3 Reasons Costco Will Eat Wal-Mart's Lunch

By Andrés Cardenal | More Articles | Save For Later
October 19, 2013 | Comments (8)

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Costco (NASDAQ: COST ) has been one of the most remarkable success stories in discount retail over the last years. However, the stock has risen by 30% in the last twelve months, and company trades at a considerable premium versus other players in the industry, so investors may be wondering if Costco has room for more upside.

The good news is that this premium valuation is well justified, and the company has plenty of room for growth, so the case for investing in Costco is as strong as ever.

The premium
When comparing Costco against industry peers like Wal-Mart (NYSE: WMT ) and Target(NYSE: TGT ) , the company is looking quite expensive with a P/E ratio above 25.3 versus ratios in the area of 14.8 and 15.4 for Wal-Mart and Target, respectively.

Looking at past performance, this premium is easy to understand since Costco has outgrown the competition by a wide margin over the last years.

And the trend is not reversing; Costco continues gaining market share according to data for the last quarter. Costco reported a 5% increase in U.S. same-store sales excluding gasoline prices for the quarter versus a decrease of 0.3% for Wal-Mart in the U.S. and a growth rate of 1.7% for Sam´s Club in the U.S. excluding fuel

Target is also losing ground to Costco, the company reported an increase of 1.2% in U.S. comparable-store sales during the last quarter.

Still, the past is only a prologue to the future, the main question to consider is if Costco can justify its premium valuation or not on a forward looking basis.

One of a kindWhile the competitive environment is fierce, there are three main reasons why Costco holds a definite edge. First, the company has an innovative business strategy implemented by a high-quality management team that sets it apart from the competition. Costco makes most of its profits from membership fees while selling products at zero profit or even at a loss. This generates considerable advantages when it comes to cost competitiveness, a key factor in the industry.

Second, the company chooses cost efficiencies over product variety when making inventory decisions, another source of pricing advantages for Costco versus the competition.

Third, even if the company strives to keep costs as low as possible in different areas, management understands the importance of paying a decent salary when it comes to attracting and retaining high-quality employees.

Costco´s hourly rate of $20.89 makes competitors like Wal-Mart look really bad with its substantially lower average rate of $12.67. This has material advantages for Costco when it comes to variables like employee turnover, and the long-term effects of having the best human talent in the industry could be remarkably important, even if they are hard to measure quantitatively.

Since profitability depends heavily on membership fees and not so much on sales volumes, the company enjoys higher reliability and stability in its cash flows. Judging by financial figures, customers are quite happy with the benefits of shopping at Costco, so investors have good reasons to expect sustained performance from the company.

Membership fees grew by 3% during the last quarter, but that number expands to 6% when adjusting for factors like calendar anomalies and foreign currency effects. New member sign ups were up 9% year over year despite one less week in the quarter, and the company also reported a strong renewals rate of 86.3% during the last quarter.

Costco has a smart business model and an innovative corporate culture which translates into happy employees and a loyal customer base; this is a big difference versus other companies in the industry.

Growth opportunitiesManagement is planning to ramp up expansion plans over the next years: the company intends to open 36 new warehouses in the next twelve months, half of them in the U.S. Even if some of these openings get delayed, this would still be a material acceleration versus 26 new locations, 12 in the U.S., during the last year.

Demand has been consistently strong for Costco in the U.S, so management is doing the right thing by growing its store base in a more aggressive way to capitalize the opportunity. Regarding international markets, Costco is just giving its initial steps abroad, and it has ample room for expansion on a global scale over the coming years.

As long as the company continues gaining market share versus the competition, sustaining strong loyalty among members and growing its membership base, investors in Costco have good reasons to expect a new store openings to translate into healthy growth rates from the company in the middle and long term.

Bottom line
Costco is looking expensive in comparison to competitors like Wal-Mart and Target, but this is not an apples to apples comparison. The company has a different business model, superior competitive advantages and plenty of room for growth over the next years. The price may be higher, but so is quality, so don´t let valuation scare you away from a long-term position in Costco.

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