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Summary

-Costco (COST) is a large warehouse retailer that sells a variety of goods in several countries.
-Five year average sales growth: 8%
-Five year average earnings growth: 4%
-Five year average cash-flow growth: 0%
-Dividend Yield: 1.30%
-Dividend Growth Rate: 12%
-Overall, I think Costco is a fantastic company, but with a P/E of over 22, it’s quite expensive.

Overview

Founded in 1983, Costco is a large warehouse-based retailer, primarily located throughout North America but with a presence in Europe and Asia as well.

With over 140,000 full-time and part-time employees, Costco operates 573 warehouses. Of these, 417 are in the US and Puerto Rico, 79 are in Canada, 32 are in Mexico, 22 are in the UK, 9 are in Japan, 7 are in Korea, 6 are in Taiwan, and 1 is in Australia. In addition, Costco operates its large online retail site. The company plans to open 9 more warehouses by the end of the 2010 calendar year.

Category Sales

Costco warehouses offer various items, clothes, food, electronics, glasses, pharmacy drugs, gasoline, car-washes, and more.

Sundries (cleaning supplies, tobacco, alcohol, candy, snacks, etc.) accounted for 23% of 2009 sales.

Hardlines (electronics, hardware, office supplies, beauty supplies, furniture, garden, etc.) accounted for 19% of sales.

Food accounted for 21% of sales.

Softlines (clothing, housewares, small appliances, jewelry, etc.) accounted for 10% of sales.

Fresh food accounted for 12% of sales.

Ancillary and other (gas, pharmacy, food court, etc.) accounted for 15% of sales.

Revenue, Earnings, Cash Flow, and Margin

Costco has been growing revenue at an impressive rate, while earnings and cash flow have grown more slowly.

Revenue Growth

Year Revenue
2010 $77.946 billion
2009 $71.422 billion
2008 $72.483 billion
2007 $64.401 billion
2006 $60.151 billion
2005 $52.952 billion

Over this period, sales growth has averaged 8% on average, which is quite good.

Earnings Growth

Year Earnings
2010 $1.303 billion
2009 $1.086 billion
2008 $1.283 billion
2007 $1.083 billion
2006 $1.103 billion
2005 $1.063 billion

Earnings growth has averaged 4% over this period.

Cash Flow Growth

Year Cash Flow
2009 $2.092 billion
2008 $2.206 billion
2007 $2.087 billion
2006 $1.827 billion
2005 $1.776 billion
2004 $2.096 billion

Operating cash flow growth has averaged 0% growth. Note that this period is shifted back 1 year from the revenue and earnings periods. This is because the 2010 cash flow statement is not yet available.

Metrics

Return on equity is a little over 12%. In comparison, Wal-Mart (WMT) has over 20% return on equity, but this number is a bit padded by their moderately larger debt ratio.

Return on investment is over 10%, compared to over 13% for Wal-Mart.

A big difference is that Costco has a profit margin of less than 2% while Wal-Mart has a profit margin of approximately 3.5%. In the low profit margin world of retail, this is huge.

Dividends

Costco currently has a 1.3% dividend yield with a payout ratio of approximately 30%. The yield is fairly low despite the reasonable payout ratio because the company has a P/E of above 22.

Dividend Growth

Year Dividend Yield
2010 $0.795 1.30%
2009 $0.70 1.40%
2008 $0.625 0.95%
2007 $0.565 1.00%
2006 $0.505 1.10%
2005 $0.445 1.00%

The dividend has grown by more than 12% annually over the past five years.

In addition to returning value to shareholders in the form of dividends, Costco repurchases some of its shares. This is a poor idea, in my opinion, because the stock has such a high valuation. The company had a net repurchase of over $3 billion in stock between 2006 and 2008, but barely purchased any during 2009 when the stock price was lower and times were tougher. This is a showcase of a bad share repurchase plan. I think it would make more sense for the company to boost its payout ratio.

Balance Sheet

Costco has a total debt/equity ratio of only 0.20, which is exceptional. The balance sheet is very strong.

Investment Thesis

Costco’s business model is meant to maximize efficiency. The warehouse format keeps costs low, as they buy and sell items in bulk. Shoppers pay membership fees, and in return receive exceptionally low prices. The warehouse model also generally operates moderately reduced hours compared to typical retailers. Although Costco offers an incredible range of products, they limit their selections in each category to only the best-selling ones, so the number of individual products is actually lower than many other retailers. This further streamlines their business.

Costco’s memberships keep customers loyal, and they have an 87% renewal rate. Costco can keep its prices reasonably competitive with Wal-Mart by maintaining such a low profit margin. The company gets most of its profit from membership fees, while its goods are sold at very low markups. This is how a retailer can slowly break through the huge economic moat of Wal-Mart.

Growth

Year Warehouses Gold Star Members Business Members
2009 527 21.445 million 5.719 million
2008 512 20.181 million 5.594 million
2007 488 18.619 million 5.401 million
2006 458 17.338 million 5.214 million
2005 433 16.233 million 5.050 million

Each year between 2005 and 2009, Costco increased their number of warehouses, and saw an increase in both gold star members and business members. As of the most recent report, Coscto now has 573 warehouses.

In addition, Costco has been reporting consistent same-store sales growth. Each year from 2005 to 2008, Costco saw 6-8% average same store sales growth. Only in 2009 did Costco saw its average same store sales fall by 4%.

Despite this setback in 2009 due to the recession, Costco became the 3rd largest retailer in the US compared to its spot at 5th in 2008. It is the 9th largest retailer in the world. According to the 2009 annual report, Costco is ranked 22nd most admired company in the world by Fortune, and they rank at the top of University of Michigan’s American Consumer Satisfaction Index.

Costco reports that its most recent warehouse openings in Japan, Taiwan, and Korea had record-breaking opening-day sales, and that the warehouse they opened in Australia was particularly well-received. The company expects these countries to be great places for continued expansion.

Overall, my opinion is that Costco has a great business model and is positioned to grow its business for the foreseeable future. Despite its great size, the company has a market capitalization of less than $30 billion, so there is plenty of room to expand. The founder and current president, James Sinegal, has said that he had the goal of building Costco to last. A company with influential leaders that operates with a long-term view is a great company to look for when building a dividend-growth portfolio.

Risks

Costco, like any other company, has risk. As a retailer, Costco is a middle-man, with limited pricing power, and the retail industry is incredibly competitive. Costco faces competition from warehouses like BJ’s and Sam’s Club (owned by Wal-Mart), general retailers like Wal-Mart, Target, and Kohls, as well as from other threats like Amazon. In addition, since the stock has a fairly high valuation, there is considerable risk of poor stock performance if Costco doesn’t perform very well.

Conclusion and Valuation

Costco is a fantastic company. Their growth is decent, their business model is very strong, and it’s a very well-respected business that is known for its integrity. I’d wager that an investor 20 years from now probably wouldn’t regret purchasing this stock at these prices, even though it’s very pricey at the moment. That being said, I do think it’s overvalued. Costco’s P/E of 22 currently matches the P/E of Google. Excellent companies are worth paying up for, but there’s a limit, and currently Costco’s price is a bit more than I’d be willing to pay. If Costco stock were to drop back into the mid $50s or lower, I’d be interested in the stock even though it would still be a bit pricier than most of my portfolio holdings.

Disclosure: I do not have any position in COST at the time of this writing.

You can see my full list of individual holdings here.

Source: Costco Wholesale Corporation: Dividend Stock Analysis