With many investors nervous about the state of the American (and global) economy, the onus is on companies to demonstrate that they have what it takes to fend off macroeconomic weakness. We believe that Costco (COST) is a retailer that is well-suited to hold off macroeconomic weakness, and we think that even after a recent rally, the retailer's shares are a buy, and we delve into our thesis below.
So far in 2012, shares of Costco are up over 12%, nearly double the performance of the S&P 500 (SPY).
Costco's shares have held up well during the market's most recent downturn, and as of this writing the stock is sitting a bit below its all-time high of $95.55. We think that Costco has more room to run, for it is a retailer with an unrivaled management team, great financials, and it is positioned well for any economic environment.
A Unique Position in the Retail Market
Most investors and retail industry analysts put retailers into some sort of subcategory, both in terms of their products and what economic environment they operate well in. There are retailers that require a relatively robust economy to do well in, such as The Gap (GPS) or Macy's (M). There are retailers that add customers when there is stress in the economy, such as Dollar General (DG). And there are luxury retailers such as Tiffany's (TIF) that have their own specific operating environments. And then there is Costco.
Costco, in our view, does not belong in any one category of the retail sector. After all, what other retailer sells both generic tissues and $4,000 bottles of wine in the same store? Costco has built its business by selling both household essentials AND discretionary goods. The importance of this, in our view, cannot be overstated. Why? Because it allows Costco to retain its customers far easier than almost any other retailer. And it is what makes economic stress much less relevant to Costco than other retailers. For most retail chains, customers either trade up or down to them, based on their financial conditions and confidence. If people are worried that they are spending too much, they will start shopping at Dollar General, possibly abandoning Kroger (KR) or Safeway (SWY). And conversely, if consumers suddenly feel better about the economy, they may stop shopping at Wal-Mart (WMT). But with Costco, customers have no need of switching. The retailer's product portfolio, which features both money-saving and luxury goods, allows customers to trade up and down within Costco.
Costco's customer base also provides the company with a source of stability. Costco's customers are on average more affluent than those of its primary competitors, such as Wal-Mart or Target (TGT). This fact also helps shield Costco from macroeconomic stress, because its customers are less likely to alter their spending habits based on broad economic trends. Costco's customers are extremely loyal to the retailer; its membership renewal rate in the United States is at 89.6% in the United States and Canada (it is 86.2% internationally). Costco now has 66.5 million members internationally (as of its latest quarter), which represents growth of 6.23% over the previous year.
International: Another Defensive Feature
Costco is not just an American retailer. With over a quarter of its warehouses outside the United States, Costco's international business will both help the retailer grow and weather any economic malaise here in the United States. But how can Costco grow if the global economy is falling apart? The answer lies in the mix of countries that Costco does business in. For starters, the company, aside from the United Kingdom, has no exposure to Europe. Outside the United States, Costco's 2 largest markets are Canada (82 warehouses) and Mexico (32 warehouses). And both countries are doing just fine. The OECD estimates that Mexican GDP will grow by 3.5% in 2012, and that growth will accelerate to 4% in 2013. GDP growth in Canada is set to be a lower, with estimates calling for 2% growth in 2012 and 2.1% growth in 2013. Costco's international business is doing quite well. After adjusting for currency effects, international sales grew 8% in June, compared to 3% for the United States, as the company steadily expands further into its international markets.
Though the United Kingdom is currently in recession, it is Costco's 4th largest market, with 3.654% of its warehouses in the country. And it is important to understand that on its own, a recession does not mean that Costco will perform poorly in the U.K. The same defensive characteristics that Costco has in the U.S. are present in the U.K., and we see no reason to think that Costco will see a collapse in its British business. The rest of Costco's warehouses are located in Japan, Taiwan, Korea, and Australia. Japan aside, the 3 other countries Costco does business all have positive GDP growth. And in Japan, where Costco has 13 locations, the retailer's defensive nature shields it from the endemic economic issues of that country. Costco's international business allows the retailer to not only expand its business, but also helps shield the company from possible economic weakness in the United States.
Happy Customers and Employees Lead to Happy Shareholders
Costco understands something that far too few retailers (and companies in other sectors, for that matter) are able to grasp: that when you treat your employees and customers with kindness and generosity, your shareholders are able to reap great profits.
Costco operates in a fiercely competitive market, and yet the company spends virtually nothing on advertising, even as Wal-Mart and Target spend enormous sums each year trying to get customers in the door. For Costco, word of mouth is enough. The retailer's customers are fiercely loyal to the chain; many of those who read this are likely customers of Costco. And Costco's employee turnover rate is the envy of the retail industry. Costco's management understands that if employees are treated well, and that they are given generous benefits, they are happier and more productive on the job, which ultimately flows through to Costco's bottom line. All of this is reflected in Costco's misson statement, which has 5 components, which we list below.
- Obey the law.
- Take care of our members.
- Take care of our employees.
- Respect our suppliers.
- Reward our shareholders.
It is important to note that Costco lists rewarding its shareholders last. Unlike far too many companies, Costco understands that the best business is one that does not operate with a focus to maximize net income and then work backwards from there. The best businesses, in any sector, are those that obsess over the experience that their customers have and create great places for their employees to work. That, in turn, is what creates profits for shareholders.
Financials & Valuation
As loyal as Costco's customers are, and as happy as its employees are to work there, none of that really matters if the company doesn't deliver profits for its shareholders. On that front, however, Costco has delivered year after year.
Costco posted record profits in fiscal 2011, earning $3.30 per share, up 13.014% from fiscal 2012. And the retailer is set to post record profits in fiscal 2012 and 2013. Profits for fiscal 2012 are set to be $3.87 per share. Based on those estimates, Costco's profit growth is set to accelerate to 17.27% in fiscal 2012. For fiscal 2013, EPS is set to come in at $4.42, which translates to growth of 14.212%.
(click to enlarge)Costco's profits in fiscal 2009 (which ran from August 2008 to August 2009 captured the depths of the recession and financial crisis) dropped 14.533%, a drop that was relatively mild when compared to the profit declines for the broader retail sector. And the company quickly recovered, with profits rising 18.219% to a then-record in fiscal 2010.
Costco has an outstanding balance sheet, with $4.603 billion in net cash. The company's management is disciplined when it comes to capital expenditures, and has shown a consistent commitment to returning capital to shareholders. In the last quarter, Costco spend $452 million on buying back stock. The company did not cut its dividend during the recession, and in fact has grown it an average of 12.7% per year over the last 5 years (the company's last dividend boost was in May, when it boosted the dividend by 14.583%).
Critics of Costco may point to its valuation as a reason to avoid the stock. The company trades at 24.238x fiscal 2012 earnings, and 21.222x fiscal 2013 earnings. That represents a premium to most of the retail sector, especially Wal-Mart and Target, which trade at 15.48x and 13.66x earnings as of this writing (per Google Finance). Given that Costco trades at such a premium, how can we recommend the shares? Well, the truth is that Costco actually trades at a discount to its historical valuation on several metrics.
In addition, Jefferies, which rates Costco a buy with a $111 price target, notes that Costco trades at 9x fiscal 2013 EBITDA estimates, compared to a historical average of 9.8x. According to the firm, "we believe this discount is unwarranted given the reaccelerating unit growth prospects, higher contribution from membership fee income, consistent share gains and strong ROIC." In our view, if there was ever a company that deserves a premium valuation, it is Costco. Few, if any, companies have demonstrated such consistent execution and discipline. Costco's management has enormous credibility on Wall Street, built up through years of consistent execution. With Jim Sinegal having retired at the end of 2011, Craig Jelinek is now the retailer's CEO, and so far he has shown that Costco will continue to perform just as it has under Sinegal.
Even with shares near all-time highs, we see no reason that Costco should not continue to outperform. The company's position in the retail sector shields it from economic stress, and its international business adds both growth and defensive characteristics. Costco has a great balance sheet, and is committed to returning capital to its shareholders, who it rewards by never taking its focus off of its customers or its employees. Costco has built a unique business, and it is one that has delivered great profits to its shareholders. And in our view, the company is set to continue doing just that.
Disclosure: I am long COST.