Fool.com: Dream Team II: Costco (Fool On the Hill) August 6, 1999

FOOL ON THE HILL
An Investment Opinion

Dream Team II: Costco

By Warren Gump (TMF Gump) (TMF Gump)
August 6, 1999

In Tuesday's column, I discussed that the current malaise in many Internet stocks might finally create an opportunity for me to jump into a couple of leading companies at values that don't seem totally crazy given their growth prospects. Several astute Fools noted on our message boards that there are many interesting opportunities developing in other sectors of the economy, as well. Those comments inspired me to look around for other companies I've wanted to own for a while, but have been reluctant to buy because they were trading at valuations higher than what I felt comfortable paying. Costco Companies (Nasdaq: COST) is the company I decided to delve into today.

Before taking a look at what's going on at Costco, I want to take a minute to talk about my investing strategy, which differs some from that of many Fools. That's really not too surprising since everyone's strategy incorporates some personal biases. For example, I doubt you'd find The Famous Chicken clucking about an ownership stake in Tyson Foods (NYSE: TSN).

I have enormous respect for leading and stalwart companies, those filtered out by strategies such as the one used by the Motley Fool's Rule Maker Portfolio. These are companies that have a massive presence and strong economic fundamentals that should allow them to grow and withstand changing consumer preferences and various competitive threats. Managers of the Rule Maker Portfolio believe that their companies are so strong that they don't need to worry about valuation. Even if these companies are currently overvalued using traditional financial metrics, the portfolio managers believe that the companies will grow enough over a ten-year time horizon to make the stock look cheap ten years hence.

Most of the time, the Rule Maker dudes will be correct. They have selected some terrific organizations whose stocks might look quite expensive to me today, but their quoted prices will be higher in ten years as the company grows. Despite that likelihood, my frugal nature results in a strong preference for acquiring the stock of a solid company after it has been beaten down rather than after it has run up dramatically. Virtually all stocks have fairly dramatic price fluctuations over the course of a year. To me, it makes more sense -- from a long-term perspective -- to buy these stocks when their price is falling rather than when it is rising.

Buying into a stock when it is falling does at times take nerves of steel. One of the primary reasons an equity is beaten up is that negative news has emerged and investors are questioning a company's ability to withstand market changes or impending competition. At those times, people tend to be focused on only the risks of the company (the glass is 1/20th empty). No one knows exactly when a shift to more realistic lenses (the glass is 95% full) will occur. A pessimistic stance could be maintained for a couple of weeks, a couple of months, or a couple of years. During this phase, the risk of having misanalyzed the company in the first place is a constant overhang.

If your original analysis was correct, however, a Rule Maker-esqe company should be able to emerge relatively unscathed from temporary weakness. When this recovery (or reduction of investor fear) occurs, the stock price should once again start to move higher.

Not all stocks are knocked down because of company-specific news. Sometimes they are hit because their sector is "out of favor" -- that is, market timers are trying plowing their money into another sector because it has the brighter near-term prospects. At other times, stocks simply fall because the market is down, or for whatever reason, investors are putting their money in something other than equities. These last two cases, where no negative company-specific news is emerging, tends to be the psychologically easiest time to invest in a company you like.

In a roundabout and long-winded way, that brings me back to Costco. I've had this company on my radar for most of the year due to accolades from fellow Fools Dale Wettlaufer and Yi-Hsin Chang. The stock more than doubled from $41 last October (when I wish the stock had been on my radar) to $94 in April as investors embraced the stock. During that period, I was starting to get to know the company and didn't feel comfortable paying more than 25x prospective earnings for the company. Over the past few months, however, the stock has fallen into the $70-$75 range. I can't find any company-specific bad news and assume that the fall is related to investors shifting out of retailers.

For those of you not familiar with Costco, it operates 290 warehouse clubs primarily in the U.S. and Canada. It also operates a few international locations in the United Kingdom, Korea, Taiwan, and Japan and has a joint venture with 16 locations in Mexico. These clubs offer a limited selection of fast selling products, including food, electronics, household supplies, jewelry, and books at rock-bottom prices. If you think K-mart (NYSE: KM) is cheap, you probably haven't been to a warehouse club. On average, Costco charges customers 11% more than it pays for merchandise, whereas K-mart charges about 28% more than its costs.

How does Costco get away with charging so little? First, it minimizes expenses by selling only quickly moving merchandise, buying in bulk, operating a bare-bones warehouse, and minimizing inventory loss due to theft. The company also charges its members -- as of last August, membership rolls totaled more than 12.4 million businesses and individuals -- an annual fee for shopping at the stores. Customers are willing to pay these fees, which range from $35 to $100 because of the company's low prices. Last year the company recorded $439 million in recurring membership fees, almost all of which drops straight to the bottom line.

Customers keep coming back to Costco because of its low prices and the quality products it sells. In fiscal 1998, 64% of sales were derived from consumables such as food, tobacco, heath & beauty aids, and cleaning supplies. These products tend to be purchased fairly regularly throughout the year, creating a steady stream of customer visits. In addition, if you are interested in one of the higher-priced items that Costco sells like electronics, you might choose Costco over another retailer because you can also pick up some of your regularly purchased items at the same time.

Naysayers might point out that the industry has saturated the market and there isn't much room for growth. Counting Costco's stores and those of competitors such as Wal-Mart's (NYSE: WMT) Sam's Club and BJ's Wholesale Clubs (NYSE: BJ), there are over 900 warehouse clubs in North America. There simply isn't too much of a need for many more clubs here. Costco has recognized that fact and has been adding only 10-20 units over the past several years. A few of these have been in international markets with different competitive dynamics and the potential for much more store growth.

With a relatively slow-growing store base, Costco relies on same-store sales growth to increase profits. The company has not disappointed on this front. Over the past two years, monthly same-store sales increased have ranged between 6%-11%, averaging 8%-9%. Maintaining this sales growth is important, since higher volume usually enables the company to lower costs and prices, resulting in even higher sales.

The company's earnings have shown steady improvement since its merger with Price Club in 1993. Profits increased from $1.66 per share in fiscal 1997 to $1.96 last year. For fiscal 1999, which ends this month, the First Call analyst consensus calls for another 19% profit improvement to $2.34 per share. Over the longer term, analysts foresee annual growth of about 15%. Based on those estimates, the stock is trading at about 31x current year estimates and 27x projections for next year, just a tad above the level of the Standard & Poor's 500 index.

When evaluating Costco, you should notice that the company is generating more cash than it is expending on new buildings and equipment, a somewhat unusual phenomenon for a growth retailer. Last year, cash flow from operating activities was $738 million, yet it spent only $572 million on capital expenditures. This trend has continued this fiscal year, with $644 million of operating cash flow and $529 million in capital expenditures through May. This extra cash can be used to reduce debt or buy back stock. You probably won't be surprised to learn that the company authorized a three-year $500 million stock repurchase program last October.

I have absolutely no idea as to what the "right" P/E multiple for Costco might be. While my target "buy" point of a 25x prospective P/E takes into account where the market and other retailers are trading, it mainly represents an arbitrary level from which I envision substantial appreciation over the next few years. The stock may or may not hit this target, which implies a price of $67. It could be hit next week. Then again, the price may start a swift move up next week, closing my window of opportunity to take the plunge. In that case, I'll simply have to wait for another downturn. In the meantime, I'll stay on the lookout for other excellent companies in the marketplace.