Why Costco Will Continue Outgrowing Wal-Mart and Target

Costco Wholesale (NASDAQ: COST  ) has been one of the most remarkable growth stories in big box retail over the last years. However, when compared against industry peers like Wal-Mart Stores (NYSE: WMT  ) and Target (NYSE: TGT  ) , the stock is trading at a considerable premium. Can Costco continue outgrowing the competition in order to justify its valuation?

Growth and valuation
When comparing valuation ratios for Costco against Wal-Mart and Target, the company looks materially more expensive than its peers: Costco has a P/E ratio of 27 versus 15.3 for Wal-Mart and 15.4 for Target. Also, while Wal-Mart and Target pay dividend yields of 2.4% and 2.7%, Costco´s yield of 1% is substantially lower.

That premium is easy to understand in terms of past performance, Costco has outgrown both Target and Wal-Mart by a wide margin over the last years, and superior growth deserves a premium valuation.

Especially in a mature and competitive industry like discount retail, where one company´s gains are in many cases the other one´s loses, sticking with the winning players can be a factor of utmost importance, and this is a powerful explanation for Coscto´s premium.

On the other hand, in business and investing past performance does not guarantee future results. Investors need to take a look at the company's fundamentals and competitive strengths to evaluate whether Costco can justify its premium valuation or not on a forward looking basis.

Competitive strengths
Costco has a smart and fairly unique business model, the company makes most of its profits from membership fees as opposed to gains on merchandise sales. This allows the company to sell its products at razor-thin profits, or even at a loss. Price competitiveness is a key strategic factor in the industry, and Costco's business model provides an advantage versus the competition.

Wal-Mart has been expanding its Sam´s Club business which has a similar membership-based business model, but it hasn´t been able to achieve the same kind of success among customers. While Costco delivered an increase of 5% in US same store sales excluding gasoline for the last quarter, Sam´s Club comparable sales without fuel increased by a much lower 1.1% as of the latest earnings report.

Costco is completely focused and specialized in its membership-based business model, this is not only a source of competitive strengths, but also a valuable trait for shareholders from a financial point of view. Since profits depend mostly on fees which the company collects in advance, this provides Costco with with higher stability when it comes to sustaining cash flows through the ups and downs of the economic cycle.

Another differentiating factor for Costco is the company´s atypical human resources policies and corporate culture: Costco pays higher salaries than the competition, the company offers more generous benefits like health care and 401-K plans and it provides more opportunities for professional growth and promotion to employees of different levels.

Attracting and retaining the best talent in the industry has important implications for the competitive dynamic in the sector, and it also means more profitability for shareholders on a long-term basis. In the words of the company's CEO, Craig Jelinek, as quoted in a Businessweek interview:

"We know it's a lot more profitable in the long term to minimize employee turnover and maximize employee productivity, commitment and loyalty"

Room for growth
Costco is planning to open 36 new warehouses in fiscal 2014, half of them in international markets. This is a considerable ramp-up versus 26 new locations opened during fiscal 2013.

Strong comparable sales data is proving that new openings are not cannibalizing sales at existing stores, so management is doing the right thing by betting on growth. In addition to that, Costco has barely tested the waters in international markets and the company has plenty of untapped opportunities for global expansion.

If Costco can replicate, at least partially, the level of success it has obtained in the US on a global scale, the company should continue generating healthy growth rates for shareholders over years to come.

Bottom line
Costco is priced at a premium versus competitors like Wal-Mart and Target, but that´s no reason to stay away from the company. Costco has a differentiated business model and a superior corporate culture in addition to plenty of room for expansion, both in the US and abroad. Costco will most likely continue outgrowing Wal-Mart and Target over the coming years, and for that reason it deserves a higher valuation.

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Read/Post Comments (7) | Recommend This Article (17)

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  • Report this Comment On November 30, 2013, at 12:27 PM, kalaloch wrote:

    Costco is the counter argument to the "race to the bottom" philosophy embraced by most U.S. corporations, including WalMart. People spend money when the vibe is good, and the vibe is good at Costco. Shoppers pick up on employee enthusiasm, high levels of customer service, relaxed professionalism and general employee satisfaction among the company's warehouse workers. The result is that I am happy to linger, shop and spend my money there on a regular basis.

  • Report this Comment On November 30, 2013, at 4:06 PM, ScamuelJones wrote:

    Answer to this is simple: Walmart and Target are BOTH pathetic scamming companies that will not pay their employees a living wage, and finding customer assistance at either one is like looking for a space alien. Whereas, Costco pays a living wage to its employees, shows them respect, and provides plenty of clerks to help customers! Another reason is that Costco sells much more American goods where Walmart and Target sell inferior cheaply made pathetic Chinese and other Asian made goods that won't work or are inferior in every way to American made goods and products!

  • Report this Comment On November 30, 2013, at 4:19 PM, cpa28 wrote:

    >>>the company makes most of its profits from membership fees as opposed to gains on merchandise sales. This allows the company to sell its products at razor-thin profits, or even at a loss. Price competitiveness is a key strategic factor in the industry, and Costco's business model provides an advantage versus the competition.<<<

    If COST makes its money on membership fees, why would its sales volume matter at all. Their inventory turnover is faster that that of WMT (which may not be as much better than it looks as we don't know about Sam's alone), but its margins are lower as well. Consequently, their return on equity and their return on assets are both lower than those of WMT. COST is a better shopping experience than SAM's Club. However, WMT is the better financial model.

  • Report this Comment On November 30, 2013, at 10:29 PM, tomclancy wrote:

    YA, AND THEY ACTUALLY PAY THEIR EMPLOYEES A VERY GOOD LIVING WAGE COMPARED TO WALMAT & TARGET, IMAGINE THAT.

  • Report this Comment On December 01, 2013, at 12:08 AM, VegasSmitty wrote:

    I won't go near Costco. Can't get in the parking lot most of the time and if you do the store is packed with long waits to check out, no thanks!

  • Report this Comment On December 01, 2013, at 10:54 AM, pwgotribe wrote:

    the logic doesn't match the reality. What makes Costco successful is its extremely limited selection, and most people who shop there can't come close to finding the variety they do at Walmart and Target, or other discount stores for that matter. If I want a large jar of marinated mushrooms, fine, it's priced well at Costco. If I want a specific flavor of Progresso soup, all I might find is a four-pack, perhaps with one of the four being what I'm looking for. The selection of electronics is very limited, and I can do better at Best Buy or online. Maybe a membership is worth it, but I find so little of what I want to buy, in the quantities we actually can use in a reasonable time, that Walmart and Target are far better choices. Percentages vs. volume that you cite are not long-term sustainable unless Costco greatly increases its variety. Right now, it's less than 10% of the others in terms of SKUs.

  • Report this Comment On December 01, 2013, at 1:36 PM, myopinion wrote:

    I'm not a Costco member and probably never will be. I don't see the benefits and especially the ones described her. I'm not paying membership fees of this kind yearly to give you what amounts to savings on bulk purchases which is what you should get with that kind of purchase anyway. Also don't see the employee friendliness described here as I've been treated extremely rude during my few trips to Costco (when using a gift card) more then when shopping at Wal Mart many more times. It's also ridiculous to have to stand in line to check out and then stand in line another line 20 feet up the store when they check your receipt to make sure you did't steal anything. Customer service is not making everyone wait in an extra line because you're being treated as a potential shoplifter. If you want bulk, buy at your warehouse grocer, otherwise you can do better price wise at Wal Mart if you pay careful attention to quality.

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