Risks of Investing in Costco Stock (COST)

Costco Wholesale Corporation (NASDAQ: COST) goes against the grain. In today’s world of shopping via smartphone and next-day delivery, Costco remains the largest warehouse retailer in the United States. Its secret is simple: Instead of trying to compete on margins alone, the company sells membership cards. And it sells a lot of them.

Costco counted roughly 111.6 million membership households in eight countries in 2021. That brought in roughly $3.8 billion a year in membership fees alone. The company boasts a membership renewal rate of over 89%, so even when sales are depressed it has a decent and predictable cushion of revenue.

That's good for investors who have already bought in, but it means that Costco's shares are never really priced low.

Getting in at the Right Price

Investors are willing to pay more per share relative to the company's earnings because they believe the company will be able to continue to grow going forward. As of Oct. 29, 2021, Costco's shares were trading at $491.54, a growth of over 20% from the previous year.

A Premium Price

Costco had a trailing twelve months price-to-earnings (P/E) ratio of 40.02, and that is fairly high for its industry. In comparison, the SPDR S&P Retail ETF has a P/E ratio of 11.7.

Costco has a dividend yield of 0.71%, which could help make up for the high prices, but some other companies are priced lower and pay a higher dividend. For instance, Wal-Mart is priced at $139 and has a dividend yield of 1.58%.

Those high share prices are good news for current investors, but prospective buyers might be cautious about investing in a stock that has already reached consistently high prices. Future gains will depend on the company's ability to continue growing its offerings and customer base.

The E-Commerce Issue

While getting in at the right price is good advice for any investment, the risk is particularly pronounced in Costco stock. There's still a question of whether the company will be able to keep up with its customers' changing habits. Online shopping and e-commerce represent potential threats to Costco's business model, allowing customers to find the lowest prices from their own homes.

Although Costco still commands significant customer loyalty, many shoppers are steadily shifting to online shopping via smartphones or laptops.

That Was Then

Back in late 2014, Costco, in a 10-K filing, acknowledged that a multichannel experience is critical to remaining competitive in the modern economy. The company identified the need to keep pace with its members' expectations as well as new developments in the retail space.

Costco said that it was making technology investments in its website and mobile apps, but it cautioned, "If we are unable to make, improve or develop relevant member-facing technology in a timely manner, our ability to compete and our results of operations could be adversely affected."

Initially, it didn't look like Costco's business model adapted well to that hyper-connected reality. "We're not going to be the company that delivers two different kinds of cereal to your doorstep at 7 a.m. as long as you order by 10 p.m. the night before," said chief financial officer (CFO) Richard Galanti in a conference call back in 2015.

A Strategic Recalculation

Galanti may have revised his thoughts since then, as the e-commerce juggernaut rolls on.

By 2021, Costco had launched e-commerce websites in eight countries, with same-day grocery delivery at most of its locations in the mainland U.S. E-commerce comparable sales were up 44% over the prior year, driven largely by an 80% increase in the first half of the year.

The company also expanded its in-store pickup option, one of the rare instances for which brick-and-mortar retail has an edge on Amazon (for now).

When Galanti made that comment about delivering groceries overnight, e-commerce accounted for just 3% of Costco's net sales. By 2021, the figure had reached 7%. That's good growth, though perhaps not enough to keep Amazon's Jeff Bezos awake at night.

The Business Model

Costco's brick-and-mortar business model is still the heart of the operation. Everything is in a warehouse setting, and the selection is limited. Pricing is unique to each store or area, and it is based as much on local' shopping habits as it is on whatever deals Costco can negotiate.

The value of being a member comes from customers purchasing staples and other necessities in bulk, and perhaps filling up their tanks on pantry-stocking trips. The margins on those items are low, but Costco makes it work through high-volume selling and the membership system.

Supply Chain Fragility

As a global retailer with operations in many countries, Costco is particularly vulnerable to supply-chain disruptions, particularly of perishable goods. This fragility became evident at the start of the COVID-19 pandemic, when the company had to limit purchases of basic goods like toilet paper and bottled water.

Although supplies later returned to pre-pandemic levels, the company still considers it a potential threat to Costco's business operations. Although the company does not rely on any one supplier or product, any major disruption to the global supply chains could affect the company as well.

As the company explained in their latest SEC filing, the pandemic "is continuing to impact the global supply chain, with restrictions and limitations on business activities causing disruption and delay, which have strained certain domestic and international supply chains, and could continue to negatively affect the flow or availability of certain products."

Customer Loyalty Is Key

Investors should understand Costco's business model before investing in the company's stock because it is a very real risk given current trends.

If Costco's members end up deciding that membership is not worth it—for example, if they find that they can find similar deals at Amazon or Walmart without ever having to leave the house, or if they decide they can buy better-quality goods for a similar price—the company loses out.

There is the issue of membership fees, which are essential to the company's business model. Another factor to watch is Kirkland Signature, Costco's private label. Because Costco owns the brand, it earns a higher margin on its products. If there is a quality issue, and the company is no longer able to command loyalty to the Kirkland Signature brand, Costco's profits will suffer.

All Roads Lead to California

Then there is the issue of geography. While Costco had roughly 815 warehouses around the world in mid-2021, the bulk of its income still comes from the U.S. As such, its sales are vulnerable to the domestic economy, which is not an unusual risk.

However, 28% of Costco's domestic sales come from a single state, California. The state's economy is strong right now, but if that changes, Costco's sales could take a hit. The company is also a defendant in several California lawsuits, many of them class actions by former employees. Unfavorable judgments in these litigations could damage Costco's profitability and business operations.