Why Costco (Nasdaq: COST) Will Keep Beating the Competition

Who doesn't enjoy a trip to Costco Wholesale Corp. (Nasdaq: COST)? Where else can you get a vat of peanut butter, have your pharmacy prescription filled, buy some fresh produce, and hunt for the latest bargain high-end merchandise - all while snacking on $1.50 hot dog combo?

Costco benefits consumers because it provides certainty that they are getting the best possible bang for their buck.

For investors, it offers a retail model that separates it from its peers - and effectively boosts profits.

Simple Shopping Experience

One of the ways Costco keeps costs down and keeps customers satisfied is that it avoids the trap of trying to be a "place for everyone." You know when you step into a Costco store that you will find very limited but quality choices.

An average Costco has only 4,000 different items in stock. In comparison a typical Wal-Mart may have as many as 40,000 different items of inventory.

Having just a few carefully chosen items allows Costco to get superior pricing from its suppliers because the supplier can mass produce for Costco alone - thereby reducing costs for everyone.

Of these 4,000 choices, only 3,000 appear consistently on a daily basis. The remaining 1,000 is where the fun begins with bargains, or as Costco terms it, "treasure hunting."

Costco can have the highest-quality Persian rugs on sale one week, but they'll be gone the next. In their place you may find designer-label handbags or name-brand furniture. The variety and mystery of these sale products keeps members coming back.

In fact, the loyalty of its membership is a key reason for investing in Costco stock.

The Benefits of Loyal Members

Costco's "members only" set-up charges annual fees ranging from $55.00 to $110.00. Its loyal membership acts as a built-in cushion that allows Costco to deliver roast chickens for under $5.00 and offer super deals that are occasionally sold at a loss.

Currently Costco has 69 million members and the membership renewal rate is a very robust 85% worldwide and nearly 90% in the United States.

Therefore, as an owner of Costco stock, the ebb and flow of sales from quarter to quarter does not carry as much weight as it might with another company. Membership expansion and renewals are just as important.

In the most recent quarter Costco's financial results (compared to a year ago) showed a 3.2% increase in membership fees to $716 million as compared to a year ago. Furthermore, the just-completed fiscal-year membership fees were up 10.2% to $2.3 billion.

So what is Costco doing to increase its membership base?

Costco (Nasdaq: COST) Knows Where to Find New Customers

With 454 stores in the United States and another 180 internationally, Costco is very diligent, and yet cautious, in its choice of locations for new warehouses.

Costco is not only looking at where it can grow the most sales but also where it can attract the most new members. And not just any members - Costco prefers to put its warehouses in more affluent areas. That's probably why the typical Costco customer has an average annual income of $96,000.

Costco is also expanding abroad. Of Costco's 26 new locations in 2013, just 12 were in the United States, with the rest in Canada, the U.K., Mexico, Korea, Taiwan - and even five in Japan. For 2014, the company plans to open 36 more new stores, including two in Spain.

There is one country conspicuously missing from this list - and it's the reason why I say Costco has a cautious approach to expansion.

That would be China. Costco (unlike almost every other Fortune 500 company) is not diving head-first into China despite that nation's burgeoning middle class.

When Costco Chief Executive Officer Craig Jelinek was questioned about why the company has refused to enter the Chinese market, his response was somewhat murky. He said it is hard to differentiate the shopping experience from one store to the next and that the uniqueness of the Costco experience may be lost.

But with the company's track record of success, I am confident Costco will figure out the right time to enter China. As Jelinek put it, "China will always be there... At some point we'll probably look at the opportunities in China."

Even without China, Jelinek still feels extremely confident in asserting that Costco will double in size over the next 15 to 20 years.

The Value of Loyal Employees

For Costco, loyal employees are just as valuable as the loyal members.

Turnover for employees is a very low 10% in the United States and Canada. That drops to 5% for those on the job for more than a year.

The average hourly Costco employee earns almost $21.00 per hour - almost triple the minimum wage - and gets healthcare benefits. Plus, don't be surprised if you find a former register clerk in upper management - the company promotes frequently from within its own ranks.

Granted, the high pay may not always be what's best for Costco's bottom line, but in many cases the complete value of a company cannot be computed in dollars and cents alone. Often, intangibles such as a company's culture needs to be considered.

"I just think people need to make a living wage with health benefits," Jelinek said. "It also puts more money back into the economy and creates a healthier country. It's really that simple."

It's quite remarkable to see that kind of partnership between labor and senior management. How to quantify this in terms of the Costco stock price is elusive, but I'm sure a majority of shareholders "feel good" about owning this company.

Why Costco (Nasdaq: COST) Stock Has Thrived

Costco's sound, simple business model has rewarded COST shareholders handsomely. Since the market downturn in 2008, the company has been on a nearly straight line upwards. Costco stock has appreciated nearly 150% over the last five years.

costco stock chart

During the economic downturn that began in mid-2008 and peaked in early 2009, the Costco stock price dropped more than 40%.

The only thing that makes me wary over the strength of COST stock is another economic downturn. Membership renewals could come under pressure if people are struggling financially and look to save money by shopping at discount stores like Dollar General (NYSE: DG).

On the other hand, with its limited selection, the products are likely those that "people need rather than want."

Despite the risk, I am confident management knows what's best and will soundly execute their business plan. Costco should be able to find a way to thrive no matter the environment. It has a proven track record and has demonstrated that kind of resiliency. I am a BUYER of Costco stock.

About the Author: David Mamos brings nearly 15 years of analytical experience to the table, with a background ranging from big-picture fundamental analysis to highly technical trading decisions. He began his career working as a financial advisor with Royal Alliance in 2001 and helped clients with portfolio management as well as buy-sell decisions before transitioning to the development, implementation, and execution of trading strategies for aggressive investors.

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