1 Big Reason Why Costco Dominates Its Peers

You might read a lot about Costco’s business model as the primary reason for its success, but there’s more to the story.

Jul 20, 2014 at 8:19AM
Costco

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Side with a company that's dominating its peers. Costco Wholesale (NASDAQ:COST) fits into this category, and the trend is likely to continue. Fortunately, the reasons for the likelihood of continued success are easy to understand.

Current competition
The biggest long-term threat to Costco is Amazon, but Costco has thwarted this threat thus far. Currently, Wal-Mart Stores' (NYSE:WMT) and Target (NYSE:TGT) are also threats, but for different reasons.

Sam's Club is a competitor because it's one of the few warehouse clubs in the United States -- and beyond -- with a large presence. Target is a competitor because it attracts a similar consumer – middle- and high-income ones. In fact, contrary to popular belief, Target's consumer is closer to Costco's than Sam's Club's consumer. Therefore, Target has more potential to steal share from Costco despite a different business model. 

Struggling competition 
First, let's take a look at recent numbers prior to getting to future expectations. In Costco's third quarter (its most recent quarter), sales increased 7.1% year over year; comps, which are sales at stores open at least one year, jumped 4% overall, both international and domestic; and earnings per share improved 2.9%, to $1.07.

Forget the noise about missed quarterly expectations. This will only lead to very short-term price swings in a stock that will likely lead you in the wrong direction. If you want long-term positive returns, pay attention to the underlying business and consistent sales, comps, and earnings growth -- not Wall Street expectations.

If you exclude expectations and focus purely on results, then Costco is performing much better than Sam's Club and Target.

In Wal-Mart's first quarter, Sam's Club sales increased 0.5%, but comps (excluding gas) declined 0.5%, and operating income slid 1.4%. Traffic and average ticket declined, as did product sales. Sam's Club cited a struggling low- to middle-income consumer.

As far as Target goes, it still felt the impact of the data breach in its first quarter. Comps declined 0.3%, and adjusted earnings per share plummeted 13.9%, to $0.70. Target must sacrifice margins in order to drive consumers to its stores via promotions. This negative cycle should eventually come to an end, but it's still not over.

Now comes the interesting part.

Business model advantage
Baby Boomers sometimes speak of a three-acre warehouse found in a random parking lot. It costs money to get in to this club, but it's an annual fee, not a cover charge. And, no, it's not a rave for hippies (sorry); it's a location where experienced and wise shoppers visit so they can save money over the course of a year. 

Sure, it might cost $55 per year to shop at Costco, but the savings will add up in a hurry if you shop there often. That's because Costco buys high-quality merchandise in bulk, then leaves many of those items on their shipping pallets in order to keep overhead costs low. This allows Costco to pass great value on to its customers. While Wal-Mart and Target offer great pricing (cheap prices), their quality doesn't come close to Costco's. But the real key here is the future. 

Will Generation X'ers and Millennials learn the shopping ways of the force from their elders, or will they shun the idea due to the upfront investment?

At the moment, Costco doesn't appear to have much of a hold on younger consumers and the digital market, but Costco is likely to expand physically and digitally in the future since it's succeeding where it currently exists. When success is apparent, it's logical to expand. This is a good sign for investors, as long as Costco can continue delivering profitable growth.

The bottom line
If you want to become a better investor, eliminate the noise, and stick with companies that deliver profitable growth and business models that present an advantage over peers.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool 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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