Do Costco and PriceSmart Deserve a Place in Your Portfolio?

Investing legend Peter Lynch once said, "Know what you own, and know why you own it." Investing in what you know and understand represents an excellent approach to investigating investment ideas. With that said, membership warehouse clubs Costco Wholesale (NASDAQ: COST  ) and PriceSmart (NASDAQ: PSMT  ) are worth considering. Most people have either shopped in these types of stores or are familiar with their concepts. Let's look under the proverbial hood of these companies to see if they generate revenue and free cash flow growth and save for a rainy day. Revenue and cash flow serves as the true catalyst for long-term capital gains and dividend growth.

High volume and no frills
Costco Wholesale believes in offering customers the lowest prices possible through "distribution efficiency" and by purchasing in high volume a limited number of SKUs for the purpose of creating high inventory turnover. Subsequently, the company sells its merchandise in a "no-frills" warehouse environment, providing customers further cost savings. Costco believes in building customer loyalty that results in comparable sales increases. The underpinning of this belief is simple: If customers like shopping at Costco, then they won't shop anywhere else.

On a similar note, the company wants to take care of its employees with decent wages and benefits in an effort to lower employee turnover. More experienced employees possess better knowledge of their store and inventory, enabling them to take better care of customers. 

Costco Wholesale has grown its revenue 6% so far in 2014. Its net income declined 8% during that same time frame, and its year-to-date free cash flow grew 9%. Comparable sales increased 3%; 27 new warehouse locations contributed to the increase in sales. Lower net income stemmed from increases in expenses such as higher employee benefit costs, opening expenses of new stores, and interest costs. Better inventory turnover, timing of payments toward vendors, and working capital improvements made positive contributions to free cash flow.

Costco sits on a pretty good balance sheet, with cash and long-term debt to equity registering at 55% and 43%, respectively. The company paid out 22% of its free cash flow in dividends so far this year. Currently, Costco pays shareholders $1.24 per share per year in dividends, translating into a yield of 1.1%.

"The Latin American Costco"
PriceSmart operates on a similar premise as Costco Wholesale, with the exception of location: It operates mainly in the Latin American and Caribbean markets. Like Costco Wholesale, PriceSmart, enabled by volume purchasing, seeks customer loyalty by efficiently and profitably selling merchandise at competitive prices. PriceSmart also provides fair wages and benefits to its employees, according to its 10-K. This implies that PriceSmart shares some of the values of its American counterpart.The company doesn't face any serious competition from U.S. membership warehouse chains. 

PriceSmart increased its revenue and net income 12% and 11%, respectively, so far this year. However, the company registered a negative free cash flow balance of $59 million. A year-to-date comparable warehouse sales increase of 7%, construction of two new warehouse locations, gains in export sales, and membership gains all contributed to gains in overall revenue and profitability. Accounting accruals, increased capital expenditures due to new store construction, and the timing of payments to vendors contributed to the negative effect on free cash flow.

Hopefully, for the full year PriceSmart will not only turn free cash flow positive, but in an amount in excess of last year as the new stores come online. The company possesses an OK balance sheet, with cash and long-term debt to equity coming in at 16% and 4%, respectively. PriceSmart currently pays its shareholders $0.70 per share per year and yields 0.80% annually in dividends.

Things to look for
Costco Wholesale plans to open up to 14 new stores by the end of its fiscal year on Aug. 31. The company went through a tough holiday quarter. If customers don't open their wallets and spend more in the coming months, this company could face short- to medium-term headwinds. Over the long term, however, fair treatment of employees and customers should provide qualitative strengths and build top- and bottom-line gains that translate into superior capital gains and dividend boosts.

In its 10-Q, PriceSmart commented on currency fluctuations and political headwinds in Latin America and the Caribbean. Investors should heed the extra political risk of solely operating in this region. If the economy turns sour in the region, the stock price could suffer a major correction. However, the company remains optimistic enough about the region to open four new warehouse clubs over the next 12 months. Over the long term, this company should also provide superior long-term capital gains and dividend increases as long as the Latin American and Caribbean economy holds up.

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