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Can Costco Continue To Grow In This Economy?

|Includes:Costco Wholesale Corporation (COST)

Costco (NASDAQ:COST) is a membership warehouse club, which operates 627 locations worldwide, providing a wide selection of merchandise, specialty departments and exclusive member services, all designed to make its customers' shopping experience simple and efficient.

Costco sells a nice, healthy mix of consumer staple and consumer discretionary items that is constantly changing in terms of inventory depending on consumer's wants and needs. Based on its past growth history, it is a good bet that Costco has a good pulse on how the wants and needs of an often fickle US consumer can change.

Costco was recently sued by another high end retail brand, Michael Kors (NYSE:KORS), because Costco legally buys grey market high-end consumer items against the wishes of these brands because of the perception that it "cheapens" their brand.

Similar lawsuits against Costco occur frequently and this is not really big news. CNBC covered this extensively in their long Costco documentary. Costco requests discounts from high-end retail brands for large bulk orders. These brands refuse and still find their products on Costco shelves.

Costco tends to buy non-selling brand name items sitting around in warehouses from other wholesalers who are in the retail or department store supply chain. Costco may even take a loss on these items in order to attract people into the warehouse. This allows them to showcase its other products and potentially sign up new members. For years, Costco has successfully applied this tactic and lawsuits, like the most recent one from Michael Kors, will not stop Costco continuing this practice.

Many analysts and value investors think Costco is massively overpriced and is not worth the premium the market is giving it. These same types of bearish arguments are published all the time for Costco even in 2009 when Costco was around $40/share.

But, Costco's model is better than competitors like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) and deserves a larger premium over these companies because by only competing on low prices, there is little or no free cash flow. Costco's model is also designed to allow the company to grow in good economies or bad ones.

Simply put, Costco's business model has more earnings power and a stronger durable competitive advantage/economic moat/consumer monopoly than competitors who only compete on price.

Costco charges an annual paid membership and every few years Costco raises membership fees by 10 percent.

Costco's customers believe they are getting very high quality goods for some of if not the lowest prices available. This perception of superb value and Costco's fight to routinely find higher quality goods and services at lower prices is what builds customer loyalty without resorting to gimmicks or deep discounting through sales.

Costco is the "total package" when it comes to a company. It is rare for customers, employees and shareholders to be happy with a company at the same time, but that is the case with Costco.

Shares of Costco are up about 950 percent since 1986 due to its business model which is committed to quality and building value.

Costco also treats its employees far better than Wal-Mart offering higher salaries, more benefits and a better chance at promotion. Costco's employees, in turn, respond to this by working harder to create a higher level of customer satisfaction.

Costco has a large and growing customer base that routinely shops at its warehouses, spending significant amounts of their daily shopping for everyday items like toilet paper, food, groceries and other staples. Costco also sells a lot of consumer discretionary items at prices consumers brag to their friends about.

Costco's abnormally high customer retention rate of 89 percent for paid members shows Costco's customers love the warehouse experience and saving money.

While the net profit margins on the items Costco sells are between 2 and 5 percent and are similar to the razor thin margins of a grocery store, Costco makes up for this by generating enormous amounts of free cash flow from charging its customers for annual paid memberships to shop in its warehouses.

For 2013, Costco is on pace to generate a record amount of over $2.5 billion in free cash flow to invest in growth or to return to shareholders thanks mostly to its growing paid membership base.

Growing its annual paid membership base of customers is absolutely crucial for Costco as more than two thirds of its annual revenues are from paid memberships and this is where more than 50 percent of the company's profits come from.

Costco has a membership base of over 38 million households and over 69 million total cardholders all paying annual membership fees. Over the last few years, Costco has seen a noticeable increase in the number of new members as the retailer added 2.3 million members in 2009 and more than 4 million customers signed up in 2011.

In the first three quarters of 2013, paid memberships are already up 19 percent compared to the previous year.

The membership base at Costco is expected to continue to grow at a 10 percent rate annually for the foreseeable future.

In the first quarter of 2013, Costco also had a solid 5 percent increase in comparable-store sales helping contribute to revenue growth.

The company is also poised to growth internationally with 16 more stores set to open outside North America in 2013. It recently opened warehouses in Japan, Mexico and the United Kingdom which have been successful. Each store has reported between 20,000 and 60,000 new memberships on its opening day.

With only about 10 percent of its total warehouses located outside of North America, Costco has more opportunity to expand in a largely untapped international market.

Costco pays a dividend yield around 1.1 percent and its growth from its business operations and its growing FCF has allowed it to grow its dividend at an impressive 13.4 percent annualized growth rate over the last 5 years.

As Costco's FCF rises in lock-step with its paid membership growth rate of 3 million new members annually, it would not be a stretch if its dividend continued to grow at 9 percent or higher for many years to come.

Costco does have a high P/E ratio above 24 which is higher than many other consumer stocks. The market is assigning a substantial premium to its earnings and the share price. However, I believe this premium is more than justified as Costco is more likely than other consumer companies to keep its revenues and earnings stable or growing whether economic conditions worsen or improve.

Costco is a growth stock that long term investors should consider buying a partial position now at current prices and accumulating in larger amounts on dips. Costco's P/E ratio may seem high, but its business model is far more insulated than its competitors and the business is worthy of a premium. Based on Costco's projected 2013 FCF, the stock is selling at under 18 times FCF estimates, which is not outrageous for a company that can grow FCF as quickly as Costco has been. Costco has a superior business model allowing the company to generate massive FCF to spend on growth or return to shareholders.

Stocks: COST