Last November I bought a relatively expensive diamond ring at (of all places) Costco. I did not even bother to shop around and yet I was quite confident that the ring would be high quality and at a price that others could not beat. Costco is a great place to shop and it has been a great investment. We are all familiar with Costco (NASDAQ:COST). Founded in Seattle in 1983, it now has 622 stores around the world. Most (448) are in the U.S. and 85 in Canada. The company also has 32 outlets in Mexico, 23 in the U.K., 13 in Japan, nine in each of South Korea and Taiwan, and three in Australia.
Although Costco is a retail operation, its stores are more reminiscent of giant warehouses. The company is able to be highly profitable despite marking up its products far less than its competitors - the average mark-up is just 13% and nothing is marked up more than 15%. In comparison, by my calculations, Walmart has a an average markup of 33%, Dollarama is 60%, Liquor Stores NA is 33%, Canadian Tire stores are 44%, and a certain ladies clothing store chain that shall remain nameless is at about 200%. With the exception of Dollarama, these other retailers earn lower profits on equity despite their much higher markups. Costco achieves high returns on equity (about 18%) by running an extremely low-cost operation.
Some of Costco's cost advantages are shared by other major competitors, including the large stores, in-house brands and the huge world-wide buying power. But Costco benefits from some other relatively unique factors that keep costs and required mark-ups low. These include:
- A single door for entry and exit. Only card-carrying members may enter and receipts are checked on the way out. This keeps shoplifting very low.
- Case-lot-only sales of many consumables.
- A very limited selection of stock-keeping items; competitors stock thousands more items per store.
- Very fast turnover such that goods are usually sold before vendors are paid, thus eliminating the need to invest in inventory.
- The warehouse format which limits merchandise handling.
- Non-acceptance of Visa and MasterCard which eliminates those fees.
- The annual member fees which provide the equivalent of an extra 4% of markup.
- Very limited use of advertising.
- Shorter opening hours per week.
The bad news is that the shares are expensive. At Friday's closing price of $116.46 (figures in U.S. dollars), the shares trade at 25.2 times trailing earnings. But the earnings growth and outlook is excellent and arguably can justify the premium price. In the past five years Costco's earnings per share have risen at an average of 9% per year. In the latest fiscal year the growth was 17%.
A very attractive feature of Costco is that it is a simple and predictable company. We can forecast with a high degree of confidence that it will continue to add stores for many years to come and that its earnings per share will continue to grow over the years and decades. Costco's same-store sales have been growing at 6% per year. The store count that has been increasing at about 3% per year. As the scale of the operation grows, profits per dollar of sales grow. Combine these three factors and it seems reasonable to forecast that Costco will continue to increase its earnings per share in the range of 9% per year.
In conclusion, Costco is a great place to shop and is a great company with significant competitive advantages and it will continue to grow.
Unfortunately, this is reflected in its high P/E ratio. Therefore, it may be preferable to wait for a market correction and hope for a lower share price. More conservative investors may wish to do this.
However, my suggestion is to take an initial position now. If the P/E does not drop it will be a good investment. If the P/E does fall, then this can be used to advantage in purchasing additional shares.
Getting back to my ring purchase, I am highly confident that jewelry stores have cost structures that require them to mark up diamond rings by a lot more than 15% - I would guess more like 50% to 100% or even higher. And I suspect that the buyers for Costco's 622 stores would be able to access high quality supply just as easily as most any jewelry store chain. Costco's modus operandi is high quality at the lowest price and I trust them.
Action now: Monitor Costco and buy if the price happens to drop to $93 which is a P/E of 20. Or take an initial 25% position now and buy additional shares at a lower P/E in future if the price happens to drop to the $93 range. (A higher or revised target buy price will apply with each new earnings release).