Why Costco Will Continue Outgrowing Wal-Mart and Target

Because of its superior business model and corporate culture, Costco is positioned to continue outgrowing Wal-Mart and Target for years to come.

Andrés Cardenal
Andrés Cardenal
Nov 30, 2013 at 8:30AM
Consumer Goods

Costco Wholesale (NASDAQ:COST) has been one of the most remarkable growth stories in big box retail over the last years. However, when compared against industry peers like Wal-Mart Stores (NYSE:WMT) and Target (NYSE:TGT), the stock is trading at a considerable premium. Can Costco continue outgrowing the competition in order to justify its valuation?

Growth and valuation
When comparing valuation ratios for Costco against Wal-Mart and Target, the company looks materially more expensive than its peers: Costco has a P/E ratio of 27 versus 15.3 for Wal-Mart and 15.4 for Target. Also, while Wal-Mart and Target pay dividend yields of 2.4% and 2.7%, Costco´s yield of 1% is substantially lower.

That premium is easy to understand in terms of past performance, Costco has outgrown both Target and Wal-Mart by a wide margin over the last years, and superior growth deserves a premium valuation.

Especially in a mature and competitive industry like discount retail, where one company´s gains are in many cases the other one´s loses, sticking with the winning players can be a factor of utmost importance, and this is a powerful explanation for Coscto´s premium.

On the other hand, in business and investing past performance does not guarantee future results. Investors need to take a look at the company's fundamentals and competitive strengths to evaluate whether Costco can justify its premium valuation or not on a forward looking basis.

Competitive strengths
Costco has a smart and fairly unique business model, the company makes most of its profits from membership fees as opposed to gains on merchandise sales. This allows the company to sell its products at razor-thin profits, or even at a loss. Price competitiveness is a key strategic factor in the industry, and Costco's business model provides an advantage versus the competition.

Wal-Mart has been expanding its Sam´s Club business which has a similar membership-based business model, but it hasn´t been able to achieve the same kind of success among customers. While Costco delivered an increase of 5% in US same store sales excluding gasoline for the last quarter, Sam´s Club comparable sales without fuel increased by a much lower 1.1% as of the latest earnings report.

Costco is completely focused and specialized in its membership-based business model, this is not only a source of competitive strengths, but also a valuable trait for shareholders from a financial point of view. Since profits depend mostly on fees which the company collects in advance, this provides Costco with with higher stability when it comes to sustaining cash flows through the ups and downs of the economic cycle.

Another differentiating factor for Costco is the company´s atypical human resources policies and corporate culture: Costco pays higher salaries than the competition, the company offers more generous benefits like health care and 401-K plans and it provides more opportunities for professional growth and promotion to employees of different levels.

Attracting and retaining the best talent in the industry has important implications for the competitive dynamic in the sector, and it also means more profitability for shareholders on a long-term basis. In the words of the company's CEO, Craig Jelinek, as quoted in a Businessweek interview:

"We know it's a lot more profitable in the long term to minimize employee turnover and maximize employee productivity, commitment and loyalty"

Room for growth
Costco is planning to open 36 new warehouses in fiscal 2014, half of them in international markets. This is a considerable ramp-up versus 26 new locations opened during fiscal 2013.

Strong comparable sales data is proving that new openings are not cannibalizing sales at existing stores, so management is doing the right thing by betting on growth. In addition to that, Costco has barely tested the waters in international markets and the company has plenty of untapped opportunities for global expansion.

If Costco can replicate, at least partially, the level of success it has obtained in the US on a global scale, the company should continue generating healthy growth rates for shareholders over years to come.

Bottom line
Costco is priced at a premium versus competitors like Wal-Mart and Target, but that´s no reason to stay away from the company. Costco has a differentiated business model and a superior corporate culture in addition to plenty of room for expansion, both in the US and abroad. Costco will most likely continue outgrowing Wal-Mart and Target over the coming years, and for that reason it deserves a higher valuation.