I Feel Bullish on Costco Due to its Business Model

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Sep 12, 2014

In this article, let's take a look at Costco Wholesale Corporation (COST, Financial), a $55.22 billion market cap company, which operates about 650 membership warehouses in the U.S., and other countries such as Puerto Rico, Canada, the U.K., Taiwan, Japan, Korea, Mexico and Australia.

Costs reduction

The company has about 3,800 active stock-keeping units per club. Other superstores keep more than 60,000. When talking about pricing power, Costco almost has as much power as its rivals Wal-Mart (WMT, Financial) and Kroger (KR, Financial).

In order to reduce handling costs, the company purchased merchandise directly from manufacturers and storing merchandise on sales floors instead of buying them in central warehouses.

Other things that helped to reduce costs were the self-service store formats which don’t require high operating costs.

A leader

The company is globally in the sense that it is a good point to buy no matter the income level of the customers. About 75% of its operating profits came from membership fees. There are two types of memberships: Gold Star (individual) and Business members. One year ago, a Gold Star membership cost $55 annually and there were 28.9 million members. Business members pay an annual $55 fee, with the ability to purchase add-on membership cards for $55 each. There were 10.1 million Business memberships.

The firm is very good in preserving markets that are already consolidated such as fresh food and gas. The fact that it can preserve the market share from other competitors like Amazon (AMZN) shows the strength of the company.

Margins

The margins per se are low, but productivity is high due to its model of having a rapid inventory turnover with important volumes of sales.

Last fiscal year, it generated about $162 million per club, which means that on a square footage basis, this represent more than $1,100 net sales per square foot, which it is considered very attractive.

Revenues, margins and profitability

Looking at profitability, revenue growth by 7.1% led earnings per share increased in the most recent quarter compared to the same quarter a year ago ($1.07 vs $1.04).

During the past fiscal year, the company increased its bottom line. It earned $4.63 versus $3.90 in the prior year. For the next year, Wall Street expects a contraction of 0.6% in earnings ($4.60 versus $4.63).

Finally, let´s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

Ticker Company ROE (%)
COST Costco 16.74
WILC G Willi-Food International Ltd 7.22
CNCO Cencosud SA 7.11
CBD Companhia Brasileira De Distribuicao 12.53
PSMT Pricesmart Inc 17.53
 Industry Median 10.64

The company has a current ROE of 16.74% which is higher than the one exhibit by it peers. In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. So for investors looking those levels or more, Pricesmart Inc. (PSMT, Financial) could be the option. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

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Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 28.1x, trading at a premium compared to an average of 21.9x for the industry. To use another metric, its price-to-book ratio of 4.69x indicates a premium versus the industry average of 2.02x while the price-to-sales ratio of 0.5x is above the industry average of 0.48x.

As we can see in the next chart, the stock price has an upward trend in the five-year period. If you had invested $10.000 five years ago, today you could have $26.021, which represents a 21.1% compound annual growth rate (CAGR).

03May20171359161493837956.png

Final comment

As outlined in the article, the turnover inventory strategy, combined with operating efficiencies and costs reductions, the self-service warehouse facility and the cash generated from membership fees, make Costco a profitable company even better than traditional retailers and other competitors.

Hedge fund gurus like John Rogers (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Jeff Auxier (Trades, Portfolio) added this stock to their portfolios in the second quarter of 2014, as well as RS Investment Management (Trades, Portfolio).

Disclosure: Omar Venerio holds no position in any stocks mentioned