Costco Wholesale (COST 1.01%) made a splash when it announced a $15 per share special dividend on Dec. 14. Costco has gained a reputation for these surprise announcements, as it pays a rather small ordinary dividend and then occasionally distributes a much larger one-time payment.
Costco has said that special dividends are a part of its DNA. But there are better uses of capital that could reward investors even more. Here's why Costco's special dividend isn't as good as it seems, what Costco could learn from other top companies, and whether the retail stock is a buy now.
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A gilded gift
When it comes to stock price appreciation, Costco has beaten the S&P 500 over the last year, three years, five years, seven years, and 10 years. So it's hard to be too critical of the company, because clearly it is doing a lot right.
Costco's returns have been so good that there really hasn't been a need for dividends at all. Investors who have been holding the stock would surely not think twice about the gains they have received in recent years even if there were zero dividends.
When a stock is crushing the market year after year, the ordinary dividend is an afterthought rather than a core part of the investment thesis. Perhaps this is why Costco's special dividends have been so thrilling.
Costco has been like a rocket ship, and the surprise special dividends have acted like boosters that give the ride an extra jolt in a way that an ordinary dividend simply can't do. The allure of a one-time cash payment that is the equivalent of more than three years of ordinary dividends is exciting and unique, and it fits the overall feel of Costco as an investment, which isn't a reliable dividend stock, but rather something investors expect big gains from -- and are willing to pay a hefty price for.
After all, Costco has a price-to-earnings (P/E) ratio of 45.1 and a forward P/E of 42.3. So it is an extremely expensive stock in general, and especially for a wholesale retailer.
Learning from other companies
Every company has a different capital allocation program. But many excellent companies handle it differently, and arguably better, than Costco.
As an example, let's look at five different companies in five completely different industries -- Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%), Deere (DE -0.18%), Illinois Tool Works (ITW 0.05%) (an industrial conglomerate commonly known as ITW), Procter & Gamble (PG -0.78%), and Apple (AAPL -0.35%).
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With the exception of P&G, all these stocks have beaten the S&P 500 over the last 10 years. A core part of each company's capital allocation program is buybacks.
Warren Buffett-led Berkshire Hathaway is famous for not paying any dividends and using excess cash to repurchase its own stock. But its pace of buybacks over the last 10 years doesn't hold a candle to Deere, ITW, or Apple.
Deere is a unique industrial because it prioritizes growth and buybacks over its dividend. It invests heavily in automation and artificial intelligence, and is a firm believer that these trends will be a part of the next agricultural revolution. It believes in itself, and therefore it feels that buying back its own stock is a better use of capital than distributing dividends.
Similarly, ITW is betting on itself. It has streamlined its business and has very high operating margins, margins that it believes will continue to grow and reach 30% by 2030. Like P&G, ITW is a Dividend King that has paid and raised its dividend for over 50 years. So its ordinary dividend is attractive on its own. But because ITW is so well run, it can afford a hefty buyback program and consistent dividend growth -- a worthy one-two punch and an epic incentive to hold the stock over time.
P&G buys back a lot of stock and boosts its dividend. And although it has lagged the market over the last decade, P&G is a beacon of safety and stability with an attractive yield. It's not a stock you invest in to try and necessarily beat the market, but rather to gain supplement income in retirement and preserve capital. It's also a good example of a well-run business that does a great job of returning capital to investors.
Apple has crushed the market over the last decade. But interestingly enough, its earnings growth, especially recently, wouldn't be as impressive without buybacks. That's because buybacks decrease the outstanding share count, thereby artificially boosting earnings per share (EPS).
Despite its incredible returns, Apple stock isn't all that expensive relative to the market because, in addition to decent net income growth, its EPS has benefited from buybacks. In hindsight, buybacks were a much better use of capital than dividends (which Apple pays too) because they permanently boost EPS and make Apple a better all-around value. Buybacks are a core reason Apple could continue delivering sizable gains for investors going forward.
The thrill factor is overplayed
Costco has done negligible buybacks over the last 10 years. Once factoring in its latest $15 special dividend, it will have paid a total of $37 per share in special dividends over the last 10 years. That decision has proven to be a big problem for the stock.
Costco has done a great job growing its top and bottom lines, but the stock has outpaced those growth rates. And because of that, Costco's P/E multiple has ballooned to 45.1, far higher than its 10-year median of 31.8. If Costco had used cash on buybacks instead of special dividends, it would have been able to buy back its stock at a far lower price than the current price, which would have been a smart use of capital, and it would have made Costco's multiple far lower than it is today.
Costco's strategy is to wait until it has excess cash on its balance sheet and then use that cash to pay a special dividend. This one is going to cost the company $6.7 billion. Other companies tend to use free cash flow on regularly scheduled dividends, which is more predictable.
As we have seen with Deere, ITW, P&G, and Apple, buybacks can work wonders for a company that continues to grow in value, no matter what industry the company is in. Costco stock is now so expensive it makes no sense to invest in it. The appeal is largely centered around its growth and the excitement from the occasional special dividend. But the special dividends get much less exciting once you realize it's one of the worst uses of capital imaginable and it triggers a taxable event, unlike buybacks.
Costco is an amazing company and fun to shop at. But I wouldn't touch the stock with a 10-foot pole -- I don't like how it returns money to shareholders, and the valuation is sky-high. Because Costco doesn't grow its earnings at a torrid rate and it isn't buying back a meaningful amount of stock, the only way its valuation can come down is over time or if the stock undergoes a dramatic sell-off. Those aren't appealing prospects. And for that reason, Costco seems like a poor long-term investment.
