Costco Wholesale (COST): A World-Class Retailer And Superb Dividend Growth Stock
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Costco Wholesale (COST) has proven itself one of the best dividend growth stocks of the last two decades, nearly doubling the S&P 500’s annualized return.

However, now with founder James Sinegal retired from the CEO position (he remains on the board) and the rise of major disruptive rivals such as Amazon (AMZN), the company’s business model faces potential threats from numerous directions.

Let’s take a look at what allowed Costco to become the juggernaut it is today, but more importantly see whether or not the granddaddy of wholesale warehouse retail deserves a spot in a diversified dividend portfolio such as our Top 20 Dividend Stocks portfolio.

Investors should note that Costco is held in Berkshire Hathaway’s portfolio, and you can see analysis on all of Warren Buffett’s top dividend stocks here.

Business Description

Founded in 1976 in Issaquah, Washington, Costco pioneered the wholesale warehouse retail business model and today operates 723 locations in nine countries on four continents.

While Costco is the world’s second largest retailer by sales (behind Wal-Mart), it generates the majority of its profits (70%) from its annual $55 and $110 executive membership fees. The company has built up a base of 87.3 million cardholders around the world.

Costco is one of the world’s largest sellers of groceries, alcohol, diamonds, electronics, prescription drugs, tires, gasoline, and even travel services.

While the company is working hard to expand overseas, the vast majority of sales and operating profits continue to come from its core U.S. operations.

Business UnitQ1 2017 SalesQ1 2017 Operating Income% of Sales% of Operating Income
U.S.$20.4 billion$506 million72.5%59.6%
Canada$4.1 billion$191 million14.6%22.5%
Other International$3.6 billion$152 million12.9%17.9%
Total$28.1 billion$849 million100.0%100.0%

Source: Costco Fiscal Q1 2017 10-Q

Business Analysis

Unlike most brick-and-mortar retailers, Costco’s business model is built around a wide moat, courtesy of its extremely loyal customer base (88% annual global renewal rate). Specifically, the company’s membership fees allow it to offer consumers greater discounts on both name brand and its own store brand goods.

In addition, the company is legendary for low turnover in its workforce, courtesy of much higher than average pay and benefits. This also helps to maintain strong brand equity thanks to employees that are happier and offer superior customer service compared to most of its rivals.

The combination of excellent service and reasonable prices has helped Costco gain and maintain its strong market share in its home U.S. market. However, in recent years saturation of the U.S. market has resulted in slowing sales and earnings growth.

Costco
Source: Simply Safe Dividends

Costco COST Dividend

Source: Simply Safe Dividends

That’s especially true given that the company has increased its investments into expanding store count, especially overseas (Canada, UK, Australia, Taiwan, and South Korea), where consumer taste has indicated that the warehouse wholesale retail business model may become increasingly popular.

Management has indeed done a good job in executing on this overseas growth, with constant currency, ex-fuel same store sales (i.e. comps) growing nicely in both Canada and overseas.

Costco COST Dividend

Source: Costco Fiscal Q1 Earnings Release

In fact, in the most recent conference call, CFO Richard Galanti announced that the company plans to open 31 new stores in 2017, up from 29 in 2016.

While a 4.3% increase in global store count won’t necessarily return Costco to its former glory days of double-digit sales growth, it should help double revenue growth (to 5% to 7%) compared to last year if comps stay the same or improve just slightly (1% to 3%).

Numerous Wall Street analysts have criticized Costco for years about its subpar margins, which are courtesy of its company policy of paying employees far above industry standards in both pay and benefits.

CompanyOperating MarginNet MarginFCF MarginReturn On AssetsReturn On EquityReturn On Invested Capital
Costco3.1%2.0%2.2%6.7%21.2%14.5%
Industry Average5.0%3.1%NA7.1%19.8%NA

Source: Morningstar

For example, Costco just announced an increase in its minimum wage from $13.00 per hour to $13.50. However, due to very low turnover, most of its starting employees last the four years it takes to reach the company’s top wage rate of $22.50.

That’s about double the wage earned by most U.S. retail employers, which is about $11.50. In addition to high pay, nearly 90% of employees also receive company-provided health insurance and a pension plan.

While this unique style of “socially responsible” capitalism is relatively new to the U.S., studies actually show that it is a vital part of Costco’s special sauce.

For example, according to MIT Sloan School of Management Professor Zeynep Ton, longer tenured workers who are happier, feel more appreciated, and less worried about making ends meet make for a far better customer experience.

“How many times have you gone to a store, and the shelves are empty or the checkout line is too long, or employees are rude?.At Costco, you see a huge line that disappears in minutes.”

And indeed it does appear that Costco’s “treat employees well” policy is working, with sales per employee nearly double that of Wal-Mart’s competing Sam’s Club warehouse stores and resulting in high and consistently growing returns on capital.

In other words, from Costco’s perspective, paying employees well in order to retain them for the long-term just makes good business sense. And as you can see above, while Costco’s operating margin may be low, it’s gradually improving over time.

This is courtesy of the company’s laser-like focus on efficiency. For example, unlike the average rival store, where around 60,000 items are sold, the average Costco sells just 3,700 goods.

However, thanks to its enormous sales volumes, as well as buying direct from manufacturers, Costco is able to obtain excellent wholesale prices along the lines of Wal-Mart and Kroger (KR).

Thanks to goods being shipped directly from suppliers to stores (instead of central distribution centers), Costco is able to achieve amazing turnover that resulted in an average of $162 million in sales per store last year, 80% more than the $90 million per store achieved at Sam’s Club.

In fact, the $1,100 per square foot in annual sales achieved at Costco is truly astonishing, and generally only seen at luxury retailers or high-end jewelry stores.

Given that this figure is double and triple that of Sam’s Club and Wal-Mart ($680 and $400 per square foot, respectively, according to Morningstar), it appears that Costco’s unique business model is firing on all cylinders.

This is especially true given the rise of online retail competition, which has yet to harm its business as it has so many other retailers. Costco’s strategy of selling numerous loss leaders, such as groceries and gas, to attract customers and make up for it with higher margin goods, has helped to insulate the retailer from the threat of Amazon.

In fact, Costco’s own online platform

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