Consider Fortifying Your Portfolio with this Solid Retail Stock

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Warehouse retailer Costco (NASDAQ: COST) has performed very well so far this year as more customers have taken memberships at its warehouse clubs in an effort to stretch their dollars in a sluggish economy. The stock has already appreciated a tad over 20% so far this year and its earnings have demonstrated sustained strength over the past four quarters.

Another Strong Showing

In its recently-reported quarter, Costco once again trumped analyst estimates as more consumers thronged its warehouses for taking memberships and shopped more to land more bargains. As a result, the company saw an improvement in all the important metrics. Its same-store sales improved 6%, revenue jumped an impressive 14% to $32.22 billion, and earnings per share spiked 29% to $1.39 per share.

More importantly, the company saw an 18% jump in fee revenue from last year, although it was aided by an extra week this quarter along with a fee hike that was introduced in November last year. But, the company’s membership renewal rate in the U.S. and Canada clocked an impressive 89.7%, slightly better than last year.

However, a standout feature of Costco’s results was that it managed to improve its operating income despite facing inflation in food costs and gasoline. Operating income jumped 25% from the year-ago period to $949 million this time, resulting in a slight improvement in operating margin.

The Way Forward

Encouraged by these results, Costco is looking forward to the next fiscal year with a lot of positivity. It plans to open around 27 to 30 new warehouses in FY13, significantly higher than the 16 it opened last year. This could result in the highest square footage expansion that Costco has undertaken in the past few years if it decides to open 30 stores. Considering the diversified range of merchandises its warehouses sell, Costco looks well-positioned to gain from a wider range of customers.

As far as inflation is concerned, it seems Costco is tackling the situation pretty nicely, a fact evidenced by its operating margin expansion. The company had increased membership fees by 10% in November last year, and this should have helped it counter inflation to some extent. Increased costs have been pinching other retailers as well.

For instance, Wal-Mart (NYSE: WMT) is looking to go the Costco way by implementing a membership fee hike for its own warehouse chain brand, known as Sam’s Club. A fee hike seems to be working for Costco and Wal-Mart could follow suit. Wal-Mart has not hiked membership fees for Sam’s Club since 2006 but with the current drought conditions in the Midwest pushing up food prices, Wal-Mart might need to take this step which is currently in the trial phase.

Earnings Growth, Dividend and Diversification

Costco currently trades at a price-to-earnings multiple of 28.35, which is high as compared to the industry average of 20.4. However, analysts expect earnings to improve going forward as shown by a forward multiple of 22.82, which will bring Costco nearer to its industry average. If you look at it from the valuation point of view, it might seem that Costco is quite expensive, but the company is expected to grow earnings at a decent pace going forward and that is indeed a positive.

Moreover, Costco carries a dividend yield of 1.10% and this is another positive which a potential investor might look at. However, one might say that Costco’s dividend fades in comparison to peer Target (NYSE: TGT), which carries a yield of 2.30%. But, it should be kept in mind that Costco is expected to improve its earnings at a faster rate than Target and has a diversified presence.

Target’s trailing P/E is 14.64 while forward P/E is 12.89. Hence, Target is cheaper as against Costco but it doesn’t exhibit the same rate of expected earnings growth. The gap between the trailing and forward multiples of Costco is far greater than Target, indicating that significant growth has been baked into it.

Moreover, Target is concentrated in the U.S. while Costco is present across the U.S., Puerto Rico, Canada, Mexico, the U.K., Japan, Taiwan, Korea and Australia. Thus, the diversified nature of Costco’s operations should cut out some of the risk arising from concentration in a single region. Target is finally waking up to diversification and is going to open its first overseas store in Canada next year. But, it will face stiff competition from the existing players in the form of Costco and Wal-Mart.

The Bottom Line

Costco has been doing solidly over the past few quarters. The company is expanding its business slowly and steadily and offers a wide range of merchandises. Moreover, it is expected that Costco’s earnings will improve significantly over the next one year and the current economic situation, although patchy, seems to be in favor of a wholesale retailer like Costco. Hence, I expect the stock to carry its upward momentum in the future and provide even better returns to investors.

TechJunk13 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.If you have questions about this post or the Fool’s blog network, click here for information.

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