Editor's Choice

This Retailer’s Expensive Valuation Is Warranted!

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

There’s no doubt that warehouse club operator Costco (NASDAQ: COST) has turned in a solid performance so far this year with a gain of around 16%. The stock trades close to its 52-week high and trades at a rich valuation, which might create some doubts in the minds of investors whether Costco can keep chugging like it has done so far.

Costco trades at 24 times trailing earnings, and the ratio drops to 22 on a forward basis. The PEG ratio isn’t that handsome either at 1.81. Moreover, the company isn’t expected to grow at a rapid rate that justifies such a valuation, with analysts expecting revenue to grow 6.6% this year and 8.7% in 2014. Similarly, earnings are expected to rise 15% this year and 11% next year.

Also, the stock won’t lead you to overnight gains, as evidenced by a gain of 23% over the past year which many might consider pretty low given the high fliers we see nowadays. However, that’s the catch about Costco. It’s been a stable performer and certainly deserves a place in one’s portfolio as it will go about doing its job silently and it also pays dividends (both regular and special), making for a really good combination.

Business model par excellence

Throw in a solid business model which ensures that customers keep coming back to its warehouses and with a lot of opportunity to expand, I believe Costco deserves its premium valuation and can prove to be a solid investment even at these levels.

Membership fees are a crucial part of Costco’s business strategy, not only because they bring in revenue and pump up margins, but also because they are a solid indicator of the strength of the Costco brand. For instance, the company witnessed a 12% jump in membership fees in the previous quarter to $531 million and new member signings jumped an impressive 19% from the year-ago period. The growth in fee income and members, despite fee hikes, suggests that consumers swear by what Costco offers.

As Fool analyst Andrew Marder pointed out, Costco has added 1.6 million members in the first two quarters this year, and more importantly, membership renewal rates continued to be strong. Renewal rates stayed strong at 93.9 in the previous quarter, which suggests the stickiness of the brand.

Expansion ahead

International expansion played an important part in the rise of Costco’s membership base as warehouse openings in Japan drove up the count. Costco has a lot of room to flex its muscles, both internationally and domestically. The company had 627 warehouses at the end of the previous quarter, out of which 448 were in the U.S. and Puerto Rico, 85 in Canada, 33 in Mexico, and other spread across the U.K., Japan, Taiwan, Korea, and Australia.

The company is aggressively opening more warehouses and is looking at square footage growth of 4.5% this year, up from last year’s 3%. This is certainly impressive, and given the fact that Costco is still going to open almost half of the expected 28 stores this year in the U.S. and three in Canada, it means that there is still room to grow in the North American market. Thus, it’s clear that Costco is still not moving aggressively in international markets and once it does so, there would probably be further room to run.

Apart from bolstering its physical presence, the company is also focusing on its ecommerce business, Costco Online. The ecommerce initiative has been deployed in the U.S. and Canada, and in the U.K. as well of late. The company saw a 20% jump in ecommerce sales in the previous quarter and this should improve with expansion into other geographies. The online business would come in handy when competing against the likes of Amazon.com (NASDAQ: AMZN).

Amazon’s Prime service was expected to be a threat to Costco as members of the service would get free two-day shipping, unlimited video streaming, and access to the Kindle Library for just $79 a year. In the ecommerce age, a service such as Amazon Prime has the potential to knock the wind out of the sails of brick-and-mortar retailers, but it seems like a trip to Costco is more cost-efficient.

Also, the fact that Costco’s members pay a membership fee, they would be utilizing it to make purchases from the warehouses or its ecommerce portal rather than looking somewhere else.

Great on all counts

In addition, given the fact that Costco takes good care of its employees, shoppers would get good service at the warehouses. The company’s exemplary employment policies and good wages don’t just help it save costs by keeping employee turnover very low, but also puts its customer service on a higher plane.

A well-paid Costco employee would serve you better than at a place such as Wal-Mart (NYSE: WMT). Employee unrest at Wal-Mart has been well-documented across the web as the company has been reported to pay very low wages to employees. Cases of theft, poor working conditions, and sometimes wages not being paid have marred the company’s reputation.

Thus, Costco, like a socially responsible company, ticks all the right boxes and looks like the Mr. Right which you can always count upon to deliver on all fronts.

Considering everything, Costco has a lot of room to grow, its brand is as solid as ever, it keeps everyone happy -- be it customers, employees, or investors -- and as such, a premium valuation shouldn’t be a deterrent if you’re thinking of investing in this impressive company.

Costco's low prices haven't just benefited customers -- shareholders have walloped the market, returning 11,000% over the past two decades. However, with prices near all-time highs, is the ride over for Costco investors? To answer that and more, The Motley Fool's compiled a premium research report with in-depth analysis on Costco. Simply click here now to gain instant access to this valuable investor's resource.

Harsh Chauhan has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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