Costco Is a Top 10 Stock

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

In the fifth installment of a series that focuses on great businesses that should be considered for core positions in anyone's portfolio, this post takes a look at how Costco Wholesale (NASDAQ: COST) differentiates itself from a crowded field of retailers.The formula for Costco is simple to understand, but apparently far more difficult to duplicate.  It starts with a focus on customers; Costco strives to create a higher-end warehouse shopping experience that provides a wide range of popular brands, superior customer service, and the best pricing possible.

Some critics may say that additional investments to make the customer experience better and lower prices lead to smaller margins, but the power of brand loyalty should not be overlooked; 90% of Costco members renew their membership each year, and that amount has not been materially impacted by either the global economic recession or the company's membership fee increases during 2012.

This focus on doing things the right way extends beyond the customer, with employees being far better compensated than their peers at competitors such as Wal-Mart (NYSE: WMT) and Target (NYSE: TGT). The result is profound; a combination of more compensation and a culture that promotes from within provides Costco employees the motivation to go the extra mile to make the customer experience better.

Additionally, Costco's management really does live by the mantra of "maximizing shareholder value" that most companies have in their mission statements. Maximizing shareholder value includes not only prudent operation and expansion of the business, but also the return of capital in the form of increasing dividends and share repurchases as well as the recently paid $7 per share special dividend. Happy customers, happy employees and happy shareholders have helped Costco earn nicknames such as the "Anti-Walmart" as described by Business Insider.

Costco has evolved into a retail powerhouse

By expanding to a total of 621 stores as of December 2012, Costco has grown into the second largest U.S. retailer in terms of worldwide sales behind only Wal-Mart and generated $97 billion in revenue in FY2012. This revenue has come from very diversified businesses, including $10.5 billion from gas, $5.1 billion from meat, $2.0 billion from TVs and even $1.4 billion from wine. Not only can you buy everything from tires to prescription glasses at Costco, but the selection continues to grow as the company finds new ways to provide value to customers.

As noted above, customers appreciate this value proposition and reward Costco with a 90% membership renewal rate. Additionally, demand has allowed Costco to continue expanding both domestically and abroad; in fact, Costco's plan to open between 27-30 warehouses next year is its largest expansion since 2007. So, the growth story appears a long way from over at Costco.

Performance has been stellar

A great business with great management is a recipe for market beating returns.  The 10-year stock price chart below says it all:

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COST data by YCharts

Among its largest brick-and-mortar peers, Costco has really separated itself in terms of investment performance. This analysis admittedly leaves out, which has crushed the market over the past decade with a return of over 1,000%. Please refer to my ongoing blog series highlighting the ways that is disrupting traditional retail business models.

Excellence is usually not cheap

The market has clearly rewarded long-time Costco shareholders for management's strong execution of its business plan and fulfillment of the ongoing investment thesis. The result is a stock price that never seems "cheap" by traditional metrics. Here is a comparison of a few valuation data points between Costco and a selection of its large retail competitors:

<table> <tbody> <tr> <td> </td> <td>COST</td> <td>WMT</td> <td>TGT</td> <td>KR</td> <td>WAG</td> </tr> <tr> <td>CAPS Rating</td> <td>4 stars</td> <td>4 stars </td> <td>4 stars </td> <td>3 stars </td> <td>4 stars</td> </tr> <tr> <td>Share Price</td> <td>$99.49 </td> <td>$68.65 </td> <td>$59.60 </td> <td>$26.30 </td> <td>$36.31 </td> </tr> <tr> <td>Market Cap (in billions)</td> <td>$43.1 </td> <td>$229.7 </td> <td>$38.8 </td> <td>$13.6 </td> <td>$34.3 </td> </tr> <tr> <td>1 Year Stock Performance</td> <td>18.4% </td> <td>16.2% </td> <td>16.7% </td> <td>8.8% </td> <td>12.5% </td> </tr> <tr> <td>5 Year Stock Performance</td> <td>41.3% </td> <td>43.5% </td> <td>19.0% </td> <td>-1.3% </td> <td>-2.8% </td> </tr> <tr> <td>10 Year Stock Performance</td> <td>262.2% </td> <td>40.4% </td> <td>110.7% </td> <td>75.3% </td> <td>30.4%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>TTM Revenue</td> <td>$101.2 </td> <td>$464.4 </td> <td>$71.9 </td> <td>$94.0 </td> <td>$71.6 </td> </tr> <tr> <td>TTM Operating Margin</td> <td>2.8% </td> <td>5.9% </td> <td>7.3% </td> <td>2.7% </td> <td>5.0% </td> </tr> <tr> <td>TTM Price / Earnings</td> <td>24.19 </td> <td>14.13 </td> <td>13.12 </td> <td>19.97 </td> <td>15.00 </td> </tr> <tr> <td>TTM Price / Sales</td> <td>0.42 </td> <td>0.50 </td> <td>0.55 </td> <td>0.15 </td> <td>0.49 </td> </tr> <tr> <td>TTM Free Cash Flow Yield</td> <td>3.7% </td> <td>6.3% </td> <td>7.3% </td> <td>4.0% </td> <td>8.4% </td> </tr> <tr> <td>Debt to Equity Ratio</td> <td>0.11</td> <td>0.73</td> <td>1.14</td> <td>2.36</td> <td>0.30 </td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td colspan="6">Source - Yahoo! Finance 12/21/12</td> </tr> </tbody> </table>

While Kroger (NYSE: KR) and Walgreen (NYSE: WAG) are not quite as direct comparisons to Costco given their more specialized focus on groceries and pharmacy, respectively, the fact remains that all five companies noted above (and many others) compete for ever dollar of consumer spending on everything from Coca-Cola to Tylenol.

While Costco typically trades at a higher P/E ratio and lower FCF yield than its peers, it is important to note that P/S is comparable to the competition, and Costco's low debt (even after its recent opportunistic $3 billion debt issuance at rates less than 2%, which is not reflected above) is a solid illustration of management's disciplined approach to expansion and conservative balance sheet management. Furthermore, it is helpful to note that Costco traded at a P/E near 30 back when Stock Advisor first recommended the company in April of 2002. As you can see from the chart above, investors were richly rewarded for following the recommendation despite the stock not appearing "cheap" based on traditional valuation metrics.

Why Costco is still a buy

The reasons to consider Costco as an investment are simple. A great management team has generated a loyal customer following by providing a superior customer service and value experience. This proven methodology has led and will continue to lead to growth both in existing stores (same store sales were up 7% in the most recent quarter) and through the disciplined expansion of new stores. The result is a company with consistently strong profits and steady growth. Like many of the high quality items found at Costco stores, Costco shares show that it is sometimes possible to pay a premium to buy a better-quality product and still get a much better value over the long term than cheaper alternatives.

For more on the Top 10 Stocks, follow the links below:

  1. Apple
  2. Diageo
  3. Coca-Cola
  4. Chipotle Mexican Grill
  5. Costco Wholesale
    More to come! 

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