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1 Green Flag for Costco in 2022, and 1 Red Flag

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Costcos business is booming, but its not all good news for shareholders.

Costco Wholesale (COST -0.96%) has been on fire ever since the onset of the pandemic. It hardly appears that anything could be a red flag for the thriving retailer. But its excellent performance is reflected in its stock price, which is meaningfully more expensive than its brick-and-mortar rivals. 

Still, Costco has an untapped opportunity to raise membership fees. The company typically increases annual fees roughly every five years, which it last did in 2017. The pending price increase is a green flag for Costco in 2022. 

Image source: Getty Images.

Green flag: Increasing membership fees

Costco is a membership warehouse retailer. Without a subscription, you cannot enter the stores, staff at the front door won't let you in unless you show your membership card. It offers consumers two tiers of membership: standard and executive. The former costs $60 per year. The latter is $120 and comes with the added benefit of 2% cash back on all eligible purchases at Costco. 

As of Feb. 13, Costco boasted 63.4 million membership households. That was up by 900,000 from the previous quarter. Of that total, 27.1 million were executive members. Even though executive members consisted of 42.7% of the overall total, they made up 70.9% of overall spending. That's understandable. The primary reason a family or business would opt for executive membership is for the 2% cash back feature.

Perhaps just as impressive as Costco's membership totals are its membership retention rates of 92% in the U.S. and Canada and 89.6% worldwide. Nine out of 10 consumers perceive they get more value from a Costco subscription than it costs. For that reason, it is arguably an excellent time for Costco to consider a membership fee increase.

In response to an analyst question regarding price increases in Costco's most recent conference call on March 3, CFO Richard Galanti said: 'Historically, we always look at things like, do we feel like we can -- we look at ourselves in the mirror, do we feel that we've continued to increase the value of the membership? Certainly, we look at renewal rates. We look less at what others do frankly but certainly is out there what others are doing.'

The last point about looking less at others was perhaps pointed at Amazon's latest price increase for a Prime membership. Amazon's offering is a competitor to Costco, and many households choose one or the other. Amazon's latest increase gives Costco room to raise its fee without losing ground competitively against the e-commerce giant. 

Regardless, Costco has a history of raising membership fees every five years. The last fee increase was in June 2017. If it sticks to its historical pattern, a membership fee increase could be coming in the second half of 2022, which is a green flag for shareholders, to be sure. 

Red flag: Expensive valuation 

Costco is trading at price-to-earnings (P/E) and price-to-free cash flow (P/FCF) multiples of 46 and 42, respectively. That is considerably more expensive than its brick-and-mortar rivals, Target and Walmart. For instance, Target stock can be had at a P/E and P/FCF of 15 and 21, respectively. Meanwhile, Walmart sells at a P/E and P/FCF of 31 and 38, respectively.

COST PE Ratio data by YCharts

An expensive valuation could limit the upside for investors in Costco. Excluding the time during the pandemic that boosted its prospects, Costco's stock has rarely traded at a P/E above 30 in the last decade. A potential adjustment to the stock, bringing it below 30 times earnings, is a red flag, to be sure.

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