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3 Reasons to Buy Costco

Source: Costco

Investors in Costco (NASDAQ: COST  ) may be disappointed after the company reported lower than expected earnings for the second quarter of fiscal 2014. However, the retailer still benefits from a smart and innovative business model that generates consistent loyalty from customers, and the company is outperforming competitors such as Wal-Mart (NYSE: WMT  ) and Target (NYSE: TGT  ) by a considerable margin. The recent weakness in Costco looks more like a buying opportunity than a reason to panic.

A high-quality business model
Costco makes most of its profit from membership fees, not margins on product sales. This means Costco can sell its products at cost, or sometimes even at loss, which provides a remarkable source of competitive strength in the discount retail sector where price is a central factor for success.

For perspective, while Wal-Mart earns a gross profit margin in the area of 25% of sales, and Target has had a gross margin in the neighborhood of 30% in recent years, Costco sells its products for a materially lower gross margin close to 12.5%.  

As the company grows in size, it gains purchasing power with suppliers, which allows Costco to negotiate better prices and financial conditions for its products. Besides, economies of scale and supply chain efficiencies generate additional cost savings as sales volume expands.

While the company gains more members and sells more products over the years, it should generate additional cost advantages which will likely translate into amazingly low prices for customers. The more successful Costco is on the commercial side of the business, the larger the savings it can pass on to customers. This produces a self-sustaining virtuous cycle by which the service provided by Costco becomes more valuable as the company becomes bigger over time.

Also, Costco collects most of its membership fees in advance, reducing volatility and dependence on sales volumes when it comes to generating cash flow and profitability for shareholders.

Rock-solid customer loyalty
The retail industry is notoriously competitive, but Costco stands away from its rivals thanks to its particularly loyal customer base. Retention rates are usually above 85% on a global basis and more than 90% in big markets such as the U.S. and Canada. Customers seems to be quite satisfied with Costco and its value proposition.

Even though sales and earnings came in below Wall-Street expectations during the quarter ended on Feb. 16, the company is still as solid as ever in terms of customer loyalty and membership renewals. The global renewal rate was 86.4% during the period, and new memberships increased by 13% versus the same quarter in the prior year.

Membership fees grew by 4% to $550 million during the quarter, but negative currency effects represented a considerable drag on performance. Membership fees excluding foreign exchange impact increased by a much stronger 7% annually to $563 million.

Outgrowing the competition
Costco has materially outperformed competitors such as Target and Wal-Mart in the last few years, and recent financial reports suggest no 
reversal in the trend.

During the 24 weeks ended on Feb. 16, Costco produced a healthy increase of 5% in total comparable-store sales when excluding gasoline prices and exchange rate fluctuations. Comparable-store sales in the U.S. increased by 5%, while corresponding revenue in international markets grew by 7%.

Wal-Mart, on the other hand, announced a decline of 0.4% in U.S. comparable-store sales excluding fuel during the 14 weeks ended on Jan. 31, while comparable-store sales excluding fuel at Sam´s Club fell by 0.1% during the period.

Target was hurt by the holiday season data breach, so performance was quite dismal during the quarter ended on Feb. 1. Total sales fell 3.8% versus the prior year, with the main driver of the decline being a 2.5% fall in comparable-store sales in the U.S.

Even if Costco has been affected by factors such as currency headwinds and harsh weather conditions lately, the company continues to gain market share versus the competition. In a mature and competitive industry such as discount retail, in which one company´s gain is usually another's loss, betting on the winners is of utmost importance.

Foolish takeaway
An innovative and smart business model, outstanding customer loyalty, and the company´s ability to outperform the competition through good and bad economic times make Costco an extraordinary player in the discount retail business. Investors have no reasons to panic about the recent weakness in performance; if anything, short-term pullbacks could provide a buying opportunity for long-term investors.

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Andrés Cardenal

Andres Cardenal, CFA is a tenacious researcher of the best investment opportunities around the world. Andres is an economist and CFA Charterholder living in Buenos Aires, Argentina. Naturally flavored. Follow me on Twitter for more investment ideas:

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