Image source: Costco.
Costco (COST 0.94%) is a best-of-breed retailer that will very rarely look cheap by conventional valuation metrics. Nevertheless, I think now is a great time to pick up some shares and learn more about this wonderful long-term investment.
FY15 sales growth better than it looked
Costco announced its fiscal 2015 sales results in early September. At first glance, these results can be a bit distressing. For the past 52 weeks, U.S. sales are up 3%, but international sales are down 4%, leading to a company average of a mere 1% sales increase. When looking just at August sales numbers overall, sales are down 2%. We would always like to see sales increasing, but upon deeper analysis, these numbers don't concern me in the least.
Excluding the negative impacts of gasoline price deflation and foreign exchange, the yearly sales numbers look markedly better. Sales increased 6% in the U.S. and 7% internationally, while August sales were up across the board as well. I'm usually a bit skeptical when companies use ex-currency numbers or "one-time events" when releasing their figures. It's like someone saying, "I'm 200 pounds, but ex the 20 pounds I gained over the holiday season I'm right at my target weight." The 20 pounds are real, just like currency fluctuations and gas prices.
But with Costco, the adjusted numbers matter more than you might think. Costco derives nearly all of its net income from membership fees and continuously operates with a net margin under 2%. As a result, member retention and customer happiness are the most important factors. Currency effects and gas price deflation can skew the numbers. Even if more people are filling up at Costco pumps, overall revenue from these transactions might be down. But having happy repeat customers is critical, as they are very likely to renew their memberships. Costco has a greater than 90% overall renewal rate, so it knows how to keep members happy.
International: Limited opportunity or pitfall?
Costco management has done an incredible job building into a $60 billion market cap business by focusing almost exclusively on North America and in particular the United States. Of its current 686 warehouses, 480 are in the U.S. and Puerto Rico, 89 operate within the borders of our neighbor to the north, and Mexico houses 36. If Costco can moderately replicate its North American success in Western Europe, South America, and China over the coming decades, the growth runway is immense.
Concerns have been raised that the Costco warehouse model isn't suitable for many of these foreign locales, and that's why international expansion has been so stunted. While some modifications might have to be made -- perhaps smaller stores or different layouts -- I think that over time, consumers in other countries will grow to embrace the value proposition Costco offers. I feel comfortable with the company's current growth trajectory, but there is optionality for explosive future growth if management can figure out how to succeed in some of these massive foreign markets.
Fair valuation?
Costco's forward P/E of 24.6 is right in line with its five-year average of 24.8. Over the previous five years, shares delivered a 135% return, and the company is operating as well as ever. I have very rarely seen bargain valuations for Costco and think this current valuation is fair for considering opening a starter position.
Sneaky high dividend
Costco can sometimes fall off of the radar for investors seeking income. Its forward yield is only 1.16%, while its trailing yield is 4.7%. This isn't due to a dividend cut or a quadrupling of the share price, but rather because Costco management sometimes makes use of special dividends. In both 2012 and 2015, management paid out significant one-time dividends of $7 and $5, respectively. Considering the current payout is $0.40 per quarter, you can see how significant these were. As of early October, the stock was yielding just over 1%.
With a 28% payout ratio, there is plenty of room for management to continue to pay and raise the regular dividend for years to come. I also have every expectation that when the time is right, shareholders will continue to be rewarded with juicy special payouts. EPS growth, share buybacks, a growing quarterly dividend, and the occasional large special dividend should continue to lead to very solid returns for Costco shareholders. Even though it's never super-cheap, this is one of the very best companies in corporate America. Even Charlie Munger holds a board seat. I look forward to decades of ownership to come.
