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Add Costco To Your Shopping List

Posted: Jul 22, 2008 14:39 PM by Ryan Barnes

Filed Under: Recession

Tickers in this Article: BJ, COST, FRED, TGT, WMT

Ever since reaching an all-time high of over $73 in mid-May, Costco Wholesale (Nasdaq:COST) shares have been unable to climb higher. By all accounts the company is firing on all cylinders, yet pessimism still abounds. It's a telling sign of just how tough the past few months have been across nearly every sector. After reporting another big comps gain in June - up 9% - and seeing the broad indexes touch off recent lows, this members-only retailer might be a prime addition to a defensive portfolio.

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The company's core value proposition is simple - it will give you something you actually want (great brands, quality at wholesale prices) for cheaper than you can find from anywhere other than a second-hand store or bargain bin. This basic premise is what helped Costco gain 400,000 new customers during its fiscal third quarter, bringing the total to 28.7 accounts, or over 50 million people when spousal cards are added to the figure.

Sales Bump Caused by More than Rebate Checks
It has been well reported that most U.S. taxpayers have received their rebate checks in the past few months. Most of this money has already made its way back into the economy, but the effects are obviously finite. I think Costco was a prime beneficiary of the rebates, but it has proved its ability to grow without the stimulus by notching high-single-digit comps in every month of 2008 thus far.

Costco's warehouses pull shoppers of all demographics: low income in desperate need of both bulk sizes and supreme values, middle income shoppers realizing that their disposable income is not stretching the way it used to, and upper income shoppers who might otherwise be oblivious to the looming quasi-recession were it not for their plummeting real estate assets. Folks from all these groups are routinely bumping shoulders at their local Costco, hoping to find either a 20 pound bag of rice or a 65-inch plasma TV for cheaper than anywhere else in town.

Gas a Great Loss Leader
Costco's cup continues to runneth over with gas sales. The company now sells ultra-cheap gas (typically the lowest prices in town) at more than 290 of its 536 locations as of May. The gas is basically a loss leader, drawing in traffic like a tractor beam. As a result, the average customer is visiting Costco more often than in the past and spending more per ticket - two very positive trends from the "battered" U.S. consumer. (Feeling overwhelmed by rising oil prices? Get some tips that will save you money in Getting A Grip On The Cost Of Gas.)

Costco manages to turnover its inventory much faster than at Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and the like by re-shuffling floor space to suit changes in consumer demand. This differs from the aforementioned behemoths that must keep thousands of products on the shelves even if they're not selling.

There's Something to be Said for Staid Management
Costco truly has something for everyone, and it's are rewriting the books on no-frills, clean management and accounting. Over the last five years Costco's operating and net margins haven't wavered more than 100 basis points in one year. If you were to back out certain one-time expenses and charges that were incurred over that time, the margins would look even more uniform. If it sounds like they've hit a wall, that's true, but only partly. You see, Costco constructed the wall itself, knowing in advance that to scale things further would likely result in damaging the customer adoration it's fought so hard to earn. And those annual membership fees - $50 for individuals, $100 and up for corporate customers - are a cash cow that must be kept healthy, not diluted in search of a 2-cent bump in the next quarter's earnings.

This is the lesson, and it remains to be seen if smaller rivals BJ's Wholesale Club (NYSE:BJ) and Fred's (Nasdaq:FRED) will be able to show the same fiscal restraint. Both companies have been turning in impressive sales comps in recent months, so they are clearly benefiting from the same trends, but I'm worried by the high short ratios at both companies. Both stand at over 15% of the float as of the end of June. (To learn more, read Short Interest: What It Tells Us.)

Parting Thoughts
With the stock at all-time highs, investors need to decide if Costco deserves to see multiple expansion with the forward P/E currently a shade under 20. That's a fairly valued number when just considering the U.S. operations, but still doesn't give much of a premium for a company with a pristine balance sheet, and roughly $1.5 billion per year in membership fees that fall, nearly untouched, all the way to the bottom line of the income report. Throw in the fact that international comps are in the low-double-digits year-over-year, shares are being repurchased regularly, and the case for shares in the $70s and beyond has sound reasoning behind it.

To learn how pick you investments during your next trip to the mall, read Analyzing Retail Stocks.

By Ryan Barnes

Ryan Barnes has over 10 years experience in portfolio management and investment research, covering equities, fixed income and derivative products. Barnes has worked with Merrill Lynch, Charles Schwab, Morgan Stanley and many others as an institutional trader, and maintained AIMR compliant performance for a diverse set of high-net-worth investors.

Barnes is currently working as a writer and financial modeling consultant specializing in capital appreciation and hedging strategies, and is the editor of EpiphanyInvesting, a website devoted to finding long-term success in the stock market.

Filed Under: Recession

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