Should You Pay a Premium for This Retail Stock?

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

There is a certain feel good factor about Costco (NASDAQ: COST), the largest warehouse retail club in the U.S. Shoppers are happy with the excellent bargains that they are able to fish out and the employees are happy with their paychecks and benefits. But, what about the investors? Can they, too, join the party and feel good about the prospects of the stock? Let's find out.

Position vis-à-vis other retailers

We find that out of the big discount retailers, Costco commands a premium valuation. It is trading at a forward P/E of 21.96 times, which is close to double that of Wal-Mart’s (NYSE: WMT) 12.85 times and Target’s (NYSE: TGT) 12.71 times.

But, Costco justifies this premium adequately through unmatched strength in its core operating fundamentals. An immediate example can be the performance of these three giant retailers in their recent quarters.

In a quarter where weather woes got the better of most retailers, Costco’s performance was impressive, to say the least. Excluding gasoline and foreign currency fluctuations, the company generated comparative sales growth of 7% in its U.S. operations.

In comparison, Wal-Mart’s U.S. comps were down 1.4% and Sam’s Club, the warehouse division, was essentially flat at 0.2%. Target, too, reported a 0.6% decline in same store sales in the U.S. retail segment.

Analyst expectations

For the full year, analysts expect both Wal-Mart and Target to report modest revenue growth compared to last year. The former is expected to increase its revenue by 3.8% to $469.2 billion, while the latter is expected to generate about a 2.2% increase to $74.9 billion.

In terms of earnings, Wal-Mart is expected to grow its earnings per share by 6% from $5.02 to $5.30. Its performance will benefit from the lack of headwinds like weather and delayed tax refunds, which affected first quarter results. Also, Target is expected to earn $4.36 per share, just below its last year’s earnings of $4.38 per share.

But, analysts expect Costco to grow its revenue by 6.7% to $105.8 billion and its earnings per share by 15% to $4.56 per share. The optimism about the company stems from key factors like its rising member base, fast growing ancillary services business, and, above all, superior customer satisfaction track record, which will continue to increase its popularity and fuel growth.

Growing membership count

Millions of shoppers are signing up for Costco memberships each year. The company witnessed 19% y-o-y increase in new signups in the third quarter, and ended up with 69.9 million cardholders. It enjoys a strong 89.9% renewal rate in the U.S. and Canada, and this comes despite a 10% fee increase that Costco implemented in November 2011 for new members and in January 2012 for renewals.

The company is seeing an increase in the proportion of executive members. The executive members pay $110 membership fees, which is double the $55, paid by ordinary members, to earn 2% annual rewards on their shopping. The proportion of executive members stood at one-third the total membership base at the end of the third quarter.

In addition to the obvious direct gains, there is an added advantage for the increasing proportion of executive members. When people pay hefty amounts as membership fees, they like to extract the maximum benefits. So, they tend to shop more. Costco saw a 5.5% increase in shopping frequency during the third quarter.

Customer satisfaction

The growing number of new members, increase in shopping frequency, and solid comps growth all tell one story, and that's of satisfied customers.

Primarily, this arises from the low prices that Costco offers. By capitalizing on its huge scale, as well as its minimal spending on store ambiance, the company is able to offer prices that are impossible to match by any supermarket or department store. In addition, Costco keeps refreshing its brands and offerings so that there is a certain amount of excitement among shoppers in keeping a look out for what’s new.  

Finally, Costco keeps its stores well-staffed and its employees motivated with good pay and benefits. This ensures stocked shelves and proactive staff to guarantee customer satisfaction. We have already seen the extent of trouble these softer issues can create with Wal-Mart. On account of its customer service issues and empty shelves, Wal-Mart ended up losing lot of sales to rival retailers, including Costco.

Ancillary services

A big opportunity lies in Costco’s small ancillary services, things like the gas stations, pharmacies, food courts, etc. These services are rapidly gaining popularity and currently account for almost one-fifth of the company’s total revenue.

The convenience of these services serves as an added attraction for shoppers frequenting the Costco stores. In terms of actual dollars spent per person, we find the annual growth in ancillary services is approximately 10 times the growth in spending on core merchandise.

Last word

Given its superior growth prospects, Costco does not seem too expensive at its current valuation. The increasing popularity of this warehouse club will allow it to post healthy revenue and earnings growth going forward. Both investors and analysts have high expectations from the company, and through good business practices and strategic initiatives management, it is ensuring that the expectations are met.

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Eshna De 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!

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