Why Investors Should be Buying Costco Stock in Bulk

Market volatility may be the norm as we head into election season and third-quarter earnings reports. And so some investors may be looking for a defensive stock to hunker down with for the rest of the year.

Costco (NASDAQ:COST) not only looks attractive as a short term play ahead of its September 24^th earnings report, but is a good bet for long term portfolios.

After suffering a relatively benign downturn in March, Costco shares have resumed their steady upward climb. Traders who noted the July 9^th gap up past resistance in above-average volume may have taken advantage of this bullish move. But since following the market down from its September 3^rd peak of $363.67, Costco looks to be once again bouncing off its 50-day moving average.

While this suggests the all-time high will soon be re-tested, investors need not find the perfect entry. Costco is the type of stock you can buy and hold for the next 10 years and beyond. The company's growth metrics and fundamentals are among the best in the S&P 500.

It should then come as no surprise that Warren Buffet's Berkshire Hathaway is a top shareholder and his sidekick Charlie Munger sits on Costco's board.

The Buffet effect aside, let's take a look at some of the reasons why investors should stock up on Costco.

How are Costco's Fundamentals?

Costco has a dominant position in the warehouse retail space. As the world's third-largest retailer, it offers a wide range of quality products at low prices. Electronics, apparel, jewelry, produce, bakery goods, meat, seafood, and wine are just a small sample of what's under a Costco roof.

The simple combination of enormous variety and discount prices has driven five-year sales and earnings growth rates of 6.6% and 10.2%, respectively.

Several data points from the last 12 months give investors a good sense of Costco's fundamental strength. Its gross profit to assets ratio is 0.42. This means it is generating 42 cents of profits for every dollar of assets. Not bad considering its $48.8b asset base is largely comprised of its 114.6 million square feet of warehouse space.

Despite operating in a low margin retail business, Costco's profitability is impressive. Its return on equity (ROE) of 22.6% is on par with that of technology behemoths like Facebook and Amazon. Although it has come down from its 26.5% peak from February 2018, there is a comfortable spread between Costco's ROE and its 7.3% average cost of equity.

The 30.1% cash return on invested capital (CROIC) further indicates how well the company is performing. It is also a signal of Costco's competitive advantage and the effectiveness of its management team.

Costco's balance sheet looks solid as well. It has long-term debt of $5.1 billion that has been reduced over the past year. Meanwhile, the $7.9 cash balance and an increasing current ratio are signs of a good liquidity position.

Income investors will appreciate that Costco's performance and balance sheet strength have enabled it to increase its dividend in each of the last 15 years. Although the current dividend yield isn't large at 0.8%, Costco's payout ratio of 34% gives it plenty of room to continue to boost a dividend that has grown at a 13% annual rate since being initiated in May 2004. 

What is Costco's Business Model?

Ok, so now that we know the highlights of Costco's financial strength, let's take a step back and look at its business.

Costco owns 787 retail warehouses around the world. Nearly 90% of them are in North America. But Costco also has a presence in the U.K., Japan, Korea, Taiwan, Australia, Spain, France—and even one warehouse in Iceland. The company also has just a single location in China, which by itself represents a huge growth opportunity. Overall, Costco has just scratched the surface in building out its global footprint and international expansion is a major part of the long-term investment thesis.

Its global membership is up to 55.8 million households and 101.8 million cardholders. An important metric in this regard is Costco's 91% membership renewal rate in the key U.S. and Canadian markets which is near record levels.

Digging into Costco's business model it becomes clear why this is a Buffet style stock. The model is easy to understand and revenue visibility is high.

Consumers have embraced the Costco retail concept and allowed the company to increase membership fees without skipping a beat. With the annual Gold Star and Gold Star Executive memberships at $60 and $120, respectively, shoppers don't mind forking over $5 or $10 a month for the privilege of club membership.

Although membership fees account for a small percentage of Costco's revenue, they account for a large portion of its operating income. Costco is on pace to collect well over $4 billion from memberships in fiscal 2020. These membership fees give Costco a stable revenue source that is uncommon in the retail world—and is the company's main money maker. This attractive fee model provides a recurring revenue stream for the company and is one of the main reasons why investors are drawn to Costco.

And while it operates at a lower margin than its competitors, Costco makes up for it by turning inventory over twice as fast as the average retailer. Despite its massive store footprint, Costco also generates higher sales per square foot than the competition. It also doesn't spend on advertising. Simply put, Costco is a lean, mean cash flow machine.

Can Costco Adapt to an e-Commerce World?

Like other retailers, Costco has had to adjust to the changing retail times. It has adopted a multi-channel approach with an emerging e-commerce presence as a complimentary sales outlet. This has been a particularly valuable asset during the pandemic.

Costco's e-commerce business has recently been expanded in the U.S., U.K., Canada, Mexico, Korea, and Taiwan as online sales have become a greater portion of overall sales. And yes, international e-commerce expansion is another major pillar of Costco's long-term growth opportunity.

Online grocery delivery services are an important growth driver. Over half of Costco's sales come from fresh food and sundry purchases. In conjunction with Instacart, Costco Grocery offers two-day nationwide delivery on non-perishable food items and household supplies. It also has same day delivery on all groceries including fresh foods in most metropolitan areas.

Costco's online storefront doesn't end there. It also operates an online travel service where members can book hotels, cruises, and rental cars.

And like other mega-retailers, Costco continues to branch out into the services economy. People can make Costco even more of a one-stop experience by taking advantage of its pharmacy, optical, and hearing aid services. Not to mention Costco's discounted gasoline, car wash, and tire center.

New brand introductions are also a key component of the Costco strategy. The company is constantly bringing in well-known products from Samsonite luggage and Weber grills to Tommy Bahama clothing and Skullcandy headphones.

Needless to say, there is something for everyone at Costco. Its treasure hunt atmosphere features popular brands that sell out fast. This creates an urgency for members to visit the clubs.

Costco's unparalleled product and service range, discounted prices, and growing online presence should make it a retail powerhouse for many years to come.