Why Costco Stock Keeps Rising

Shares of Costco Wholesale (NASDAQ: COST  ) hit an all-time high last Friday, ahead of next week's third-quarter earnings report. Costco stock has been a very consistent long-term winner for shareholders. Over the last 10 years, it has moved steadily higher, aside from a dip caused by the Great Recession.

COST Chart

Costco 10 Year Price Chart, data by YCharts.

Costco stock trades at 25 times earnings, so it's not exactly cheap. However, the company is still probably one of the best investments out there, because it has a powerful business model that engenders strong customer loyalty, and there is plenty of room for long-term growth.

The power of Costco
There are essentially two reasons that Costco stock has performed so well over the years. First, the company is very efficient. For example, Costco ended last quarter with inventory of just $7.6 billion, which is less than a month's worth of sales. Furthermore, this is almost entirely financed by vendors, which minimizes working capital requirements. In other words, by the time Costco has to pay its suppliers, it has already sold most of the relevant inventory. This reduces costs and allows Costco to maintain a very steady gross margin rate.

Second, Costco has the lowest operating expenses in the business, due to a focus on reducing costs and "investing in price" -- i.e., lowering prices in order to drive more traffic. Last year, Costco had operating expenses of just $9.5 billion, or 9.6% of sales. By contrast, operating expenses at Amazon.com, which is generally considered a very efficient retailer, totaled 23.6% of sales.

Costco's rock-bottom operating expenses give it the ability to match or beat the prices of all its competitors. This is good news for those who own Costco stock, because it means that the company should not be vulnerable to disruption by online competitors. Shareholders can be reasonably confident that Costco's industry-leading prices will be as big an attraction in 10 or 20 years as they are today.

Growth prospects
Costco is not a high-growth company anymore; revenue is growing in the high single digits, with earnings growing slightly faster. The logistical challenges of finding appropriate real estate, securing the necessary permits, and building new warehouses put a cap on growth, for all practical purposes. Costco plans to open approximately 30 new warehouses per year for the next few years, which implies 4% to 5% annual growth in square footage.

However, while Costco's growth rate is modest compared to that of Amazon, it is probably sustainable for a long time. This can justify Costco stock's relatively high multiple compared to that of most of its retail peers. As of February, Costco operated 622 warehouses, of which more than 90% are located in North America.

Costco continues to open new warehouses in North America, suggesting that it has not yet saturated that market. However, Europe, Asia, and Australia represent big future opportunities for the company. Costco already operates in the U.K., Japan, Korea, Taiwan, and Australia, with plenty of room for growth in all of those markets. The company is also interested in entering continental Europe, which could eventually become a large market for Costco.

With all of these opportunities, the company should be able to keep growing its warehouse count by 3% to 5% annually for the next decade and beyond. Comparable-store sales should also continue to grow as Costco takes share from less-efficient competitors. This provides a road map to long-term value creation for Costco shareholders.

Foolish bottom line
Costco has hit upon a winning formula for long-term profit growth with its low-cost model and commitment to keeping prices low for customers. The company's cost advantages constitute a wide moat that should keep it immune to the disruption occurring elsewhere in retail. Moreover, Costco has only penetrated a small portion of its worldwide market opportunity. As a result, Costco stock seems like a bargain, even at 25 times earnings.

Costco has made itself a leader in today's retail market. To learn more about Costco and another retailer with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they’re planning to ride the waves of retail's changing tide. You can access it by clicking here.


Read/Post Comments (9) | Recommend This Article (15)

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  • Report this Comment On May 21, 2013, at 9:05 PM, Regulator1956 wrote:

    Costco stock keeps going up because . . . . . people are willing to pay more for it. Duh.

    The 25 multiple is quite high and if people "felt" otherwise, the stock price would fall.

  • Report this Comment On May 21, 2013, at 9:18 PM, Gunnyphillips wrote:

    Hmm. As a long time Costco member, I agree with the loyalty angle, but I wonder how Costco will continue to grow [at least in the US] when their product offerings are so basic. Whenever I am in the market for decent home theater equipment [projector, speakers, etc] I find myself forced to go elsewhere. The food court is also an anachronistic bore.

    But the one thing Costco does better than anyone else [aside from rock bottom operating efficiency] is take care of their customers. Unlike others, when they say they guarantee everything they sell, they mean it.

    I will probably always be a Costco member, but I do think the company needs to do some rethinking when it comes to offering better products in some areas like mid to high level consumer electronics and adding decent healthy choices in their food courts.

  • Report this Comment On May 21, 2013, at 9:39 PM, TMFGemHunter wrote:

    @Gunnyphillips: Thanks for the comment. On the food courts, I think you're probably right.

    As for high-end consumer electronics, I think the problem may be volume-related. Costco's business model works really well for things that people buy a lot of. Expensive home theater systems may not move fast enough to make sense within Costco's business model. The company's primary focus is providing basics at rock-bottom prices.

    Adam

  • Report this Comment On May 21, 2013, at 9:42 PM, TMFGemHunter wrote:

    @Regulator1956: That's not a very useful or meaningful statement, in my opinion. From that perspective, investing is just tossing darts while wearing a blindfold!

    The real question is what makes people think that the stock is worth 25 times earnings. That's the case that I've tried to lay out in the article.

    (Side note: some stocks are so volatile that the pricing on any given day is somewhat arbitrary. But Costco's stock hasn't had much in the way of big ups and downs. There's "real" value creation going on behind the scenes.)

    Adam

  • Report this Comment On May 21, 2013, at 9:52 PM, banmate7 wrote:

    I really love Costco. My family does a lot of shopping there. I have little doubt reasonable growth can be sustained. Your article is basically spot on.

    I've been wanting to invest in Costco for a while. But the PE has kept me away. Today it is at 25, which is in my mind expensive. You won't go wrong in the long term, but something tells me opportunities will materialize where it is at fair value.

    I patiently waited for such opportunities in companies like Coca-Cola, JNJ, and CNI. All have done extremely. I am waiting for a suitable opportunity with Costco...although I admit I had plenty of chances to buy at $50 - $60 a share...and today it sits at $113.

    Still, I've never gone wrong with waiting for value, at least for a major investment. I guess I'll have to wait for some market irrationality to open up a value opportunity here.

  • Report this Comment On May 22, 2013, at 5:51 PM, junkmunk2u wrote:

    Next stop: $128.56. Costco stock will do great.

  • Report this Comment On June 03, 2013, at 5:40 PM, TMFGemHunter wrote:

    That's a very specific target...

  • Report this Comment On March 24, 2014, at 12:22 PM, estellefields wrote:

    Costco is the best!. I love Costco. I shop at Costco twice or three times each week.

    I love to shop there. The staff is great. Policy is super great. Price is great!!

    Stock will do great.

  • Report this Comment On June 19, 2014, at 11:22 PM, carrbucks wrote:

    Ahhh... Love Costco. Bought $10k worth of their stock in 1998. (winner, winner...chicken dinner!)

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