The Best Retail Stock To Own For The Long Haul

Buying in bulk remains a great value proposition for shoppers, but it can also be a great way to invest.

#-ad_banner-#There’s only one pure play on the U.S. warehouse retail market. Even better, this stock is one of the best investments in retail thanks to its wide moat. Sadly, investors won’t get a discount for buying the stock in bulk — but they can still make money over the long term by buying the stock in bulk.

Costco (Nasdaq: COST) remains the only pure play on the U.S. warehouse retail market. Its most formidable competitor, Sam’s Club, is owned by Wal-Mart (NYSE: WMT), and another major peer, BJ’s Warehouse, was taken private in 2011.

To shop at the major warehouse retailers, customers must buy a membership, which then allows them to save money by buying a wide variety of products in bulk. Costco uses its membership fees to offset the cost of the goods it sells, keeping its prices even lower for shoppers.

Costco often gets unfairly grouped with many of the discount and variety retailers. These include the likes of Wal-Mart and Target (NYSE: TGT), as well as the various dollar stores. However, many of these other retailers lack Costco’s economic moat — its membership base.

Between its 2009 and 2013 fiscal years, Costco saw its bases of paying members and total members grow 27%, to 39 million and 71.2 million, respectively. Last year, Costco’s member renewal rates were 90% in the U.S. and Canada and 86% worldwide.

Thanks to the membership structure, shoppers are incentivized to keep coming back to the warehouse since they’ve already paid the membership fee. Costco also has a strong presence with business customers, which make up about a third of its total memberships.

This moat and Costco’s customer loyalty has helped the company remain resilient regardless of the economic backdrop. In eight of the past nine fiscal years, Costco has posted year-over-year gains in revenue, including a 5% gain last year.

  Flickr/Picture Des Moines  
  Between its 2009 and 2013 fiscal years, Costco saw its bases of paying members and total members grow 27%, to 39 million and 71.2 million, respectively.  

While the recent bout of cold weather across the U.S. has put a strain on many retailers, Costco has continued its resiliency. Sales were up 6% year over year in January, and comparable-store sales were up 4%, beating consensus estimates of 3.3% growth.

With a number of stores concentrated in the California area, there’s still room for Costco to expand across the U.S. The company opened 26 locations last year and is looking to open another 30 in 2014.

The U.S. accounts for around 70% of revenue, but I expect Costco to continue expanding its presence in international markets. Costco is also expanding its e-commerce platform to better compete in North America and the U.K., with e-commerce sales up 24% year-over-year during its most recent quarter.

Costco trades in line with its historical average price-to-earnings (P/E) multiple, but the case can be made that we might see some slight multiple expansion going forward. This comes as the company continues to set new highs when it comes to operational performance. Both its operating margin and return on invested capital are near decade highs.

Costco’s P/E is over 50% above the industry average, but Costco boasts a return on investment (ROI) of better than 13%, which is above Wal-Mart’s 11.7% and Target’s 7.3%. Costco’s recurring revenue stream of membership fees also helps justify its premium valuation when compared with the other major retailers.

Over the past five years, COST is up 170%, compared with the S&P 500 Index’s 125% gain. What’s more, Costco has outperformed the market over this time with significantly less volatility. Its five-year annualized beta is roughly 0.65, meaning it’s about 65% as volatile as the broader market.

However, over the past six months, Costco has underperformed the S&P 500 by 10 percentage points. The market appears to be presenting investors with a compelling buying opportunity.

Also, don’t overlook Costco’s dividend, currently yielding 1.1%. Since 2004, the company has increased its dividend payout every year and in 2012, it paid a $7 special dividend to investors.

Risks to Consider: While the bulk products business is a bit different than conventional products, Amazon could well look to enter the bulk products market. That could potentially steal sales from Costco. The other angle is that Wal-Mart and other major department retailers could get more aggressive with their pricing and try to undercut Costco’s prices, ultimately forcing Costco to lower prices, potentially putting pressure on margins.

Action to take –> Buy Costco for the long term. You can’t take the conventional valuation approach with Costco. It’s more of a growth story with a very loyal customer base. The over 70 million members provide Costco with a strong moat and recurring revenue stream. Management has proved that it can outperform the broader market and investors should look for this trend to continue.