What Makes Costco Wholesale a Best-in-Class Retailer?

Costco Wholesale has proven to be a market beating investment in recent years, and the company's strengths make it likely that Costco will continue to perform better than rivals such as Wal-Mart and Target.

Jul 9, 2014 at 11:14AM

Discount retail is a highly competitive environment led by the world's largest retailer, Wal-Mart Stores (NYSE:WMT). With Wal-Mart, bricks-and-mortar rival Target (NYSE:TGT), and e-commerce giant Amazon.com (NASDAQ:AMZN) all fighting for market share, Costco Wholesale (NASDAQ:COST) has managed to carve out a successful niche that is equally popular with customers and investors. The reasons behind Costco's market-beating returns are really quite simple: growth, competitive position, management, and shareholder friendliness.

Strong growth opportunity
In a retail environment that has proven challenging for Wal-Mart and Target, Costco stands apart from its bricks-and-mortar peers with solid growth:

COST Revenue (Quarterly YoY Growth) Chart

COST Revenue (Quarterly YoY Growth) data by YCharts

Costco has achieved consistently higher revenue growth in recent years through a balanced combination of comparable-store sales growth and new locations. In the most recent quarter, Costco reported comparable-store sales growth of 4% (6% excluding the impact of gasoline prices and foreign exchange rates); in contrast, both Wal-Mart and Target reported slight declines in comparable-store sales.

Costco is also driving growth through expansion to new locations. With just 655 stores,Costco is still significantly smaller than Wal-Mart with 10,994 locations and Target with 1,789 locations. Costco is taking a disciplined approach to expansion and has locations in just nine countries; in the one it has entered most recently, Spain, it has just one Costco open in Seville with plans for a second location in Madrid later this year. Significant opportunity remains for further growth both domestically and internationally as the company is ramping up the pace of its investment in new stores.

Looking ahead, Costco is expected to grow revenue and earnings next year by 8% and 12%, respectively, while Wal-Mart is expected to report growth of just 4% and 9%.

Solid competitive position
With such formidable competition, it is important for Costco to create a unique value proposition. Costco has done exactly that with its members-only warehouse format. Wal-Mart's Sam's Club and BJ's Wholesale offer competing options, but Costco has continued to grow while Sam's Club has reported sales declines and layoffs thanks to several key differences.

First, Costco has placed an emphasis on higher-quality brands and a "treasure hunt atmosphere" that caters more specifically to higher-end customers. Second, Costco has a number of exclusive products under its Kirkland brand which range from dress shirts to wine with high ratings in comparison with name-brand products. Not many private brand labels receive high scores from industry publications such as Wine Spectator. Third, the company creates a more hospitable environment for customers by focusing first on its employees. The combination of these points of differentiation results in highly satisfied customers, as measured by an impressive 90% membership renewal rate each year.

Screen Shot

A collection of Kirkland Signature products available exclusively at Costco. Source: Investor Presentation at www.costco.com

Costco also offers highly competitive prices. When Wal-Mart recently unveiled its Savings Catcher price-matching functionality to wage a price war against Target and grocery store competition, Costco was one of several retailers that Wal-Mart deliberately left off the list of stores that it would match. 

A different approach to management
As part of its customer-centric approach, Costco takes a different approach to managing its workforce. Costco pays its employees more than the competition and provides exceptional opportunities for advancement. This opportunity is evident with Costco's CEO, Craig Jelinek, who has advanced through the ranks during his 30-year career with the company.

The effect of Costco's focus on the employee is remarkable: Jelinek has a 95% approval rating on Glassdoor.com and the sixth-highest ranking among all CEOs. By comparison, Amazon.com CEO Jeff Bezos is ranked 33rd with an 85% approval rating, while Wal-Mart CEO Doug McMillion has an approval rating of just 48% and Target CEO John Mulligan has an approval rating of 64%. While this may seem anecdotal, it is not; Glassdoor rankings have a strong correlation to stock performance. Here's a visual illustration of the stock market performance of the two highly rated CEOs noted above compared to their counterparts:

COST Chart

COST data by YCharts

Notice which two companies have outperformed the S&P 500 and which two have lagged the market?

Very reasonable valuation
Shares of Costco typically reside in a consistent valuation range. Based on its price-to-sales ratio, Costco trades at a lower valuation than its peers:

COST PS Ratio (TTM) Chart

COST PS Ratio (TTM) data by YCharts

Admittedly, this chart shows only part of the story. Given Costco's obsession with creating a solid value proposition for members, Costco's lower margins result in a higher valuation than that of the bricks-and-mortar competition on a price-to-earnings basis:

COST PE Ratio (TTM) Chart

COST P/E Ratio (TTM) data by YCharts

This premium is well-founded given Costco's operational excellence, stability, track record of market-beating performance, and superior growth. At 22 times next year's earnings, Costco provides both stability and growth for investors who are weary of the valuations of pure growth stocks like Amazon.com.

Shareholder friendliness
It probably should come as no surprise that a company that is focused on satisfying both customers and employees is also shareholder friendly. Costco has rewarded shareholders by returning capital through a combination of share buybacks, quarterly dividends, and special dividends.

During the most recent quarter, Costco repurchased 1.6 million shares of stock for $184 million and has almost $3 billion of authorization remaining under its latest repurchase plan. In 2012, Costco paid a special dividend of $7 per share. Additionally, the company has paid a quarterly dividend that has grown each year since its inception in 2004. The current quarterly dividend of $0.355 per share equates to a dividend yield of just 1.2%, but the facts that the dividend payout has doubled in the past five years and the company has a current payout ratio of just 29% are strong indicators that dividend increases will continue for the foreseeable future.

Best-in-class investment
Shares of Costco are not cheap today by most valuation metrics, but they seldom are based on historical data. Given the strength of Costco's business and track record of success, Costco is a perfect example of Warren Buffett's famous quote from his letter to Berkshire Hathaway shareholders:

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Very few companies fit this description today better than Costco, and as a result Costco remains an excellent long-term investment option.

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Brian Shaw owns shares of Amazon.com, Berkshire Hathaway, and Costco Wholesale. The Motley Fool recommends Amazon.com, Berkshire Hathaway, and Costco Wholesale. The Motley Fool owns shares of Amazon.com, Berkshire Hathaway, and 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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