Membership Fees Account for 15% of Costco’s Stock

Costco (NASDAQ:COST), which competes with Wal-Mart’s (NYSE:WMT) Sam’s Club and BJ’s Wholesale Club (NYSE:BJ), is the second largest retailer in the US.  It is also the largest retailer in the warehouse club category with revenues of about $70 billion in 2009.  The retailer operates on the business model of charging membership fee from its customers in exchange for heavy discounts on selected brands of a wide variety of merchandise.

We estimate that about 15% of Costco’s value comes from just the membership fee that it collects annually from its members. This amounts to $3.3 billion in absolute value based on our estimated $21.9 billion value for Costco.  Below we discuss factors that essentially result in high valuation of membership fee.

Average membership fee is expected to grow as a result of increasing executive membership penetration

Costco’s Executive members pay a high membership fee of $100 annually, double the fee of business members, and account for about 60% of Costco’s total sales.  Executive membership penetration is on an upward trend and has increased from about 23% in mid-2007 to about 29% in mid-2009.  As the penetration increases further, it is likely to sustain growth in Average Membership Fee per Cardholder.  We expect this figure to increase to more than $32 by end of our forecast period

You can modify our forecast above to see how Costco’s stock depends on average membership fee.

Number of cardholders are expected to grow as Costco expands and executive membership penetration increases

Although Costco’s pace of expansion has slowed down recently, the company has plans to increase pace of expansion in the future. As the retailer expands, its membership count will increase as customers in newer geographies sign up for Costco membership.

Executive members tend to have higher renewal rates than other members. For example, membership renewal rates are about 92% for executive members, 5% higher than the overall membership renewal rates. Thus, with increasing executive membership penetration, membership continuation rates are likely to go up, impacting membership count positively.

High margins on membership fees result in significant value

We believe that the membership fee has minimal direct costs associated with it. Costco’s direct costs essentially come from the inventory that it purchases. Therefore, we have estimated the gross margins for the membership fee division to be close to 100%.  This has a significant positive impact on cash flows that can be attributed solely to this division and is the primary factor behind the significance of Costco’s membership fees for the company’s stock.

You can see our complete model for Costco’s stock here