of the time, people would make trips out of going to Costco, with 2 or 3 people using one person’s membership. So even if the member was present to verify it was their card, multiple people could pay for their items with that one card.

Adding value to the customer is great, but this puts Costco at a crossroads.  Since the bulk of their business is in the collection of membership fees, Costco could risk customers either downgrading their membership (if they raised fees), or having customers split the tab of a purchase, like a restaurant bill.  If Costco raises the mark up on their wholesale prices, customers could go to BJ’s(BJ) or Walmart(WMT).  If they try to enforce the membership policy more aggressively, customers can simply find another loophole or shop somewhere else.

For an investor, this is a nightmare.  COST has no real price control on either their wholesale or membership fees, both are red flags.  With a dividend of 1.1%, the stock doesn’t look too appealing from a dividend investor’s perspective.

Costco is also trading at 4.4 times its book value, 33 times its free cash flow with  $3.07 in free cash flow per share.  When we input $3.07 into Guru’s DCF model, we get a fair value of $49.86 with a margin of safety of - 136%.

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I just don’t see the value of investing in Costco, or the moat some analysts are talking about.  I think the fair value of COST is even lower, considering their competition and lack of price control. If we were forced to, I wouldn’t mind paying the $55 a year gold star membership fee, but I definitely wouldn’t pay to become an owner of Costco.

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