Costco has built a near-perfect business model and has a loyal customer base.
For roughly 40 years, the quarter-pound all-beef hot dog and 20 oz. soda (with refill) at Costco Wholesale (COST -0.15%) has been priced at $1.50.
The Costco hot dog has received a sort of cult following for maintaining the same price despite inflationary pressures. And in many ways, it embodies Costco's core principle of making customers happy so they view the membership as a good value. There's no reason to think the price will change anytime soon.
"To clear up some recent media speculation, I also want to confirm the $1.50 hot dog price is safe," said Costco CFO Gary Millerchip on the company's May earnings call.
Customer perception that Costco stores are a good value is especially important, considering the company just announced its first membership price increase since 2017. Here's what the membership increase means for the dividend stock and whether you should buy it now.
Image source: Getty Images.
Understanding Costco's membership model
Costco blends a subscription model with low prices better than any other retailer. About half of Costco's operating income comes from membership fees, which is practically pure profit. With so much guaranteed income up front, Costco can then drive value for its customers with competitive pricing on bulk items and provide services from tires to eye exams and more.
Effective Sept. 1, Costco's basic members will increase from $60 to $65 per year, its executive membership will go from $120 to $130 per year, and the maximum annual 2% reward with the executive membership will increase from $1,000 to $1,250. In a statement, Costco said that the fee increase will impact around 52 million memberships in the U.S. and Canada -- over half of which are executive tier.
Executive members earn a 2% annual reward certificate -- which is mailed with the renewal notice around two months before the renewal date. The reward is based on purchases at Costco. To get the maximum $1,250 credit, a member must spend a mind-numbing $62,500 at Costco in a single year. That's 41,667 hot dogs.
Jokes aside, the executive membership is worth it as long as you spend at least $3,250 at Costco per year, which would result in a $65 reward certificate.
Costco's business model is set up to encourage customers to shop for items far beyond groceries. The company offers a variety of discretionary goods, including TVs, appliances and more. The value proposition is a win for Costco and the customer -- as evidenced by Costco's low 3.6% operating margin.
As mentioned, about half of Costco's operating income comes from membership fees, meaning the margin on merchandise is less than 2%. The $1.50 hot dog is a symbolic value-add for customers, but the numbers indicate that Costco isn't overcharging on its merchandise either.
Delivering value for customers and shareholders
The 8.3% increase to both membership tiers could effectively boost Costco's operating income by 4%, all else being equal. However, Costco intends to use that money to improve its product mix and pass value back to customers through competitive prices.
In its recent earnings call, Costco noted an uptick in discretionary spending -- which is the exact opposite trend many other consumer-focused companies are seeing. For example, McDonald's stock is down big this year as it scrambles to try and provide value for customers and boost sales. Costco doesn't have that problem because value is already ingrained in its brand.
Costco is a textbook example of having a strategic vision. The best way for Costco to grow its business isn't by squeezing extra profit out of customers, but by growing the customer base through higher volume per store, new store openings, and gradual membership fee increases. It can then use that higher operating income to give customers more value through products, services, and lower prices.
As for the stock, Costco has crushed the S&P 500 over the last year, three years, five years, and 10 years -- producing a total return of 72.5% over the last year compared to 29.7% for the index. Costco pays an ordinary dividend of $1.16 per share for a yield of 0.5%, but it is also known for paying special dividends every few years once its cash position reaches a comfortable level. Its most recent $15-per-share special dividend was announced in December.
In this vein, Costco isn't the traditional dividend stock, but it does use the dividend as a way to reward shareholders.
Shop elsewhere for quality dividend stocks
Costco stands out as one of the best business models in retail. The company's ability to leverage membership fees and provide transparent value to customers is impressive. The brand has never been stronger, as evidenced by strong membership growth.
Unfortunately, Costco trades at a 52.6 price-to-earnings ratio. Analyst consensus estimates call for $17.67 in 2025 earnings per share -- implying a 47.9 P/E based on 2025 earnings. That's a sky-high, borderline stratosphere-level valuation for a low-to-moderate-growth-level business.
There are countless examples where paying a premium price for a quality company has produced outsized gains. But many of those cases involve a company with sustained high earnings growth -- such as megacap tech companies. There are dividend-paying companies that routinely sport a premium valuation -- like Procter & Gamble -- which has a portfolio of top consumer brands, 68 consecutive years of dividend raises, and buys back a ton of its own stock. But even P&G's P/E is just 27.1 -- nowhere near Costco's levels.
The fact that Costco is nearly double the multiple of a top-tier dividend stock like P&G puts into perspective just how expensive it is. Costco's business model is great, and the membership fee increases will probably help drive even more value, but it is too expensive even to consider adding to a watch list now.
Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy.
