Why Costco Is a Great Stock to Own

Anindya is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Costco (NASDAQ: COST) recently announced its operating results for the first quarter of fiscal 2013, ended November 25. Net sales for the quarter increased 10%, to $23.20 billion from $21.18 billion during the first quarter last year. Net income for the quarter increased 30%, to $416 million or $.95 per diluted share, from $320 million or $.73 per diluted share, last year.

The company has been maintaining profitability in good times and bad. Its ability to scale down costs when needed makes its business fairly resilient. Shares of the company have been in a major uptrend for the past two-and-half years. Since hitting a low of $51.96 in June 2010, the stock has nearly doubled. I expect this uptrend to continue going forward, because I feel Costco’s unique revenue model will be a strong source of cash generation and value creation for its shareholders.

Costco’s Unique Revenue Model

Issaquah-based Costco operates membership warehouses that offer a selection of branded and private label products in a range of merchandise categories in no-frills, self-service warehouse facilities. Almost all of its revenues directly come from membership fees. Membership fees are paid up front, and membership renewal rates are consistently above 85%.

Costco reported a 14.3% jump in revenue from membership fees, helping to boost its fiscal first-quarter profit by 30%. Deutsche Bank analyst Charles Grom projected 17% growth in membership-fee revenue. He described Costco’s performance as solid, especially considering “today’s choppy retail environment.”

Costco: A Perfect Blend of Value and Growth

Costco’s ROIC vs. Peers: Costco’s ROIC (return on invested capital), a measure to understand how efficiently the company is using capital, is on a strong growth path. While Costco’s performance on the capital front is slightly worse than Wal-Mart (NYSE: WMT) in absolute terms, it’s far better than another rival, Target (NYSE: TGT). However, in relative terms, Costco’s ROIC has been most impressive since the last one year, as it’s growing at a faster pace than that of its peers. With a 3-year average operating income growth of 15.79%, Costco’s ROIC has been a solid source of cash generation and value creation.

<img src="http://media.ycharts.com/charts/dcb0ddddc609892515b9d9e6637a9da9.png" />

COST Return on Invested Capital data by YCharts

Costco’s Revenue per Share vs. Peers: Costco’s Revenue per Share remains at a higher level than that of both Wal-Mart and Target. Along with an impressive revenue growth, Costco’s bottom-line is expected to improve significantly going forward. 

<img src="http://media.ycharts.com/charts/24e9c8a905e5e46da72ce5ee8a54d839.png" />

COST Revenue Per Share TTM data by YCharts

Key Drivers for the Stock

Economic slowdown: The biggest driver for the stock is the ongoing worldwide economic slowdown. During recessionary periods consumers tend to cut back on expenses. As a result, they turn to low-cost retailers like Costco for buying.

The company sells its products like food and gasoline at cost. Costco can do this because it derives all of its profits from membership fees. The CEO of the company had kept his faith in low pricing.

International expansion: Costco currently operates 621 warehouses, including 448 in North America. However, having warehouse facilities in only 169 locations in the rest of the world, the company is just in the early stages of its international growth. For fiscal 2013, Costco plans to open as many as 30 new stores, nearly twice as many as last year. The company also operates Costco Online.

Continued membership retention: Costco charges a $55 annual membership fee to all of its customers. Raising the membership fee could result in a fall in retention rates below the historic 85% level. If the company is able to maintain a stable retention rate going forward, investors will feel confident.   

Downside Risk: Costco’s Debt 

Costco is paying a special dividend of $7 per share this month ahead of higher tax rates that may kick in come January. The company is selling $3.5 billion in debt to cover the cost of the special dividend. Costco will sell $1.2 billion in senior notes due in December 2015, $1.1 billion in notes due in December 2017, and $1.2 billion due in December 2019. 

Fitch Ratings said that it lowered Costco's issuer default rating one notch to "A+" from "AA-" because of the debt the company is taking on. But "A+" is still considered an above-average, investment-grade rating. Costco’s exposure to this debt may worry some investors. "The company has access to a fairly cheap debt and we want to capitalize on it", Costco's CFO Richard Galanti said.

Costco’s Relative Valuation

Given Costco’s better growth prospects, its stock enjoys a premium in terms of PE multiple among its peers. 

<img src="/media/images/user_14403/cost_large.png" />

(Data Source: Morningstar)

Costco is trading at a forward PE of 18.9, whereas Wal-Mart has a forward PE of 12.3 and Target has a forward PE of 11.6. It’s clear from the table presented above why Costco trades with such a higher PE multiple. 

Conclusion

Despite having a relatively rich multiple on its stock, Costco remains a strong buy at the current price. With a limited downside, the stock is expected to appreciate significantly over the medium to long term to catch up with its strong fundamentals. 

 


Anindya7 has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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