Market Mad House

In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule. Friedrich Nietzsche


Inside the Costco (COST) Money Machine

The Costco (COST) Money Machine is one of the simplest yet most brilliant retail strategies of all time. Essentially Costco Wholesale (NASDAQ: COST) obligates consumers to shop at its stores by charging a membership fee.

In fact, the membership fee is at the heart of the Costco (COST) Money Machine. The membership fees expand Costco’s business in two interesting ways.

How Membership Fees power the Costco (COST) Money Machine

First, the membership obligates people to shop at Costco. To explain, a person who spends $60 or $120 for a Costco membership will drive an extra five or 20 miles to reach the Costco store.

Not surprisingly, Jeff Bezos; a friend and admirer of Costco founder Jeff Brotman, stole Costco’s membership strategy for Amazon Prime. For a good overview of Bezos and Brothman’s relationship see The Everything Store: Jeff Bezos and the Age of Amazon by Brad Stone.

To explain, the Prime Membership obligates consumers to shop at Amazon (NASDAQ: AMZN). In addition, Amazon offers low prices like Costco.

Can the Costco (COST) Money Machine Survive in the Age of Amazon?

Under these circumstances we must ask, can the Costco (COST) money machine survive the age of Amazon?

Hence, Costco, sold 17.9 million new memberships in four years, despite aggressive expansion by Amazon. Therefore, I conclude Costco’s money machine is safe from Amazon for the immediate future.

To explain, there are enough people who value a Costco membership to keep the warehouse clubs functioning. However, there could be limits to Costco’s growth.

The Limits to Costco’s Growth

Notably, two trends in American society threaten Costco’s future. Those trends are the aging of the Baby Boomers and middle-class wage stagnation.

The Baby Boomers are the generation of Americans born between 1945 and 1964. Unfortunately, the roughly 73 million Boomers make up Costco’s core demographic and they are aging fast. In fact, the youngest Boomers are now 53.

Boomers’ aging threatens Costco because people buy less as they get older. For instance, retired people have less money to spend and no rationale for a Costco membership. Thus we are likely to see a drop off in Costco Membership in the US and Canada in the next few years.

How Wage Stagnation Threatens Costco

Wage stagnation is a greater threat to Costco because more and more Americans have less money to spend.

For example, the purchasing power of the average Americans’ wage has not increased in 40 years, Pew Research claims. To clarify, when adjusted for inflation the average American’s paycheck equals what his father made in 1978. In addition, most wage gains went to the upper class.

Wage stagnation is both good and bad for Costco. Costco profits from wage stagnation because cash-strapped workers are more likely to bargain hunt and bulk buy. However, wage stagnation is bad for Costco because workers have less disposable income.

For instance, the soccer mom saying I want the neighbors to see Amazon boxes on my doorstep. The woman wants the Amazon boxes on her doorstep to show the neighbors she is middle class.

In addition, the affluent have fewer reasons to pinch pennies and bulk buy. Thus Costco will need new strategies for luring customers.

How successful is the Costco (COST) Money Machine?

Fortunately, the financial numbers show Costco shareholders have little to worry about despite the existential threats.

For instance, Costco records a gross profit of $4.446 billion; a 10.25% revenue growth rate, and revenues of $35.069 billion for 4th Quarter 2018. In addition, Costco Wholesale reports an operating income of $949 million and a net income of $767 million for the same period.

Thus the Costco money machine is running and generating lots of cash. For example, Costco reports an operating cash flow of $2.177 billion and a free cash flow of $1.447 billion for 4th Quarter 2018.

Finally, Costco has a lot of money in the bank for a retailer. For instance, Costco reported $6.778 billion in cash and equivalents and $1.175 billion in short-term investments on November 25, 2018.

The Costco Dividend is Safe

Consequently, I conclude the Costco dividend is safe for the foreseeable future.

This is superb news for Costco shareholders because the next COST dividend is 57¢ scheduled for 22 February 2019. Importantly, Costco’s dividend grew by seven cents in 2018 rising from 50¢ in February 2018.

Thus, Costco’s dividend could increase by a few cents in 2019. Such growth is likely because Costco offers shareholders 15 years of dividend growth. Plus, a share of COST offered investors a dividend yield of 1.05%, an annualized payout of $2.28, and a payout ratio of 33.5% on 18 February 2019.

I think Costco was still a value investment at $216.47 a share on February 18, 2019. However, Costco’s value could vanish overnight because its basis is a specific behavior.

The behavior is the willingness of middle-class consumers to buy a Costco membership every year. If that behavior changes, Costco will lose all of its value.