2 Questions You Should Ask Before Buying Costco

Buying Costco instead of Wal-Mart and Target? Ask yourself these two questions first.

Jun 30, 2014 at 4:01PM

Costco (NASDAQ:COST) has rewarded investors with market-crushing returns over the past decade. Thanks to its popular in-store experience and employee-friendly policies, it's held in better esteem than traditional retail competitors like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT). While customers still hold a sweet spot for the wholesale giant, now is a good time to decide if Costco's next decade will be as profitable as its last. 

Here are two questions to ask yourself before investing in Costco. 

COST Chart

COST data by YCharts.

How much growth is left? 
The first question that investors should ask with almost any stock is where the company is in its growth cycle. Even if you are the staunchest value investor, knowing how much growth is left is the first step to determining a relative valuation. Costco trades at a P/E ratio of 25, Wal-Mart at 15 and Target at 19,  so Costco has the richest valuation of the group. Looking at it simply, you'd think a higher P/E would mean a better growth landscape.

At a distance, it seems like Costco has more opportunity for growth than Target or Wal-Mart. Costco only has 649 stores; when you compare that to Wal-Mart's 11,000 locations, it seems tiny. Those numbers are misleading, however, due to the differences in Costco's business model. Customers need to purchase a membership to shop at Costco; it's a commitment, so it doesn't get as much "walk-in" traffic. The Wal-Mart wholesale brand Sams Club is Costco's most direct competitor and it has 602 stores. Costco's other major wholesale competitor, BJ's, only has 200 stores.

So while Costco has a relatively low number of retail stores, it's actually a high number for a wholesaler. It raises the question: When will saturation become an issue? To determine this, you should watch Costco's same-store sales very closely going forward. For now, demand is still fairly strong. Same-store sales were up 4% in Costco's most recent quarter --that's solid. How high can Costco's store count rise before demand slackens? The answer depends on how much market share you feel Costco (membership fees and all) can take from traditional retailers.

Could higher wages backfire? 
Costco is really good at differentiating itself. There's nothing structurally different about Costco than its close competitors, but it wins market share by treating customers well. Recently, Costco has also been thrust into a national debate about how different it is when it comes to pay. 

Proponents of a higher minimum wage have pointed to Costco's higher wages and demanded that Wal-Mart and Target follow suit. It is remarkable, really, that a Costco cashier is paid an hourly wage in the teens, while at Target or Wal-Mart they may be paid closer to $9 per hour. 

What's intriguing about this is that a wholesale business really shouldn't be able to pay higher wages. Costco makes almost all of its profit on its membership fees -- its goods are often sold at a wash -- but even with the membership fees, it's a really low-margin business model. 

COST Gross Profit Margin (Quarterly) Chart

COST Gross Profit Margin (Quarterly) data by YCharts.

There are tremendous advantages to paying your people more. The two biggest advantages are having lower turnover and a more engaged workforce, both of which have a positive impact on customer service. One could also argue that Costco, through lower turnover, saves some money in hiring costs. 

It's a fine line between differentiating yourself and letting your expenses run wild. I personally believe Costco's investment in its people has helped it win market share over the years.  With that said, you should know that this approach has risks for a lower-margin business. Do you feel the value outweighs the risk? 

Investing is about tomorrow
These two questions cut right to the heart of Costco's investment thesis. By asking them, you'll weigh growth potential against value, and risk against culture. Costco has wowed investors, and customers, over the past decade, but investing is about what happens next. The answers to these two questions will help you determine where you stand on Costco's future. 

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Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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