With a dividend yield of just 1.1%, Costco Wholesale (COST -1.85%) is probably not on anyone's list of best dividend stocks. But long-term investors know that the warehouse retailer is more generous than first glance might indicate.
In recent years, the company has paid out two special dividends. In December of 2012, it issued a special distribution to shareholders of $7/share, and followed that up with a $5/share payout in February 2015.
Those payouts are more than the company has made in regular dividends since it began paying quarterly dividends in 2004, with the quarterly dividend now at $0.45 per share. Considering how big of a reward each of those special dividends were, investors may be wondering if they can expect another such special payout from Costco. To answer that question, let's take a look at the circumstances under which management decided to offer those previous dividends.
A little history
Costco's first special dividend in December 2012 cost the company approximately $3 billion, and came at a time when sales were thriving -- it had just completed a year when comparable sales increased 6%, earnings per share were up 18%, and membership fees increased 11%.
CFO Richard Galanti explained the move at the time, calling it "our latest effort in returning capital to our shareholders while maintaining our conservative capital structure. Our strong balance sheet and favorable access to the credit markets allow us to provide shareholders with this dividend, while also preserving financial and operational flexibility to grow our business globally."
Notably, Costco only had $3.9 billion in cash on its balance sheet, meaning that that special dividend would have wiped out more than three-quarters of its cash balance.
The company instead took out $3.5 billion in long-term debt to fund it, at interest rates between 0.65% and 1.7% with maturities between 2015 and 2019, hiking its long-term debt from just $1.4 billion to nearly $5 billion.
In 2015, Costco made a similar move, allocating $2.2 billion to pay a special dividend of $5 a share, with CFO Galanti using much of the same language to justify the decision.
By that time, the company's cash balance had ballooned to $6 billion, though it still owed $5 billion in long-term debt. Costco borrowed $1 billion at interest rates of 1.75-2.25% and paid the rest of the dividends out of cash.
Where Costco stands today
The warehouse retailer has paid such special dividends because while maintaining a regular dividend payout ratio of about 33%, meaning there's plenty of cash left over to reinvest in the business or save for future use. Unlike other companies that pay out most of their profits in dividends, Costco seems to prefer to keep its regular dividend modest to allow for occasional special dividends depending on performance. This gives management more flexibility in how it returns cash to shareholders. Since investors expect regular dividend increases, companies with high payout ratios can be stuck not investing enough cash into their businesses if they instead use the money to keep the dividend rising.
As of its most recent earnings report, Costco had $4.9 billion in cash and $5.1 billion in debt. However, with falling gas prices and a stronger dollar, the company's profit growth has turned negative this year, though its underlying comparable sales and membership fee growth remain positive. Corporate borrowing rates remain low, however, and are likely to rise in the near future as the Federal Reserve is expected to raise the benchmark interest rate. Through the first three quarters of this year, the company's cash balance has remained flat as it paid down $1.2 billion in debt and returned about $700 million to shareholders through share buybacks and dividends.
Based on Costco's history and its low dividend payout ratio, I would expect the company to eventually issue a special dividend. However, Costco doesn't generate enough profits for a payout of $5 or $7 a share every year. Given its current circumstances, the company will likely wait for profit growth to return and for its cash balance to grow substantially ahead of its debt, which should take a year, if not two.