Don't Underestimate This Low Cost Leader

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

I've read many positive articles about Costco (NASDAQ: COST) on in the past. I've even written myself about the amazing diversity of products and services that the company offers. However, I'll admit I've always been a bit skeptical of the company's seemingly high P/E ratio. That was until I looked at the company's most recent earnings, and realized that analysts could be underestimating this low cost leader.

Understanding Costco's appeal isn't terribly difficult. Customers can pay a once a year membership fee, and at the standard cost of $55 they need to save just $1.10 per week to justify this cost. The company offers so many deals on products and services that most people use every day or week, that saving this amount is almost guaranteed. If customers take full advantage of the company's wealth of service savings, they can pay for their membership fee from just one of these deals alone. Costco has taken the idea of warehouse club to a new level by offering services like auto buying, auto and home insurance discounts, brokerage discounts and more. How can Costco offer these savings? Quite simply the company pinches a penny so hard you can hear it scream.

It's rare when you find a retailer that can make Wal-Mart (NYSE: WMT) look expensive, but that is exactly what Costco aims to do. In a key point of comparison, take a look at the operating margin of Costco versus several of its retail competitors:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Operating Margin</strong></p> </td> </tr> <tr> <td> <p><strong></strong> <span class="ticker" data-id="202816">(NASDAQ: <a href="">AMZN</a>)</span></p> </td> <td> <p>0.80%*</p> </td> </tr> <tr> <td> <p>Costco</p> </td> <td> <p>3.01%</p> </td> </tr> <tr> <td> <p><strong>Target</strong> <span class="ticker" data-id="205706">(NYSE: <a href="">TGT</a>)</span></p> </td> <td> <p>7.47%</p> </td> </tr> <tr> <td> <p>Walmart</p> </td> <td> <p>5.86%</p> </td> </tr> </tbody> </table>

(*Amazon is spending a lot of money on fulfillment expenses that should change once the company curtails these expenses. It's not a completely fair argument to say that this 0.80% margin is “normal” for the company.) 

While I usually prefer to invest in the companies with the highest margins, Costco is using this lower operating margin to pass along savings to customers. Since this is one of the keys to the company's competitive advantage, it's understandable that the company would lose this battle to most of its competition. What is truly amazing is that even with this relatively low operating margin, Costco keeps turning in impressive results.

In the company's most recent earnings, sales were up 14% and reported EPS increased by 28.70%. Now, I do have to clarify that this EPS increase was actually due to a 17 week quarter, versus a 16 week quarter last year. However, even if you adjust for this additional week, the company still grew EPS by 19.88% on a comparable basis. Equally impressive has been the company's consistent increase in comparable store sales. For the second quarter in a row, comps. were up 5%. When other grocery related stores are seeing 1% or negative comps., showing multiple quarters of 5% growth in same-store sales is impressive. In fact, these same-store results would have been even better if not for foreign currency impact, which drove international comps. down from a 7% increase to a reported 2% increase. Equally important to investors is that the company is nowhere near saturation. The company only operates about 600 stores and plans to open 14 new locations before the end of the year. This growth has been pretty consistent as well, with the company opening six to seven new stores each quarter. So why do I think analysts are underestimating the company?

I'm basing my assumption that Costco could do better than analysts think on some simple comparisons. For instance, both Target and Wal-Mart operate a multiple of the locations that Costco currently operates. However, analysts see Wal-Mart growing earnings by about 8.4% and Target by 12.13%. Costco by comparison, is projected to grow earnings by 12.88%. Here is my problem: Both Target and Wal-Mart are expected to grow revenues by 6% and 5% respectively. Costco, on the other hand, is showing a new store run rate of about 4% annually, and is consistently reporting 5% or better same-store sales. This gives Costco a revenue growth rate of about 9%, which is close to what analysts are suggesting. Looking at the following, tell me if these numbers make sense to you:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Revenue Growth</strong></p> </td> <td> <p><strong>EPS Growth</strong></p> </td> <td> <p><strong>EPS to Revenue </strong></p> </td> </tr> <tr> <td> <p>Costco</p> </td> <td> <p>9.00%</p> </td> <td> <p>12.88%</p> </td> <td> <p>1.43</p> </td> </tr> <tr> <td> <p>Target</p> </td> <td> <p>6.00%</p> </td> <td> <p>12.13%</p> </td> <td> <p>2.02</p> </td> </tr> <tr> <td> <p>Walmart</p> </td> <td> <p>5.00%</p> </td> <td> <p>8.38%</p> </td> <td> <p>1.68 </p> </td> </tr> </tbody> </table>

As you can see, there seems to be a bit of a disconnect in the revenue to EPS comparison. Given the fact that Costco has a much smaller store base and recently raised its operating margin from 2.7% last year to 3% this year, I don't see a reason for this disconnect. If we assume that an average between Target and Wal-Mart is reasonable, then Costco could grow earnings by as much as 16.65% if they achieve 9% revenue growth. If Costco surprises analysts in the future, what about the value of the stock?

This part is a bit trickier to figure out. Amazon is the clear leader when it comes to expected earnings growth, at over 36%, and a 2013 P/E ratio of 102.94 suggests that expectations are high. The combination of these numbers gives Amazon a PEG ratio even on next year's earnings of 2.79. Wal-Mart and Target show PEG ratios of 1.83 and 1.18 respectively. Costco, as it stands, has a PEG ratio of 2.01, but that's because analysts are calling for 12.88% growth. If the company delivers on the 16.6% growth above, the company's PEG drops to 1.32 at today's prices. For the last few quarters, the company has turned good revenue growth into huge EPS growth. It looks like analysts could be underestimating this low-cost leader; as an investor this could be an opportunity to profit from their mistake.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of and Costco Wholesale. Motley Fool newsletter services recommend and 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.If you have questions about this post or the Fool’s blog network, click here for information.

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