The Best Blue Chip for 2007: Costco

Retailing is a cutthroat competitive business, with razor-thin margins and constant promotions needed to lure customers into a company's stores. One retailer, however, provides such phenomenal value that it actually convinces customers to pay a membership fee in order to have the privilege of shopping there.

Who is this mystery company? Costco Wholesale (Nasdaq: COST  ) .

The qualitative case
Why would people (like me) pay to shop at Costco? Because it provides an unbelievable variety of items, both brand-name and Kirkland private label, at deeply discounted prices. You can buy everything from clothes to canned goods, hearing aids to tires, all under one 150,000-square-foot roof!

The prices are so low (the maximum amount Costco will mark up an item is 14%, about half the retail average) that the membership fee of $50 easily pays for itself after three or four visits. But the low prices are only half the story. What makes Costco so special is its customer service, specifically its return policy. You can return anything, no reason required, and with virtually no time limit. (Understandably, returns on tires are limited to defects, and returns on computers are capped at six months.) You don't even need a receipt, since Costco's computer system has your membership purchasing information on file.

The quantitative case
OK, Costco is a great place to shop, but is it a great stock to own? I think it is, and now's the time for new money. For starters, consider that in its last fiscal year, the company had around 48 million members and earned $1.1 billion, despite having operating margins of only 2.7%. That's still higher than the 2.5% operating margin of BJ's Wholesale Club (NYSE: BJ  ) , one of its pure-play competitors. Costco is the fourth-largest retailer in the country, and the seventh-largest in the world, with $60 billion in sales generated from 488 warehouse locations. Its nearest competitor in the wholesale retail space is Wal-Mart's (NYSE: WMT  ) Sam's Club, which has almost 80 more stores than Costco, yet generates $20 billion less in sales. Fewer stores and more sales -- now that's efficiency!

Part of this efficiency stems from Costco only carrying 4,000 items, about one-tenth the number of a traditional supermarket, and one-thirtieth the amount at a Wal-Mart Supercenter. Costco's philosophy is to simplify logistics by only selling popular products that customers buy in large volumes. With simplicity come lower operating costs. The logistics are similar to those of Southwest Airlines (NYSE: LUV  ) , which only operates one model of aircraft, the Boeing 737.

Costco's compounded annual growth over the past five years has been a solid 11.6% for revenues and 12.9% for earnings. This growth has come despite an unlevered balance sheet, with a debt-to-capital ratio of less than 10%. And there's no reason to think the growth will not continue. While the company opened 27 new stores in fiscal 2006 (ended Sept. 3), it plans to open even more stores (37) in fiscal 2007, and 40-plus stores in 2008. At 23 times trailing-12-month earnings, Costco is not cheap, but premier retailers that sport consistent double-digit growth rarely are.

Foolish bottom line
Some analysts have expressed concern about the company's liberal return policy and generous employee-compensation scale. (Costco's average hourly wage is $17, versus $10 at Wal-Mart, and workers must contribute only 10% of health-care premiums, versus a retail average more than double that). I believe that it takes money to make money, and Costco's financial success over the years has been a direct result of its customer-friendly and employee-friendly policies. Costco is the perfect investment, because it allows an investor to profit and feel good about supporting one of the good guys in corporate America.

So is Costco the best blue-chip investment for 2007? I sure think so. If you agree with my position, let us know by participating in our community intelligence database, Motley Fool CAPS. All you need to do is rate Costco "outperform." If you disagree with me, you can rate Costco "underperform." To make your voice heard, click here.

To read about the rest of our blue-chip candidates, click here.

Costco is aMotley Fool Stock Advisorpick.

Jim Fink does not own any shares in the companies mentioned.Costco is a Motley Fool Stock Advisor pick. Wal-Mart is an Inside Value choice. The Motley Fool is investors writing for investors.


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