Costco (NASDAQ: COST) is not a stock that requires an introduction for many investors. Even if you aren’t one of the retailer’s 140 million cardholders, you have surely seen its massive warehouses. You might shop at a few small businesses that source their products from Costco, too.
All told, the company books more than $250 billion of annual sales, putting it in second place behind Walmart (NYSE: WMT) in the battle for physical retailing dominance.
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Costco has a powerful business model that’s made the stock a favorite on Wall Street for decades, and so you’ll rarely get a chance to buy shares for a screaming deal. But that doesn’t mean you should ignore it as an investment opportunity. In fact, Costco could be just the right addition to your portfolio now. Here’s why.
1. Customer loyalty
Shoppers are famously fickle when it comes to deciding where to purchase their daily essentials, and there’s always a competitor out there ready to steal your market share. Yet Costco has managed to hold on to (and expand) its customer base through a wide range of selling conditions since its founding in 1983.
It helps that Costco operates as a membership club rather than a retailer, which provides an incentive for members to try to maximize the value they get in exchange for their annual fees.
You can see evidence of Costco’s stellar customer loyalty in its growth rate. In April, it was a healthy 7% in the core U.S. market and 13% across its e-commerce channels. A more effective metric to follow is the chain’s renewal rate. That’s been hovering near all-time highs of 93% lately, indicating that shoppers remain thrilled with Costco’s low prices and its no-frills shopping approach.
2. Cash flow
Costco’s profit margin is the lowest in the business because its selling model relies on membership fees to subsidize the low prices it offers. The chain’s operating profit margin is below 4% of sales, compared to Walmart’s 4.3% and Target‘s (NYSE: TGT) 5.2% rate.
Concentrate instead on Costco’s annual operating cash flow, which jumped to more than $11 billion from below $5 billion in the past decade.
COST Cash from Operations (TTM) data by YCharts.
Success here funds investments in growth initiatives like the company’s highly successful online shopping channel. It also gives management resources to periodically send big lump sums of cash directly to shareholders in the form of special dividends. Further payouts like these should buffer your long-term returns while holding this stock.
3. Price and value
It’s true that you’ll have to pay up for such a successful business. Costco shares today are trading at nearly 60 times earnings, as compared to price-to-earnings ratios of 40 for Walmart and just 11 for Target. The premium shrinks when you consider the price-to-sales metric, with Costco trading at 1.7 times sales compared to Walmart’s 1.2.
If you’re risk-averse, that higher valuation might convince you to watch the stock for a chance to pick it up at a discount during the next market downturn. Costco also isn’t ideal for income investors, since its dividend yield is relatively low and it’s impossible to predict when the next special dividend will be announced.
However, for most investors, this retailing business is likely to boost their portfolio returns. Over the next several years, the chain should expand its sales base, improve cash flow, and keep thrilling subscribers with low prices and a great merchandise selection.
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Demitri Kalogeropoulos has positions in Costco Wholesale. The Motley Fool has positions in and recommends Costco Wholesale, Target, and Walmart. The Motley Fool has a disclosure policy.
