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The Next Blue Chip Stock: Costco Wholesale

By Dan Caplinger – Oct 3, 2014 at 11:30AM

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By taking the retail model and flipping its traditional profit center on its head, Costco has aligned customers' interests with its own.

The retail industry is a cutthroat business, with tough price competition making it very hard for companies to earn big profits, even as they grow their overall sales. Thanks to a revolutionary business model that was almost unheard of at the time, Costco Wholesale (COST -0.51%) found a way to gain impressive profit margins while still offering rock-bottom prices on the merchandise that its members want to see.

Costco's strategy seems ridiculously simple in hindsight, yet it represents a huge departure from traditional retail. Charging an annual membership fee to get into the store might drive some customers away, but it also piques the curiosity of some who see membership as a mark of distinction.

Then, once you've paid the price of admission, Costco gives its customers bargains you won't find anywhere else -- because it doesn't have to earn a big profit from merchandise sales. Let's take a closer look at some of the factors that turned Costco into a blue-chip stock, and why it should continue to improve over time.

Costco dominates the membership-based retail market
Costco isn't the only player in retail using a membership model, with Wal-Mart's (WMT 0.29%) Sam's Club being its main rival. But Costco has had a huge amount of success in its efforts. According to the company's 2013 annual report, Costco had 28.9 million Gold Star members, and 6.6 million business members, with 648 warehouse locations in operation as of the end of last year.

Moreover, Costco has demonstrated its ability to generate customer loyalty. Membership retention rates remained at 90% in North America and 86% worldwide, helping to boost overall membership-fee income by 10% last year. That's been an extremely important component of Costco's overall success, as the company has had its membership-fee revenue exceed its net income in each of the past five years, and is likely to continue to do so in the future.

Costco has kept its balance sheet solid
Many struggling retailers have seen their debt levels rise in the past, as losses from fickle shoppers abandoning their stores has forced them to tap lines of credit and other sources of cash. But Costco has always been fairly conservative in its capital management, keeping long-term debt to a minimum.


Source: Costco Wholesale.

Costco raised some eyebrows in late 2012 when it said it would pay a $7 per share special dividend immediately before a rise in tax rates on dividend payments was scheduled to take effect. Instead of using available cash to fund the dividend, Costco issued $3.5 billion in debt, with maturities ranging from three to seven years. Given its past practices, it's likely that Costco will simply retire the debt when it comes due; but bond-rating agencies nevertheless seemed concerned at the uncharacteristic move from the warehouse retailer.

How Costco expects to grow
Even with its capital discipline, Costco hasn't been afraid to spend money to grow its business. The company is likely to spend more than $2 billion on capital investments during the current fiscal year, with nearly all of the cash going to fund Costco's ongoing store expansion efforts. Given the immense size of new stores, Costco has to spend substantial amounts on real-estate acquisition and development costs, especially when you consider typical add-ons that include gasoline sales.

Costco's growth plans include both domestic and international expansion. New locations within the U.S. seek to take advantage of gaps in the company's already impressive coverage, but larger long-term opportunities exist in serving international markets like Japan and Korea. Even though peer PriceSmart (PSMT 0.03%) already covers portions of Latin America and the Caribbean, the potential for Costco to expand worldwide is huge.


Source: Wikimedia Commons.

Costco is a leader in business
Costco's most impressive achievement is the reputation it has built as a steward, not just for shareholders, but for employees and the community, as well. Unlike many other big-box retailers, Costco pays healthy wages to its workers, and it also offers benefits like company-sponsored health insurance, for which employees pay only a minimal contribution toward the total cost of coverage. The company has also made efforts to support the environment through moves like heightened use of solar power and adoption of sustainable fishing practices as sources for its seafood.

Overall, Costco makes a strong case for being among the blue-chip representatives of the retail industry. Costco's business doesn't operate the same way as many retailers; but in the long run, it has demonstrated its ability to be profitable and produce consistent growth to keep shareholders and other stakeholders happy with the company.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale and PriceSmart. The Motley Fool owns shares of Costco Wholesale. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Walmart Inc. Stock Quote
Walmart Inc.
WMT
$153.51 (0.29%) $0.44
Costco Wholesale Stock Quote
Costco Wholesale
COST
$530.92 (-0.51%) $-2.74
PriceSmart Stock Quote
PriceSmart
PSMT
$72.03 (0.03%) $0.02

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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