DD is hard, so I did it for you. Your Due Diligence on Costco is here 👇

Costco has a bulletproof balance sheet and low prices, but is now the time to invest?

Highlights

- Costco has long been a leader in bulk groceries and has built up an impressive membership-only customer base.

- Costco pays a small 0.81% yielding dividend but has increased its dividend an average of 13% annually for 18 consecutive years and has paid 4 special dividends in that time.

- Costco has found a way to handle inflationary costs while offerring low prices to members and is poised to withstand a coming recession.

- Costco has an impending lawsuit regarding its popular $4.99 rotisserie chickens.

Thesis

Costco (COST) is a world-renowned seller of consumer staples used by families around the globe. With their worldwide presence, low-cost diversified product offerrings, and stable demand for bulk discount goods, COST is poised to benefit in the future as well as in these current inflationary times.

Recent News

• For the 39 weeks ended May 29, 2022, Costco reported net sales of $165.56 billion, an increase of 16.5 percent from $142.17 billion during the same period last year.

• The Board of Directors approved a 13.92% increase on the quarterly dividend from 79 to 90 cents per share, $3.60 on an annualized basis.

• Contrary to rumours, the $1.50 hot dog and soda combo combo will remain at $1.50, staving off inflation.

• 2 shareholders are suing Costco over claims that the company are neglecting and abandoning 1 million chickens a week at their Nebraska facility.

Positives

COST has many positive catalysts, and the first one I’d like to bring up is that they have a robust membership base that gives the company a fantastic moat. COST offers 2 membership options, a $60 Basic Membership and a $120 Executive Membership which both give customers access to members-only stores. Costco has 62.5 million members and the membership sales accounted for $4 billion in revenue with 90% of members renewing in the last year. Membership revenue is a huge portion of overall revenue and without it, the budget big-box store operates at a slim 2.65% margin.

The next positive for COST is their company culture. Costco is known for taking care of their 288,000 employees and they have the stats to back it up. The average hourly employee at Costco makes $23.56 per hour and the average 10 year clerk makes $30.08 per hour. 33.5% of Costco employees have 10+ years of service which is phenomenal, and they have an extemely low turnover ratio, with only 9.2% of employees leaving after the first year. For comparison, Wal-Mart’s turnover ratio over the same period is 44%.

It makes me much more confident investing in a company that values its workforce because employees are the driving force of a business. As a company you also want to avoid expenses related to employees, such as losing their skills, recruiting, and training new employees.

Another positive for COST is its worldwide presence. They have operations in North America, Europe, Asia, and Australia. Costco boasts a total of 828 warehouses, with 572 in the US, 105 in Canada and the rest are spread out through other countries such as Mexico, Japan, United Kingdom, Korea, Taiwan, Australia, Spain, France & Iceland. They are the 3rd largest retailer in the world and boast over 120 million square feet of warehouse space. In 2021, Costco added 20 new locations, showing that they are still looking to grow and expand into new territories.

The last positive I’d like to talk about is their stock performance. Since 1985, Costco has returned an average of 17.3% annually. In the same time period, the S&P 500 returned 9.3% annually. Costco over time has returned 8% more annually and that’s without dividends and share repurchases factored in. I’ll talk more about the dividends later but as far as stock repurchases, Costco has executed them spectacularly. Since 2005, the company has repurchased 132.6 million shares at an average cost of $73.12 per share. In 2021 alone, Costco repurchased $495 million worth of shares at an average cost of $364.39 per share. While I perfer companies to reward shareholders through dividends, I do appreciate buybacks if done wisely. Buybacks make existing shareholders own more of the company, thus making your shares more valuable.

Negatives

There are some negatives to consider when examining Costco. Q3 earnings showed tightening margins, with merchandising expenses increasing 14.97% year over year. Costco is already operating at razor-thin margins of 2.65% and inflation related input costs will be something to watch, as they may put even more of a dent in Costco’s profits. Something worth mentioning is that COST sells some of its flagship products at a loss, like the famed $1.50 soda and hot dog combo and the $4.99 rotisserie chicken. At the moment, Costco’s membership sales outweigh these unprofitable products, but time will tell how long that lasts.

Shares of COST at this point are also a bit pricey in my opinion. COST trades at 35.58x P/E (price to earnings) and over the last 5 years, COST has traded at an average of 36x P/E. For comparison, competitors Wal-Mart and BJ’s trade at 25.81x and 17.62x respectively. While I believe COST is a better company than both Wal-Mart and BJ’s and is worth paying a higher premium for, you have to remember that with higher premiums, higher valuations are needed to make your investment profitable. We’re currently in a bear market where valuations are being compressed and buying at these levels may be dangerous, as we might not revisit these levels for an extended amount of time. Also keep in mind, COST has to keep growing at a substantial rate in order to warrant these higher P/E multiples.

The last negative I’d like to talk about is the lawsuit brought on against Costco. 2 shareholders filed a lawsuit in Costco’s home state of Washington accusing Costco of “illegal neglect and abondonment.” Costco operates a $450 million chicken facility in Nebraska that opened in 2019, and they process about 2 million chickens per week. The 2 shareholders argue that Costco knowingly breeds chickens too large to stand up, and the “disabled birds die from hunger, thirst, injury and, illness.” Costco sold 106 million chickens in 2021 and it remains to be seen how this lawsuit will affect Costco as a whole.

The Dividend Breakdown

For those that don’t know, I mainly use 3 metrics to assess the quality of a company’s dividend. The first is the Dividend Growth Rate, which I use to assess the company’s ability to raise dividends and combat inflation. When assessing the Dividend Growth Rate, I look at the 10 Year Compound Annual Growth Rate (CAGR) because it’s usually the longest-term data readily available and more indicative of long-term company trends. The second metric I use is the Dividend Payout Ratio, which tells me how much of the company’s profits are going to shareholders. The Dividend Payout Ratio also shows me how much room a company has to grow its dividend before it becomes unstable. The last dividend metric I use is Dividend Yield. Dividend Yield tells me how much “bang for my buck” I get as a shareholder. Yield isn’t everything, but it’s nice to see how much money I’ll get back as an investor in the next quarter.

With that being said, I’ve developed a scoring method for rating a company’s dividends that I’m excited to share with you all! It consists of the previously mentioned metrics scored out of 5 and each score is multiplied and weighted by importance. The highest possible score a company can receive is a 31, and members of the Dividend Aristocrats club will receive an extra point for their long-standing history of reliable dividend raises. Each metric has its own criteria which I’ll share below:

• Dividend Growth Ratio is the most important metric for me, so scores will be multiplied by x3

• Dividend Growth Ratio of 0%-5% is a 1, 5%-7% is a 2, 7%-9% is a 3, 9%-12% is a 4 and a rate of more than 12% is a 5

• Dividend Payout Ratio is the second most important metric, so scores will be multiplied by x2

• Dividend Payout Ratio of 95% or more is a 1, 75%-95% is a 2, 55%-75% is a 3, 35%-55% is a 4 and a rate of less than 35% is a 5

• Dividend Yield is the least important metric of the 3, so scores will be multiplied x1

• Dividend Yield of 0%-1.5% is a 1, 1.5%-2.5% is a 2, 2.5%-3.5% is a 3, 3.5%-4.5% is a 4 and a rate of more than 4.5% is a 5

COST scores are shown below:

COST 10 year Dividend Growth Rate (CAGR) is 13.04%, obliterating the consumer staples sector median of 6.75%. Their Dividend Payout Ratio is 28.35%, well within the margin of safety with room to grow their dividend over time comfortably. Their dividend yield is only 0.81%, however, that’s more indicative of a rising share price, which is also good for shareholders. Lastly, COST has been raising its dividend every year since 2004 and is on pace to become a Dividend Aristocrat in 2029. COST has also issued 4 special dividends throughout the past 10 years, with the most recent being $10 per share in December of 2020. Overall, Costco scored a 26/31 points, proving that the company has a highly respectable dividend with the potential to reward shareholders for a long time.

Final Thoughts

After weighing the positives and negatives, I’ve decided that I will initiate a position in COST, just not at this moment. They currently trade at around the 5 year average P/E of 36x and when compared to other competitors they are very pricey. While I believe COST is superior to their competitors and a little bit of premium in price is warranted, we are currently in a bear market with more potential for lower prices. I’d like to accumulate COST shares below their 5 year average P/E and I’m targeting to buy below $440.

I also have concerns with their shrinking margins. Input costs have risen for just about every company due to inflation, but Costco is a company that prides itself on low prices and as a result, they have very slim operating margins of 2.65%. I expected Costco to raise membership prices on their last earnings call to combat inflation but they didn’t. I believe that raising membership prices would be the easiest and most effective means for Costco to fight inflation. In doing so, we’d be able to see Costco’s true pricing power and they can avoid slim margins and product prices can remain extremely low.

Overall, Costco is a fantastic company! They have a phenomenal history of dividend growth, a plethora of products across foods, electronics, furniture & more, and a wide moat due to its membership loyalty and worldwide presence. I’m excited for lower prices on COST and I’m looking forward to adding companies in the Consumer Staples sector, as they hold up well during recessions.

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