Costco: A Great Long-Term Stock With a Business Model Even I Can Understand

When I began investing, I was starting from a knowledge base of zero.

One of the first books I read was The Motley Fool's Rule Breakers, Rule Makers. In it, Motley Fool co-founder Tom Gardner laid out specific criteria for crowning a company a "Rule Maker": a mature, consumer-facing business that's king of its market space, and an investment that can confidently and profitably be held onto for years with only quarterly check-ins.

His step-by-step process for analyzing a business was an easily understandable way for a beginner like me to quickly get up to speed, but its back-to-basics approach will benefit even advanced investors. Today we're going to run discount giant Costco (Nasdaq: COST  ) through Tom's merciless gauntlet and see if it has what it takes to make the Rule-Maker grade.

1. The mass-market, repeat purchase of low-priced goods
While Costco does sell plasma-screen televisions and, strangely, grand pianos, what keeps people coming back again and again are the less-expensive, day-to-day items they feel the need to buy by the case, gross, or 5-gallon bucket: food, drink, household essentials, and even clothing. As such, Costco easily maxes out our first Rule-Maker metric.

2. Gross margin
Gross margin indicates manufacturing efficiencies, brand power, and pricing power. The ideal gross margin for a Rule Maker is 60%.

  • With a gross margin of 12% for the trailing 12 months, Costco falls well shy of our benchmark. More on this in a minute.
  • Target (NYSE: TGT  ) hits 30% TTM here.
  • Wal-Mart (NYSE: WMT  ) hits 25%.
  • Safeway (NYSE: SWY  ) manages 28%.

Supermarkets, a category that Costco falls broadly into, traditionally operate on the thinnest of margins. Costco, being a discount house, operates on even thinner margins. Thus, its 12% gross margin, while absurdly low by normal standards, is something we're not going to bang on Costco too hard for in this analysis.

3. Net-profit margin
Net-profit margin dictates how many pennies a company gets to keep from every dollar of sales. Tom Gardner likes to see net-profit margins of 10% for his Rule Makers, but again, bear in mind we're talking essentially about supermarkets here.

  • Costco's net-profit margin TTM is 1.72%.
  • Target's net-profit margin TTM is 4.12%.
  • Wal-Mart's net-profit margin TTM is 3.53%.
  • Safeway's net-profit margin TTM is 1.29%.

Given the realities of this sector, this is another Rule Maker metric we'll have to go easy on in our analysis.

4. Sales growth
Year-over-year sales, or revenue, growth counts even for big companies, where it will naturally slow with age, because it's an indicator of business momentum. Top-tier rule makers grow their sales by 10% every year.

  • Costco grew its revenue by a big 14.3% YOY. Nicely done.
  • Target grew its revenue by a more modest 3.3% YOY.
  • Wal-Mart did a bit better, hitting 4.5% YOY revenue growth.
  • And Safeway did a bit worse, with YOY revenue contracting by 2%.

5. Cash-to-debt ratio
Rule Makers should be cash-heavy and debt-light, ideally having at least 1.5 times as much cash as debt:

  • $4.8 billion in cash and $1.4 billion in debt give Costco the beautiful C/D of 3.43.
  • $1.5 billion in cash and $18.6 billion in debt give Target the ugly C/D of 0.08.
  • $8 billion in cash and $55 billion in debt give Wal-Mart the only slightly less ugly C/D of 0.15.
  • Finally, $203 million in cash and $6.4 billion in debt give Safeway the downright tragic C/D of 0.03. After doing these Rule Maker analyses for a year, that's the lowest C/D I've seen.

Money is so cheap right now. As such, too many companies are in debt up to their corner offices. When the bad times come, which they always do, the companies with the most cash and least debt will be better able to make it through to the other side. Way to go, Costco.

6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. A company should be keeping its inventory and accounts receivables low and its accounts payables high: strong indicators of market-space dominance.

To calculate the Foolish Flow Ratio, take current assets minus cash, cash equivalents, and short-term investments, and then divide by current liabilities. The acceptable upper limit for the Foolish flow ratio is 1.25, but the lower the number the better:

  • Costco hits a lovely, low F/F of 0.69.
  • Target hits a solid F/F of 1.12.
  • Wal-Mart comes in with an also lovely F/F of 0.71.
  • Safeway hits a healthy F/F of 0.86.

Well done to all our Rule-Maker contestants on this metric.

7. Your familiarity and interest
What's in a name? Quite a bit. Your familiarity and interest with a company help you understand exactly what it does and how it makes money, thereby lowering your overall investing risk.

In the past 10 to 20 years, Costco has become synonymous with discount shopping, and high-quality at that. And if you yourself, Foolish reader, don't shop there, chances are someone you know does. Costco easily maxes out this final Rule-Maker benchmark.

Costco rules!
Yes, Costco wildly misses our gross-margin benchmark, as well as our profit-margin ideal, but these are realities of the industry: no one in this sector can hit Tom Gardner's Rule-Maker margins. But Costco is extraordinarily strong otherwise and, as such, can confidently be crowned a Rule Maker in the finest tradition of the words.

But always remember to check in on your Rule-Maker investments once a quarter by running them through this simple checklist. In Rule Breakers, Rule Makers, Tom Gardner goes into even greater depth and detail about what exactly makes a Rule Maker a Rule Maker. So I suggest you pick up a copy for yourself and get the whole story from the man who wrote the book on it.

Have I whetted your appetite for intriguing consumer-goods stocks? Check out our premium report on SodaStream: a razor-and-blade company with an intriguing opportunity for growth that may be harder to duplicate than at first appears. You'll get gives three reasons to buy, as well as three reasons to sell. The report comes with a year's worth of updates, so just click here to get started.

Fool contributor John Grgurich owns no shares of any of the companies mentioned in this column, but he loves Costco's pickles-by-the-5-gallon bucket a little too much. Follow John's dispatches from the bleeding edge of capitalism on Twitter, @TMFGrgurich.

Motley Fool newsletter services have recommended buying shares of Costco Wholesale. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a strangely gripping disclosure policy.


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