Costco: The Next-Gen Dividend Aristocrat?

| About: Costco Wholesale (COST)

Summary

Cosco's business model, growth and profitability allow it to be a long-term dividend grower.

But is Costco being conservative about increasing dividends -- or just wisely consistent?

Let's see how their dividend strength can elevate them into dividend aristocracy over the next decade and a half.

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From a dividend yield perspective, Costco (NASDAQ:COST) doesn't seem all that attractive. The company's yield has been historically around the 0.9% to 1.5% range.

Though that has a negative ring to it, it will be a huge mistake to ignore the company's ability to keep increasing its dividends for the next 10 years and beyond. The retailer has been increasing dividends since they started paying out in 2004, and they have increased dividends for almost 11 years -- and they look good for the next 13.

The key element we need to look for in any company is their ability to keep growing -- or at least to hold on to what they have. We need to look at factors like the kind of business they are in, and how prone their model is to being disrupted by a new company, a.k.a. the moat. Other considerations include their current dividend payout ratio with respect to net income and free cash flow, as well as the strength of their balance sheet.

Growth Potential

Costco operates in a very traditional industry that has been recently disrupted by electronic commerce companies such as Amazon (NASDAQ:AMZN). One would expect a certain amount of market erosion as more and more e-commerce operators enter the fray and take bites out of conventional retailers' pockets. Not so with Costco -- at least not as much as to be a major point of concern.

They have achieved this primarily because of their loyal customers. Their membership system is one that has been copied by several retailers since, and it goes beyond a mere loyalty program that rewards shoppers for spending more. Aside from the discount benefits on nearly anything they purchase, customers also get Costco's brand value and signature product lines that they can't get anywhere else. Of course, low pricing is definitely a significant point, but it is not the entire point.

Some of the more intangible benefits that Costco customers enjoy are the reason they've formed that moat around themselves that is preventing the encroachment of e-tailers (electronic retailers) into the market space they have created, and one that they are continually expanding.

Costco is also making its presence felt in the online arena in places like the United Kingdom where it is testing various options for online growth and addition to its membership pool.

With nearly 500 physical stores in the United States, it does give them lot of room to make things happen on the online front, although they seem to be moving cautiously in that specific market segment.

International expansion is also in a growth phase, and the company has steadily increased its store presence in multiple countries. This is another growth area with strong impact on the bottom line.

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Costco's Dividend Scenario

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The company's dividend yield history is just one part of the equation. I feel that the more pertinent question is how their dividends are growing year over year. The chart above reveals more about the true strength of the company than historical yields can, in our opinion. A quick look shows a high level of sustainability of dividends -- something you cannot tell from looking at yields over time. Since yields merely show dividends as a percentage of stock price, consistent yields are far better than yields that are increasing year over year because stock price is on the decline. Many companies keep their dividends up in a non-sustainable fashion so their yields keep growing despite what's happening to the stock.

Costco's case is very different. The consistent yield means they're increasing their dividends in proportion to gains, and that proportion is at a highly sustainable 13% level over the last decade.

The next pulse point to check is their payout ratio, or how much of their earnings are going out as dividends to the qualifying class of shareholders. It can also be shown by calculating dividends as a percentage of net income.

Payout Ratio Analysis

Costco's payout ratio has been less than 27% for the last five years. This means the company has a lot of room to keep paying dividends -- and keep increasing them over the next decade assuming their earnings are steady and/or growing.

On a slightly different note, a retained earnings rate of 73% is extremely healthy, and much more than a lot of other, even mature, companies enjoy.

Generally, at this point I would like to have a look at how much free cash flow is being used to pay dividends; but when payout ratio is this low, it's obvious that dividends paid to free cash flow will also be low. However, for the sake of not missing something, let's take a look anyway.

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As you can see, dividend payout ratio calculated using free cash flow was less that 30% in 2010, 2011, 2012 and 2014, while it spiked beyond 100% in 2013 and 2015. During those two years, the company paid a special dividend of $7 per share and $5 per share, respectively.

As predicted, dividend payout as a percentage of FCF is also low. My inference is that a year-over-year dividend growth rate of +10% one that can be sustained for several years.

Investor-speak: The Right Way to Pay Dividends

A final note is warranted here: typically, I would look at the dividend capabilities of a company from several perspectives. As just one example, I might look at whether cash flow from operations fully covered all types of dividends, and then viewed retained earnings from that perspective.

In Costco's case, international expansion, membership growth and the online opportunities ahead of them are three growth areas that will further strengthen their ability to pay out dividends for several years.

In closing, despite the consistently low payout ratio, we find that Costco's practice of making special dividend payments an occasion rather than a regular practice is based on a sound management decision that allows them to use retained earnings for the kind of aggressive international growth that they expect over the next 10-year period. Physical growth in this industry is capital-intensive, and Costco cannot afford to tie up more than a reasonable quantum of reserve cash in short-term returns for income investors.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.