- Costco resides at the No. 2 spot in terms of market leadership behind Wal-Mart.
- Costco’s fundamentals have expanded at a decent pace over the past five years.
- As of today, Costco sits on a solid balance sheet.
Membership warehouse chain Costco (NASDAQ:COST) really sets itself apart by offering fewer SKU units, which enables the company to focus on volume. This also enables the company to profitably offer lower prices to its customers. The company expanded its footprint from 592 locations in FY 2011 to 697 locations in FY 2015. Costco manages to consistently grow sales at its established American locations. Over the past five years, Costco’s stock price increased 126% versus 62% for the S&P 500 (see chart below).
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A market leader
Fewer SKUs help build the company’s position as a market leader. Costco commands an 18% market share in the North American Mass Merchants market giving it the No. 2 spot behind Walmart (NYSE:WMT) and ahead of the No. 3 spot held by Target (NYSE:TGT), according to the Bloomberg Leaderboard. Wal-Mart commands a 57% market share.
In terms of sales, Costco resides in the No. 3 spot, according to the National Retail Federation’s “Top 100 Retailers Chart 2015”, with $79.7 billion in 2014. Grocery chain Kroger (NYSE:KR) actually holds the No. 2 spot on this list with $103 billion last year. Of course, the juggernaut that is Wal-Mart holds the No. 1 spot with $343.6 billion in 2014 sales.
Costco’s revenue, net income and free cash flow expanded 49%, 82% and 10%, respectively, over the past five years due to location expansion and an increase in same store sales. Costco’s comparable sales in FY 2015 registered at 7% versus 0.5% at Sam’s Club when excluding fuel sales. So far during FY 2016, Walmart’s Sam’s Club same store sales increased 0.4% when excluding fuel versus 6% for Costco.
Balance sheet in solid shape
Costco sits on an excellent balance sheet. In FY 2015, Costco lowered its long-term debt 5% year-over-year. Costco’s FY 2015 operating income exceeded interest expense by a very prudent 29 times. In the most recent quarter, its cash balance stood at $6.3 billion, which equated to an incredible 57% of stockholder’s equity at the end of FY 2015. Costco’s long-term debt came in at $4.8 billion, a reasonable 44% of stockholder’s equity in the most recent quarter.
Solid regular dividend
Costco paid a $5 per share special dividend in February 2015 in addition to its regular dividend. Costco’s total dividends in FY 2015 amounted to $6.51 per share, equating to 151% of its free cash flow. The company even went into debt to pay this dividend, which I disagree with because….companies should always return capital from their free cash flow and balance sheet.
Normal dividends equated to an estimated $668.5 million when multiplying the normal dividend of $1.51 by 442.7 million diluted shares outstanding, making up a reasonable 35% of Costco’s FY 2015 free cash flow. Costco’s current normal annual dividend rate equates to $1.60 per share per year translating into a 1% yield.
Costco Stock Valuations
Like most companies that are currently doing well, Costco comes at a high valuation. Costco’s P/E ratio clocks in at 30 versus 19 for the S&P 500 (see chart below). Costco’s P/E resides near a five year high, which is also true for the S&P 500. To put things into perspective, a P/E of 19 would put Costco’s stock price at $101.46 representing a 37% decrease from its current share price.
Source: Costco PE ratio chart by amigobulls.com
Keeping SKUs lower so that it can buy more of fewer items represents a brilliant strategy for Costco and its shareholders. This translated into superior fundamentals for the company and subsequent superior returns for its shareholders. The company exercises prudence in the managing of its balance sheet. Hopefully, Costco won’t make a habit of going in for debt to pay dividends.
Wall Street’s appreciation for Costco’s efforts translated into a high valuation for the company, giving it a high market price risk. Any earnings disappointment, market correction or fears surrounding the encroachment of e-commerce could send the shares of this company plummeting. Right now prospective investors may want to wait for a better valuation.