3 Reasons Costco's Stock Could Rise

After more than doubling in the first few years after the Great Recession, Costco Wholesale (NASDAQ: COST  ) stock has leveled out in the last year. Since summer 2013, shares have been stuck in a $110-$125 trading range.

COST Chart

Costco Wholesale five-year stock chart, data by YCharts

This share price stagnation can be explained in large part by a sharp slowdown in Costco's earnings growth. Analysts expect the wholesale retailer's earnings per share to grow just 2% year over year in fiscal 2014, to $4.59.

Obviously, earnings growth will need to accelerate for Costco stock to perform well going forward. Fortunately, the company has three important business drivers that could send shares marching higher again.

Consistent sales growth

While Costco's earnings have come under pressure in the past year, sales growth has remained strong. The issue has instead been a slight dip in the retailer's profit margin, as the company made a strategic choice not to pass on food cost inflation to customers in order to build loyalty. This was magnified by the fact that Costco operates on razor-thin margins.

Excluding the impact of gasoline prices and foreign exchange rates -- both of which tend to be volatile -- Costco's comparable-store sales have risen 6% in each of the last three years. The company is on pace to post another year of 6% comp growth in fiscal 2014.

Costco has been posting strong comparable-store sales growth recently. Photo: The Motley Fool.

Costco's consistent comparable-store sales growth, along with its steady pace of new warehouse openings, is driving a long-term revenue growth rate in the high single digits. The company's long track record of steady growth and an industry-low cost structure suggest that its growth rate will be sustainable for years -- or even decades -- to come.

Limited international competition

A second positive driver for Costco stock is the company's expansion in international markets, where it faces less competition. In the U.S., Costco faces direct competition from two rivals: Wal-Mart's Sam's Club and BJ's Wholesale Club. By contrast, the discount warehouse club concept is much less developed outside the U.S.

Lower competition means that Costco can earn higher margins abroad. In fiscal 2013, Costco's operating margin was 2.4% in the U.S., but hit 4.4% in Canada and 3.9% in its other international markets.

Part of this gap in profitability is the result of Costco's stock-based compensation (and some other overhead costs) being allocated to the U.S. segment. However, even without the impact of this accounting issue, Costco would be more profitable outside the U.S.

This is important because 466 of Costco's 660 warehouses are today located in the U.S. While the company is still opening warehouses in its home country, most long-term growth will come from international markets, where it can earn higher margins. Costco has plenty of room to grow in Asia, and it just opened its first store in continental Europe in May.

As international markets come to represent a larger portion of Costco's business, the company's profit margin should gradually rise. The combination of high single-digit revenue growth and expanding margins should allow Costco to achieve double-digit long-term earnings growth.

Member loyalty

In the U.S. and Canada, Costco membership renewal rates have reached 90% (Photo: The Motley Fool)

The last potential driver of long-term Costco stock gains is member loyalty. In the U.S. and Canada, Costco's two most mature markets, membership renewal rates have reached 90%.

That's a considerable show of customer loyalty, given that there are a variety of reasons why someone might drop a Costco membership, aside from being dissatisfied (for example, moving, becoming an empty nester, or experiencing a change in household income). This loyalty gives Costco pricing power.

In the past, Costco has tended to raise annual membership rates by $5 (or $10 for executive members) every five years or so. The last increase went into effect in late 2011. In another two years, Costco could consider another membership price increase, which would likely bring in $200 million-$300 million in incremental pre-tax profit.

Foolish takeaway

Costco shares currently trade for about 23 times forward earnings. That makes it more expensive than many other retail stocks. However, that premium is fully justified by the three key factors above. 

Of course, this doesn't mean that Costco stock is a sure thing. E-commerce usage is growing rapidly, led by, and Costco has a relatively small foothold in that space. Nevertheless, Costco's industry-leading cost structure is a potent tool to retain customer wallet share.

Costco is likely to return to a faster earnings growth trajectory as soon as next year, as its margin issues begin to ease. That is likely to rejuvenate the stock and lead to above-market returns for long-term investors.

Top dividend stocks for the next decade
The smartest investors know that dividend stocks like Costco simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Read/Post Comments (0) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3068378, ~/Articles/ArticleHandler.aspx, 9/5/2015 10:43:51 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Adam Levine-Weinberg

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry!

Today's Market

updated 13 hours ago Sponsored by:
DOW 16,102.38 -272.38 -1.66%
S&P 500 1,921.22 -29.91 -1.53%
NASD 4,683.92 -49.58 -1.05%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/4/2015 3:59 PM
COST $138.48 Down -2.00 -1.42%
Costco Wholesale CAPS Rating: *****