Costco: You shop there but should you buy the stock as well?

Costco 1Dear Mr. Market:

Take a moment to think of a ‘big-box’ retailer – is it a position that you would like to own in your portfolio? Over the last several years investors have been burned by these stocks as the retail industry has been hit with negative headlines and security breaches while at the same time resisting change in consumers preferences and technology. When investors think of ‘big-box’ retailers the two names that often come to mind are Wal-Mart (WMT) and Target (TGT). There is, however, a name that has become a leader posting impressive returns for years and in our opinion will continue to do so for the foreseeable future.

Costco Wholesale Corporation (COST) is a leader in the Consumer Staples industry that truly embraces and drives change enabling it to earn the loyalty of its members while also recruiting new ones. At the end of 2014 the company operated 664 warehouses with 469 in the United States, 88 in Canada, 33 in Mexico and the remaining 74 in the United Kingdom, Japan, Korea, Taiwan, Australia and Spain. The company was founded in 1976 and is currently based in Issaquah, Washington.

When we look at Costco there are several key factors that differentiate COST from their competitors and in our opinion make a case for why it can serve as a core holding in a diversified portfolio. Today we will not be wearing our ‘analyst hat’ and dig into the financial reports instead we will highlight several compelling points that make Costco a leader and innovator in their industry.

Memberships – Costco is unique in the retail space as they operate with a subscription or membership model, which creates a consistent ongoing revenue stream. Recent estimates state that nearly 65 million Americans are Costco members; that’s nearly 25% of all American adults! The base membership costs is $55 per year while the executive membership costs $110 per year offering a 2% annual reward based on purchases made. The retention rates for the company are impressive with nearly 88% in renewals for 2010 and most recently 91% in 2014.

Global Expansion – Based on current data 75% of Costco’s stores are based in the United States with 25% overseas. Global memberships have grown 35% in the last five years driving annual membership fees from $1.5 billion to more than $2.5 billion over that same time frame. Costco has shown the ability to move into new markets (both domestic and international) and post impressive numbers. The same can’t be said for their competitors like Target that announced they are pulling out of Canada after extremely disappointing results.

New Visa relationship – Starting April 1, 2016 Costco will start accepting Visa (V) credit cards after its current agreement with American Express (AXP) expires which has been in place since 1999. While the exact financial benefits have not been confirmed the new relationship will give Costco the opportunity to establish relationships with 281 million Visa credit card holders as compared to the 55 million American Express members currently in place.

Unique business model – The majority of Costco’s profits come from its membership fees not margins on the products it sells. The numbers for Costco are quite alarming when compared to its competitors. Wal-Mart posts a gross profit margin around 25% while Target comes in at 30%; Costco is significantly lower at 12.5%. While most retailers consider more choices to be better, Costco strategically offers limited choices. The typical Wal-Mart super center carries over 100,000 different items while a Costco Warehouse carries only 4,000. This creates pricing competition with the vendors that are fighting to gain exposure to Costco customers.

Here are some other interesting facts regarding Costco that separate it from its competitors:

  • Happy employees – while other retailers struggle with their workforce Costco realizes that happy employees make a difference. Last year employees gave CEO, Craig Jelinek, a 92% approval rating. The average employee makes $20.89 and hour compared to $12.67 at Wal-Mart. 88% of Costco employees have health insurance through the company.
  • Wine and alcohol – Costco is the largest seller of fine wines in the U.S. with sales over $1 billion each year.
  • Product mark-ups – nothing is marked up more than 15% as the membership fees give them the flexibility to keep prices low.
  • Management/Executive Pay – CEO, Craig Jelinek, earned $5.4 million in 2013 compared to $26 million for Wal-Mart CEO, Doug McMillon.
  • The number one selling product for Costco is toilet paper.
  • They truly know their clients and deliver products and services that keep people coming to their stores. For example they sell 60 million rotisserie chickens at $4.99 each and for 25 years they have offered a hot dog and soda for $1.50 (they sell over 100 million of these combos a year). These could be viewed as loss leaders but they help establish loyal customers and keep them coming back.

Buy, Sell or Hold….

Our analysis of Costco is primarily focused on being a long-term holding and not a short-term play. While many retailers are attempting to evolve and adjust to consumers demands Costco continues to move ahead with a business model that has proven to work well in both bull and bear markets.

For the first half of this year the stock is essentially tracking the S&P 500 with both of them being up approximately 2% on the year. Since 2000 Costco has outperformed the S&P 500 for 10 out of the 15 years. It also offers an attractive dividend of 2.74% and has a track record of increasing the dividend by over 16% annually over the last ten years.

One factor that often causes investors to second guess buying COST is the apparently frothy P/E ratio, currently at 27.9. For comparison the S&P 500 is at 20.55, TGT is 20.80 and WMT is 14.78. The significant amount of cash flow that is generated by membership renewals certainly has an impact on the company’s P/E and needs to be accounted for when analyzing this figure. In our opinion the stock is trading at close to fair market value.

While many retailers have become nothing more than a shadow of their former glory we do not have such fears with Costco. Management continues to grow the company at a responsible rate with 12 new stores expected to open by the end of the fourth quarter this year. CEO, Craig Jelinek, is focused on employees and unlike many CEOs, gives them more than just lip service. He recently introduced a new 401(k) and was quoted as saying, “I just think people need to make a living wage with health benefits. It also puts more money back into the economy and creates a healthier country. It’s really that simple.”

Currently there are 29 different analysts that offer opinions on Costco with an average rating of ‘strong buy’ and an average target price of $157. The stock is currently trading at $145. Our bottom line opinion is this: We’re buyers of the stock on any broad market dips. A simple rule in investing comes down to owning the best-managed companies that are leaders of their respective industries. You simply won’t find a better managed big box retailer. We see Costco outperforming the S&P 500 for years to come.

Costco 2Wall Street is in the business of making money between now and next Tuesday. We’re in the business of building an organization, an institution that will be here 50 years from now. Strategic planning is an important part of running any business and more so for businesses operating in multiple states and countries.”

                                                                        – James Sinegal, Co-Founder of Costco

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