This Stock Is Going Strong

pranay 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) has worked really hard to create a deep discount model that has kept its customers happy over the years. The reason for me to believe that the customers are happy is the company's ever growing number of members and a very strong membership renewal rate of over 90% domestically and 86.4% in total.

Charging membership fees upfront works in Costco’s favor in many ways. First of all, though membership fees form only 2% of its revenue, it makes up about 75% of its operating profit, and that's took a year in advance. The membership fee in itself generates cash flow and also assures steady cash receipts in the form of future sales. Members are psychologically inclined to purchase goods from Costco’s warehouse in order to derive the benefit from the fees they have paid.

Further, the company does not spend much in beautification of its stores or on decorating them and returns these savings to its customers, thus operating at the lowest operating expenses in the industry, which is under 10% of sales. The customers are also satisfied, which can be fathomed from the terrific same store sales growth rate of 6%.

Satisfied customers generate sales, but satisfied employees help in boosting the sales further and keep other operating costs at bay too. Costco is one of the few retailers that give its employees benefits such as living wages, health insurance, and also pays wages of $12 an hour. Well treated employees serve better which has been a key driving factor for customers apart from discounts. Costco also saves a lot of expenses due to reduced employee turnover.

Currently, Costco’s warehouses are concentrated mainly in the U.S., Canada, and Mexico, with hardly any warehouses in Europe, Asia, and Australia. About 40% of the company’s revenue comes from the U.S., which gives a clear indication that the response of its warehouses in the international market is also overwhelming. The company seems to have a lot of potential to grow internationally, as it has only 24 warehouses in the United Kingdom, 15 in Japan, 9 in Taiwan, 9 in Korea and 3 in Australia. In the future, international expansion will be a major driver of future growth.

Other than international expansion, Costco’s focus on its e-commerce business has also started delivering results. In the last quarter, it registered a 20% hike in online sales on a comparative basis. At the moment, its e-commerce offerings are focused in the U.S., Canada, and the U.K., but as the company expands internationally into newer markets, its online sales are also expected to pop up.

The company thinks about satisfying its investors too, and thus maintains a decent share repurchase and dividend program. Costco has grown its dividend at double-digit rates since it started paying it in 2004. Though the company currently yields 1.05%, the investors should continue to see increasing returns.

Further, between 2003 and 2012, the company repurchased 40 million shares, reducing the number of outstanding shares from 479 to 439 million. Currently the company has plans to buyback shares worth $4 billion. Returning cash to investors acts as an additional incentive apart from the growth it offers, which the analysts expect to be 13.5% in earnings and 6.9% in revenue every year for the next five years.

Costco is growing and has opportunities to grow in the future too, but currently it’s trading at 26 times its earnings and its forward P/E ratio is 23.5 times. The company currently seems overvalued as its current P/E ratio is higher than both, its 5- and 10-year averages. In short, a good company, but overpriced, wait for a correction in price to buy it.

The industry giant

People often say that Wal-Mart (NYSE: WMT) is not growing, it has turned flat, but have they ever analyzed Wal-Mart’s numbers? The company generates revenue of $460 billion, well over four times what Costco generates. It employs over 2.2 million people. If I compare the numbers of revenue to the GDP of a nation and the number of employees to a country’s population it would not be an oxymoron. Do you think that such figures for a company where 60% of the U.S. population shops indicates weakness.

As I said, about 60% of the U.S. population shops from Wal-Mart, thus it leaves little room for growth from the domestic market, symbolizing international expansion and e-commerce as the future driver of growth for the company.

The company is currently trying to expand its operations in Canada by opening 40 new Supercenters and in Brazil, China, and South Africa with its "Everyday Low Prices" concept. Wal-Mart’s focus on e-commerce is evident from the acquisition of Grabble, which will provide it assistance with mobile technology and Kosmix, its digital advertising partner. The company also acquired Yiahodian, a Chinese online store, to strengthen its e-commerce operations in a highly populous and emerging market, China.

The best part about Wal-Mart is the amount of cash it returns to its investors to keep them motivated. In the last 39 quarters the company has significantly grown its dividends and currently yields a handsome dividend of 2.4%. Further, the company currently has a repurchase program worth $15 billion, which spells more happiness for the company. With a P/E ratio of 15.5 and a forward P/E of 13.5, the company looks fairly valued too.

What about Target?

Target (NYSE: TGT) is another substantial retailer that operates mainly in the U.S. market. Target’s revenue has been growing steadily and the growth rate is improving every year, which I believe is a very good sign. The reasons for improvement in revenue are its merchandise assortments, convincing pricing and marketing strategy. The company’s P-fresh remodel program and Pharmacy rewards program are worth mentioning in this regard. Further, to create a loyal customer base, the company’s 5% REDcard Rewards program for their cardholders is also showing results. 

Canada opens up new avenues for the company, as 70% of the Canadian population knew Target as a brand even before it started its operations there. This is a good sign and will make the company’s penetration in Canada easy. Currently, Target’s 24 stores have generated $86 million in sales in its last reported quarter with a gross margin rate of 38.4%, far better than the 30.7% achieved in the U.S. Spreading its operations in Canada and as it has planned, in Latin America, will only add to its top and bottom line and provide the benefit of diversification.

The company currently returns decent cash to its investors, as it repurchased shares worth $547 million and paid dividends totaling $232 million, which amounts to a yield of 2.4% on current prices. The company is currently trading at 17 times its earnings and looks fairly valued. Further, with a PEG ratio of 1.5, comparatively lower than both its peers, the company is expected to offer better growth possibilities.

Bottom line

Costco does not represent a good investment opportunity as it is trading well over its peers and its own previous averages. The company no doubt represents a strong business model, but a correction in its share price is necessary for it to become a good investment candidate. As for Wal-Mart, if investors expect an overnight capital gain then they should search elsewhere, otherwise with robust dividend and share buybacks along with decent capital appreciation, the company should prove to be a good fetch. As Target carries better margins and has started diversifying too, it comes across as a good investment to me.

The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

pranay agrawal has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of 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!

blog comments powered by Disqus