Costco: A Premier Retail Dividend Play

| About: Costco Wholesale (COST)

Summary

Costco has proved to be a consistent, solid performer over an extended period of time, delivering superior investor returns.

While the stock only offers a modest 1.00% yield, the dividend has grown rapidly and is likely to experience solid growth going forward.

I am regularly accumulating the stock quarterly.

With retail stores under an ongoing siege by online concepts, there are relatively few retail concepts that provide compelling long-term growth opportunities for solid dividend income. Costco (NASDAQ:COST) happens to be a standout for long-term growth. While Best Buy (NYSE:BBY), Wal-Mart (NYSE:WMT) and others experience stagnating growth as a result of consumer showrooming, Costco continues to see strongly increasing same-store sales. Costco is one of 30 dividend paying stocks that I am accumulating quarterly through a Motif.

Subscription model powers growth

The secret sauce underpinning Costco's success is its subscription model. This provides a highly dependable locked-in revenue stream for the business. Provided Costco can manage member attrition appropriately, then it isn't as dependent on the day-to-day vagaries of foot traffic and individual item sales. Membership revenues were almost $2.4B in 2014, and represented over 75% of Costco's 2014 operating income.

Such is the loyalty of Costco's base that membership renewal rates remain at close to 90%, both in the US and internationally. Not only is member retention impressive, but Costco has also done a strong job of pushing members to higher tiers. Top tier gold member numbers have increased from 22,500 in 2010 to over 31,600 in 2014, representing an annual growth of over 8%.

Locked-in revenues allow for purchasing discounts

Costco's subscription revenues help promote a virtuous cycle for the business. As memberships grow, and locked-in revenues grow, Costco increases its effective purchasing power and can exert greater and greater leverage on suppliers to extract favorable discounts on items. Costco can then give its customers access to the best goods at the best prices.

Costco also purchases merchandise directly from suppliers for storage on retail floors, minimizing warehouse storage and handling. An intelligent strategy of well positioned loss leaders from staple products drives consumers into the stores, where they are upsold more profitable, higher margin items. This strategy helps consumers see ongoing value in a membership and helps explain why renewal rates are so high.

Costco keeps posting solid operational results

A recent theme in Costco's results has been what appears to be superficially low levels of growth. However, FX translation and fuel deflation have masked a rather strong operating performance in recent quarters.

Q4 2015 appeared to show comparable store sales actually down 1% for the quarter. However, peeling the results back a layer more revealed that Costco's same-store sales were up strongly across the board. Excluding FX impacts and fuel deflation, Costco saw same-store sales growth in all regions of between 6% and 7%. A similar theme was observable in Q1 '16. Costco's high level results showed comp sales of just a 1% increase, but stripping out FX and oil prices showed comp sales increases of 5%, with the US up 4% and international up 6%.

Growth options should bolster long-term performance

Costco's product and service innovation should keep the membership concept fresh and appealing to its base, as well as to new users. In addition to a compelling merchandise line up, the company is now a strong player in automobile sales and insurance also.

However, Costco's real growth options should come via expanding international distribution. Costco has expanded to Spain, Taiwan, Korea and Japan in recent years. The company clearly has significant opportunity for the deployment of its discount store concept in much of Europe and also Asia, including China. As disposable incomes increase in some of these emerging markets, Costco will continue to find attractive opportunities internationally for expansion.

Dividend and Valuation

Costco's dividend yield is fairly paltry, at just 1%, but the dividend has been increased aggressively by the company, more than tripling over the last decade. While perhaps not suitable for folks looking for current income, the business may be one to consider for investors who have a longer period of time before they need to draw income.

Costco currently trades at a P/E ratio of 29.1 and a forward P/E ratio of just over 24.5. Costco is trading well above its average multiples over the last five years, including price to earnings and price to sales. The key question will be whether Costco's growth can continue at the levels to justify these kinds of multiples. Morningstar rates Costco's stock at two stars at present.

Disclosure: I am/we are long COST.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.