Is Costco's Dividend Sustainable?

Costco (COST 0.54%) has paid a quarterly dividend to shareholders consistently since May 2004. It has also paid out two larger special dividends, in December 2012 and February 2015. Shareholders who have held onto the stock have been rewarded with ever-increasing payouts, ranging from $0.10 a share per quarter in 2004 to a recently distributed $0.40 per share payout on May 15. That's a 13.4% compound annual growth rate over 11 years and at recent prices the stock yields 1.2%.

A track record of consistent and prudent dividend payments is a good sign for the security of a future dividend stream, but it is no guarantee. While many Costco shareholders, including myself, have been invested mostly for the outsize growth opportunities, one can easily see this company evolving into a prodigious dividend payer in the future. In order to assess the safety of its dividend, let's take a look at three questions.

1. Does Costco have a strong business model and predictable cash flows?
Without a belief that future earnings will be there to support future dividend payments, no amount of cash on the balance sheet should convince an investor to buy a stock for its dividend. Costco has a tremendously strong business model and competitive advantage, or "moat," with regards to its cost advantages. By buying a small number of items and a ton of those products, it can drive down its costs. No item can be marked up by more than 15%, which causes the company to operate on razor-thin margins of generally 2%-3% while providing great value for its customers.   This value proposition is what promotes such incredible loyalty from Costco members toward the company. 

The company is rock-solid in its business model and the cash flows are predictable as the vast majority of earnings come from its membership model. Consumers and businesses pay a flat fee up front for the privilege to shop in Costco's 673 warehouses. This revenue drops almost entirely to the bottom line. The renewal rate is approximately 90% overall, which shows that consumers are happy with the company and are likely to plunk down their membership payment next year as well. Membership fees for the latest quarter were $584 million compared to $561 million for the same quarter of 2014.

Powerful and predictable cash flow is a good sign for dividend safety. Costco has grown yearly revenue from nearly $89 billion to over $112 billion over the past few years, while increasing EPS from $3.31 in 2011 to $4.65 in 2014. In it's most recent quarter EPS was $1.17 compared to $1.07 the same quarter last year while revenue remained largely flat year over year. These are healthy growth numbers for a $60 billion dollar company that went public nearly 30 years ago.

2. Is Costco management in good hands?
Costco is often named as one of the best-run companies in corporate America. It has only had two CEOs in its history. Jim Sinegal from 1983-2012 and longtime Costco vet Craig Jelinek since then. Both men have been a part of creating and protecting a valuable corporate culture that helps to secure great employees, provide excellent assistance to customers, and prevent frivolous waste in the C-suites.

In 2011 as CEO Sinegal received $350,000 in base pay and just over $2 million in other compensation. While that is a lot of money, it's much lower than what some peers got. In that same year the CEO of Wal-Mart  earned about $18.7 million. 

Sinegal's successor, Jelinek, receives base pay of $650,000. In 2013 Wal-Mart's CEO pay to median employee pay ratio was 1034:1, Target came in at 597:1, while Costco was 57:1. Costco's CEO is the one I want to be partners with as (relatively) conservative pay is a good sign of prudent financial management. 

3. Is the current payout ratio conservative enough?
Even the greatest business in the world won't be able to protect its dividend if it's paying out significantly more than it takes in. Cash reserves burn out, debt markets dry up, and the dividend must be cut or eliminated. Costco does not have this problem to worry about for the foreseeable future. It's trailing-12-month payout ratio is 30.7%, which means it could more than double its current payout without any expansion in free cash flow and continue to pay it without much worry going forward. The company has judiciously used large special dividends to juice cash returns to shareholders. Doing so allows them flexibility to keep their quarterly payout ratio very manageable. 

Costco has a relatively low yield compared to some of its competitors. This is partially due to the fact that it has been such a wonderful growth story. The stock price has more than doubled in the past five years and as a result the effect of the dividend hikes have kept the yield in a similar range.

For someone who bought the stock earlier on, their yield on cost will be significantly higher. The use of special dividends further muddies the true yield received by investors. This year's special dividend of $5 per share yielded 3.4% on its own.. I'm sure the dividend yield will rise as store growth slows and less money is poured into these new investments. This is not something to necessarily look forward to, but Costco will become a fully mature concept at some point in the future.

As mentioned above, I trust management to be shareholder-friendly, competent merchants who understand good capital allocation. Costco's dividend looks very safe and for a long-term Foolish investor, I recommend picking up some shares.