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Costco Can Thrive In Any Climate

Posted: Apr 18, 2008 09:56 AM by Ryan Barnes

Filed Under: Recession,Warren Buffett

Tickers in this Article: BRK.A, BRK.B, COST, WMT

Costco Wholesale (Nasdaq:COST) is like a flowering cactus that looks great among the other plants in a garden but can also survive in the middle of an arid desert that would kill its weaker brethren. The members-only discount retailer's shares are up over 9% since it reported fiscal second quarter earnings on March 6th - handily beating out both the S&P 500 (up about 3%) and the Dow Jones U.S. Retail Index (up 5%). Despite the recent bump, I still see Costco shares as undervalued based on its cash flow generation, idyllic management philosophy and growth strategy.

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While a recession weighs on every investor's mind these days, Costco is one of very few companies that has earnings stability - dare I say opportunity? - if the U.S. slump continues. (For more defensive plays, read Recession-Proof Your Portfolio.)

Inside the Numbers
For the quarter ending February 17, Costco saw strong growth in its core market of bulk retail goods and membership fees. Total revenue was up 12%, to $17 billion from $15.1 billion in the year-ago quarter. Net income shot up 31% to $328 million year-over-year, although it was on relatively easy comparisons. Membership fees were up 11.5%, a positive result from this most important contributor to pre-tax income.

Considering the sluggish domestic environment, I was relieved to see same-store sales were up 7%, including 17% comps growth in the company's international markets (mainly Canada and Mexico). I'd be remiss not to note that gas sales juiced this number a bit, but even when we back that out, we're left with warehouse comps of over 4%, which beats the pants off of both Wal-Mart (NYSE:WMT), up less than 1% in March, and Target (NYSE:TGT), down over 4%. (To see how to use what people buy and where they buy it as an economic indicator, read Using Consumer Spending As A Market Indicator.)

Adaptable, Yet Predictable Business Model
Management commented on the fact that clothing sales were gaining traction. As people cut back on trips to the mall, many of the non big-box clothing retailers are left no choice but to clear out inventories to Costco at reduced prices. The one weak area of store sales came from home furnishings, as could be expected given the dire straits of the housing market.

But Costco has a unique advantage here, in that it can simply re-shuffle floor space away from these products and replace the square footage with different goods. Customers expect to see different things for sale each time they walk into the store - for a devotee like me it's part of Costco's charm - and the company isn't bound to long-term deals with certain suppliers. If something isn't selling, it's gone.

Tight Fists are Healthy Fists
Rarely have I seen a company as fiscally tight as Costco. Its after-tax and gross margins have remained amazingly constant over the past five years, never wavering more than 30 basis points from one year to the next. Sound unsexy? Well, in a way it is, but uncomplicated is a great trait to have in shaky markets.

Costco has firmly established that it can survive on ultra-thin margins, but some investors still wonder why a low-margin company deserves a premium P/E to the rest of the retailing sector, and especially the pink elephants of Wal-Mart and Target. How about these for some quick reasons: a pristine balance sheet with over $3 billion in cash, strong relations with labor groups (which leads to easier entry to new communities), over $2 billion per year in cash flow, and a CEO/co-founder that denied his own bonus last year and pays himself the meager, by CEO standards, salary of $350,000 per year.

This business is perfectly positioned for continued self-funded growth, while having the beautiful kicker of nearly $1.5 billion per year in recurring membership revenue, money that drops like a rock to the bottom line. (To learn more on how to analyze a company's fiscal strength, read Analyzing Operating Margins and Do-It-Yourself Analyst Predictions.)

And while I can't justify a monetary benefit to the fact, Costco shareholders can be comforted by the fact that Berkshire Hathaway's (NYSE:BRK.A, BRK.B) No.2 man Charlie Munger has been on Costco's board for the past 10 years, and Warren Buffett himself is a shareholder.

Parting Thoughts
I think the U.S. economy will be able to skirt around a recession in boilerplate terms (i.e. negative GDP growth for two quarters), but we will end up awfully close. Even at 80% strength, a recession will lead to further profit shortfalls and many stock prices will likely go lower than their recent bottoms. Investors should remain wary of companies that take in a lot of discretionary income, and that means most retailers. But Costco is not most retailers. The previous all-time high is right above $70 per share, and I look for Costco to advance through that level in the coming months, and likely not look back.

For related reading, see our article 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,Warren Buffett

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