Investors Wrong-Footed on Costco's Exposure to Amazon

The stock of Costco Wholesale (COST) has lost 13% just since its August high of nearly $170 a share, and now trading at $147 is down 8% since the start of the year. There's one big bugaboo that's been stalking the stock: that business model disruptor known as Amazon (AMZN) .

In April 2014, Amazon introduced Amazon Prime Pantry. The service will deliver everyday essentials via a familiar e-commerce model. Amazon always made sure to point out that the contents of the grocery box you just received came in "everyday sizes" - a clear jab at the warehouse-sized packages that the Costcos of the world made you buy.

It threatened to be a problem and not just competitively. Amazon's entry into the grocery space also created significant reputational damage. Costco was supposed to be Amazon proof. It had long had one retail model that Amazon couldn't match, let alone blow up.

Now they were going to go head to head.

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Walmart (WMT) -- the original grocery store disruptor -- got so scared about Amazon's straying into its lane that it went out and agreed to spend $3.3 billion on e-commerce grocery purveyor Jet.com, just to build a moat between its e-commerce opportunities and Amazon's scorched earth business model.

But the reality for Costco is that there's no monster that looks like Jeff Bezos hiding under the bed.

What Costco management appears to have realized is that Amazon isn't going to wreak the kind of havoc on the grocery business - let alone the warehouse style grocery business Costco has polished - that Amazon acolytes might have projected.

Look at the details.

Take membership. Costco hasn't exactly been leaking members. For fiscal 2015 its membership renewal rate in North America reached 91%. That's the definition of "sticky." There are 34 million consumers who spend $55 a year - some spend double that for extra rewards like cash back on purchases - for the right to shop at Costco. Add in the 7 million business members, and Costco's membership gets it right in line with the 40 million subscribers to Amazon Prime, a prerequisite for being able to take advantage of Amazon's Pantry service. (Of course, Amazon Prime gets members a lot of other perks, like no-charge shipping on non-pantry items and access to entertainment content.)

An Amazon Prime subscription costs $99 a year. That doesn't figure the $6 per delivery that Amazon charges for its pantry service, which has a one box, 45 pound weight limit per shipment. Six bucks might be a single digit percentage of the cost of a box of groceries. But it's six bucks that customers don't have to spend at Costco. If Costco customers weren't, above all else, frugal ... well, they wouldn't be Costco customers in the first place.

The membership stability is critical to the Costco business model. Those membership fees account for only 4% of revenue, but they amount to 75% of operating profits, according to analysts covering the company.

Granted, Costco is expensive. At 27 times forward earnings, according to Morningstar, it trades at a 68% premium to the 16 times figure of comparable retailers, including Walmart, which operates the rival Sam's Club.

It's also true that same store sales haven't been blowing analysts away. October comparable sales growth amounted to 2%, a level that has kept analysts waiting a little longer for the return to historic comparable sales growth. Costco, sensitive to cannibalizing sales at its existing locations, doesn't just open new stores by the dozens to show growth. Nevertheless, purchases of staples are effectively pathways to sales of higher margin discretionary purchases, like electronics and liquor. (Costco is the largest purveyor of imported French red wine in the country.)

There have been a couple of hiccups in the Costco story recently. It quietly backed away from selling tobacco at a majority of its locations. Its conversion this summer to a Visa product from its American Express branded credit card was kind of clumsily executed.

Deflation in food prices, especially for proteins, has put a crimp in revenues. But fresh food, like meats, fish and dairy products, are the fastest growing category at Costco. And Amazon Prime Pantry, with its "up to four days for delivery" model, can't sell fresh food. So Costco has a whole category of products that it can merchandise, and one that isn't susceptible to the low margins and brutal pricing wars of packaged goods.

And customers insist the chance to "splurge" at the Costco food court is worth the gas it costs to drive to the closest outlet. A slice of pizza the size of a first baseman's mitt costs two bucks. Costco will sell four times as many hot dogs this year as Major League Baseball stadiums, and for the same $1.50 the company has charged for years.

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