Why This Huge Discount Store Keeps Growing

The past 5 years have been very challenging for retailers. Most of them had to pay the consequences of missing the e-commerce revolution. Some of them, like giant Wal-Mart , are trying to catch up as fast as possible, but revenue growth is still not happening.

A clear exception is Costco Wholesale , which recently reported growth of 7% in net sales for July. Costco's growth figures are hard to believe in an industry that gets surprised when Wal-Mart manages to keep comparable-store sales growth in the 2% range. But what is driving Costco's revenue growth? When will it stop? And does Costco represent an interesting investment opportunity given the current stock price?

COST Chart
COST Chart

Understanding Costco

Founded in Seattle in 1983, Costco is the third largest retailer in the US and the seventh largest retailer in the world, with 632 warehouses, including 451 in the US and 85 in Canada.

Unlike Wal-Mart, Costco uses a membership-only system. In other words, you have to be a Costco member or a member's guest to buy there. As of February 2013[update], Costco had 68.2 million members.

At first glance, this practice looks harmful for revenue growth, because a potential customer needs to pay at least $55 per year for membership. However, the membership-only system is a competitive advantage.

4 reasons to be a bull

1. Low risk, high return

Just like J.C. Penney or Wal-Mart, Costco's revenue is highly exposed to macroeconomic cycles. However, by using a membership-only system, Costco is able to book nearly all of its profits one year in advance. R.J. Hottovy from Morningstar states that membership revenue actually accounts for nearly all of Costco's operating profits.

How big is the membership effect? Assuming that each of Costco's 68.2 million members has the cheapest membership package ($55 per year), that's about $3.751 billion just from memberships secured 12 months in advance! Despite the increasing membership fee, the number of new members has increased substantially from 2.3 million in 2009 to 4 million in 2011.

2. Consistently profitable

Unlike J.C. Penney, Costco has been consistently profitable for several years. More recently, in the third quarter Costco's operating income was up $100 million, or 16% from the same period last year.

3. International expansion

Costco's international expansion has just begun, but results are very promising so far. It operates 170 international warehouses, which make roughly 50% of total revenue. This proportion is significantly bigger than Wal-Mart's international revenue. Furthermore, considering that 170 international stores make as much as Costco's 451 U.S. stores, we can infer that the average revenue for each of Costco's international warehouses is much higher.

By owning more than 80% of the properties where it operates, Costco's return on net assets (RONA) for operations outside of North America is roughly 12%, well above the company's cost of capital. In contrast, Wal-Mart's RONA range for international operations over the last 10 years is 6%-7%.

Asia is a key market for Costco. The company has seen 20,000 to 60,000 membership signups on the opening day of Asian stores. That's why the opening of 7 Asian warehouses this quarter could accelerate the company's current growth rate.

4. High EPS, safe dividend and increasing share repurchases

Since 2007, Costco's diluted quarterly EPS has grown 73%, well above Wal-Mart's 29% and J.C. Penney's -380%. At this pace, analysts estimate that Costco's EPS will reach $5.05 by 2014.

Costco's dividend has also grown steadily since 2004. The current yield is just 1.11%, but it is worth keeping in mind that for the past 4 years, Costco's payout ratio did not change much.

Finally, the company actively repurchases shares. Between 2003 and 2012, Costco's total number of outstanding shares dropped by 40 million.

COST EPS Diluted Quarterly Chart
COST EPS Diluted Quarterly Chart


Costco isn't particularly cheap. Using Oldschoolvalue financial spreadsheets, I ran a discounted cash flow model to estimate Costco's fair value. I used a 3% terminal growth rate and 9% discount rate assumptions. In order to justify Costco's current stock price, the company would need to grow its free cash flow for the next 10 years at around 18% annually, which is very optimistic because the average growth rate for the past 10 years was slightly above 12% per year. This scenario gives a $113 price target, $2 above the current stock price.

My estimate is not too "unrealistic" according to the Street consensus, which is $116.23 per share according to Yahoo! Finance. Morningstar optimistically gives a fair value of $115 per share.

In conclusion, we could say that at the moment Costco seems fairly valued. An interesting entry point could be $105 per share, which represents a 5% correction. This could materialize if Costco misses the consensus due to over-expectations.

Final foolish thoughts

Due to its membership-only system, Costco's a unique warehouse stock with attractive high margins and downside risk limited by more than $3 billion in revenue coming from fees secured one year in advance.

With a net loss of $348 million ($1.58 per share) in the first quarter, J.C. Penney's profitability is far away from Costco's. Increasingly price-sensitive consumers are leaving the store in droves.

An absence of sustainable competitive advantages has taken this legendary company very close to bankruptcy. According to a recent press release, cash amounted to $1.535 billion, while total debts were $5.82 billion at the end of the quarter. The company is clearly running out of both time and money.

Wal-Mart, on the other hand, has more stable and safe cash flows, but it faces a challenging trade-off between profitability and growth. The company has reached a size where the only way to keep growth positive is to increase discounts. This hurts profitability.

Notice that Wal-Mart already has 6,242 international stores and is finding it increasingly difficult to keep annual revenue growth in the 2% range.

With only 170 warehouses abroad, Costco's growing fast in Asia and has plenty of room left for further growth. It makes sense to assume a relatively high growth rate for the next 10 years. Unfortunately, the current stock price is too close to the company's fair value, but investors should watch for market corrections.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

The article Why This Huge Discount Store Keeps Growing originally appeared on Fool.com.

Adrian Campos 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.

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