Why should you own Costco
Actually, I'd like to build the argument up in stages, because most people don't understand the warehouse-club business. Once it "clicks" for an investor why clubs are the best and most advanced retail model, it's only natural to want to own the best club operator in the world.
Retail or distribution?
Warehouse clubs started in the '70s with The Price Company. By the mid-'80s, there were seven companies in this business, but industry consolidation reduced that down to the three operators we have today -- Costco, the Sam's Club division of Wal-Mart
The idea is simple but incredibly effective. Instead of being a traditional retailer, be a distribution company instead. Carry only a limited assortment of the best items in each category. Price them at "operating cost," only enough to cover expenses -- which means a price that no other retailer can match. Make your profit by charging people a membership fee for the privilege of shopping at your warehouse. It's much closer to a distribution model than traditional retail.
Dodge and frisk
It's really an ingenious model. Customers pay to walk in the door -- there's someone there to check to make sure. There are no frills once they are inside, only concrete floors and steel racks. Need a single item? No can-do, because shoppers must buy large quantities while they're dodging forklift trucks. To finish it off, you limit payments to cash or a company-sponsored credit card and then frisk patrons as they leave to make sure they aren't stealing anything.
The virtuous circle
Sound inviting? It really isn't, and yet the value proposition of high-quality merchandise at the lowest possible prices is overwhelmingly powerful. The company owns the "virtuous circle" that every retailer strives for: Higher volume means expense leverage, passed on as lower prices, which drives ever higher volume. Costco generated $127 million in sales per building last year -- higher than any other retail company. I could rest my case right here, but let's get under the covers a bit deeper -- it gets even better.
Sales and membership drive it all
Look at the first page of Costco's annual report. It's the only retailer I know that publishes average store sales by year of opening, also known as "vintage." Not only has the company grown average sales per building every year, but each annual "class" of new stores has grown average sales per building every year, as well. By the way, the 25 new warehouses opened last year started off with $92 million annualized sales, the highest first-year sales of any "class" in the company's history. Wal-Mart just announced that it is slowing new Supercenter growth to curb cannibalization. Costco has new store openings figured out.
Membership is what drives warehouse club sales. Costco has 22.5 million primary members. We can interpolate that into approximately 18.2 million domestic primary members (I'm not counting add-on members), meaning more than one in every 10 U.S. households owns a Costco card. These people aren't popping into the warehouse to pick up milk and bread; they're stuffing shopping carts to the tune of about $100 per transaction, three to four times Wal-Mart's average ticket.
Even with this kind of saturation, the membership base is growing at a double-digit rate, and last year 87% of existing members plopped down $50 to $100 for the right to give their shopping dollars to Costco for another year. It's no wonder the company delivers mid- to high-single-digit comp sales like clockwork. Costco doesn't even feel the need to advertise to the general public, because members know that everything in the store is offered at the best price all the time.
New merchandise categories
It used to be that Costco's focus was food and general merchandise. Not anymore. The company has been highly innovative in developing new categories of stuff to sell. Over the past 10 years, Costco has grown pharmacies, photo centers, optical shops, and gas stations into important parts of the business.
Check out a Costco gas station in states where gas prices are particularly high, like California. You'll see lines of cars six to eight across and five to 20 deep. Why anyone would wait that long to save $0.10 a gallon is beyond me, but they do. Since the early '90s, Costco's pharmacy business has grown to more than 26 million prescriptions filled per year, during the same time that Walgreen
A screaming buy?
Costco is hands-down the best of the three warehouse-club operators. But some investors will look at the numbers and question whether the stock is a good value. They'll say the best growth years are behind the company, or flinch at paying a P/E multiple higher than 20 or a PEG ratio higher than 1. My view is that Costco's stock price is rarely a screaming buy.
The ace in the hole for Costco investors is that management cares more about their members than they do about Wall Street analysts. They don't try to downplay hiccups in the business. This means that about once a year, the stock price catches a serious cold for a few months. You can see it in a five-year chart. Those are the times when the stock is truly a great value. With the retail industry looking like it's about to get a case of the flu, we could easily see the stock in the low $50s. I would judge that to be a superior value.
Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles, and owns shares of Costco and Wal-Mart. No membership card is necessary to read the Fool's disclosure policy.