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Warren Buffett Stocks in Focus: Costco

Published by Nick McCullum on May 30, 2017

When Warren Buffett has a multi-hundred-million dollar position in a company’s stock, investors tend to take notice.

Buffett is arguably the most famous – and the most successful – investor ever. As the Chief Executive Officer and Chairman of Berkshire Hathaway (BRK.A) (BRK.B), Buffett oversees a ~$160 billion portfolio of common stock investments.

You can see Warren Buffett’s 20 highest conviction dividend stocks analyzed in detail here.

Berkshire Hathaway owns 4,333,363 shares of Costco Wholesale (COST) with a market value of $727 million at the time of its last 13F filing. This makes Costco Buffett’s 26th largest position.

In addition to the company’s significant ownership stake in Costco, Berkshire’s management has vocally praised the business’ performance.

“It’s hard to think of people who’ve done more in my lifetime to change the world of retailing for good, for added human happiness for the customer.” 

“Generally speaking, I believe Costco does more for civilization than the Rockefeller Foundation.”

– Charlie Munger, Berkshire Hathaway Vice Chairman

Clearly, Warren Buffett and his business partners are a fan of Costco’s business. Their ownership stake and vocal praise of this company are two reasons why dividend growth investors might take an interest in this stock.

This article will analyze the investment prospects of Cosco in detail.

Business Overview

Costco’s corporate history dates back to 1976 when its earliest predecessor Price Club was founded in San Diego.

Through various mergers and organic growth, Costco has grown into the world’s premier membership-based retailer.

Today’s Costco is headquartered in Issaquah, Washington, and generated $116 billion of sales in fiscal 2016 through 213k employees operating in 105+ million square feet of warehouse properties.

COST Costco Wholesale Costco Today

Source: ‘Costco Today’ Investor Presentation

Costco’s business model is based on offering its customers an annual membership that allows them access to the company’s locations (called warehouses), where they have access to attractively-priced goods in a wide variety of product categories.

The company offers two membership programs: executive and standard (also called gold star membership). While both provide access to Costco’s warehouses, the company’s Executive Membership gives additional perks such as a 2% rebate on qualified Costco purchases.

COST Costco Wholesale Executive Membership

COST Costco Gold Star Membership

Source: Costco Website

Although Costco began as an American enterprise (and still operates the majority of its warehouses domestically), the company has built an impressive global network of retail warehouses.

Right now, 508 of Costco’s 727 warehouses sit within the United States. The remainder can be seen below.


COST Costco Wholesale Costco Today Part Two

Source: ‘Costco Today’ Investor Presentation

Moving on, the next section will discuss Costco’s growth prospects in detail.

Growth Prospects

In an increasingly price-conscious world, Costco will benefit as more consumers switch to Costco from its more expensive competitors.

Costco will also benefit from the widespread difficulties that essentially every other retailer is experiencing. Many of Costco’s smaller competitors are in rapid decline, which means that Costco has a tangible opportunity to win over more customers.

The company is also actively rolling out new membership initiatives.

Last June, Cosco launched the Citi/Visa co-branded Costco credit card. The card has been a tremendous success for Costco, boosting the company’s earnings-per-share by $0.17 in the most recent quarter.

Cosco is also making some changes to its membership system.

Namely, the company is increasing its annual fees. Standard annual membership fees will be increased from $55 to $60, while executive membership fees will be increased from $110 to $120.

Given Costco’s exceptional brand loyalty, I expect these price increases will have a very minimal effect on the company’s membership base while simultaneously providing a meaningful increase to the company’s sales.

Competitive Advantage & Recession Performance

Costco has two main competitive advantages.

First, it is the undisputed leader in the membership retail space. Costco has 88.1 million cardholders and these cardholders tend to renew their memberships at a very favorable rate.

COST Costco Wholesale Costco Strengths

Source: ‘Costco Today’ Investor Presentation

Costco’s membership structure has led to remarkable brand loyalty, translating into robust same-store sales growth in an environment where most retailers are losing the bulk of their sales to Amazon (AMZN) and other digital sales channels.

Costco’s year-to-date and most-recent-quarter same-store sales growth can be seen below.

COST Costco Comparable Same Store Sales

Source: Costco Third Quarter Earnings Press Release

Costco’s second major competitive advantage is its impressive size and scale.

The company purchases most of its merchandise in bulk, which allows the business to command absolute pricing power from suppliers. Costco can pass these savings onto its customers, increasing brand loyalty and creating a self-reinforcing cycle for the business.

I would expect Costco to perform well during future economic downturn based on two pieces of evidence.

First, Costco has performed well in past recessions.

During the global financial crisis of 2007-2009, Costco experienced only a single year of declining earnings-per-share and it reported a new high for per-share net income in the subsequent year.

Costco’s adjusted earnings-per-share history during the last recession can be seen below:

Second, the company’s balance sheet is very strong, giving them plenty of financial flexibility to maneuver through the next economic recession.

COST Costco Wholesale Financial Position

Source: ‘Costco Today’ Investor Presentation

At the time of Costco’s last investor presentation, the company reported $6.0 billion of cash and equivalents and $5.1 billion of total debt. Remarkably, the company had sufficient cash reserves to completely eliminate its outstanding debt (if desired).

Since that investor presentation, Costco has released interim financial statements that reported the same situation – sufficient cash and equivalent to pay its outstanding debt (both current and long-term).

Thus, Costco’s fundamental business can be expected to perform well during the next recession, although its stock price might decline significantly thanks to its high valuation (shown in the next section).

Valuation & Expected Total Returns

Costco’s future shareholder returns will come from valuation changes, growth in adjusted earnings-per-share, and dividend payments.

Before I outline Costco’s valuation, it should be made clear – Costco will not appeal to value investors.

Costco’s very low prices, unique membership system, and positive same-store sales growth have earned it one of the highest valuations in the retail industry.

Costco reported adjusted earnings-per-share of $5.33 in fiscal 2016. The company’s stock price of $177.86 is currently trading at a price-to-earnings ratio of 33.3 using 2016’s adjusted earnings.

On a forward-looking basis, Costco has reported year-to-date earnings-per-share of $3.99, which puts the company on pace to report adjusted earnings-per-share of $5.32 for the full-year period. The company’s price-to-earnings ratio usin this estimate of 2017’s earnings is the same 33.3 figure.

The following diagram compares Costco’s current valuation to its long-term historical average.

COST Costco Wholesale Valuation Analysis

Source: Value Line

Compared to its historical average valuation levels, Costco appears to be grossly overvalued. Costco’s current price-to-earnings ratio of 33.3 is also well in excess of the S&P 500’s price-to-earnings ratio of 25.5.

Thus, valuation compression will likely have a significant negative effect on Costco’s future shareholder returns, and investors would be better off waiting for a more attractive opportunity to invest in this company.

With that said, Costco is highly likely to continue delivering strong earnings growth moving forward.

The company has compounded its adjusted earnings-per-share at 9.9% per year since 2001 while registering only 1 year of negative earnings growth during the bottom of the great recession of 2007-2009.

COST Costco Earnings-Per-Share Growth

Source: Value Line

Based on their track record and growth prospects, I would expect Costco to continue delivering 8%-10% annual growth in earnings-per-share over full economic cycles.

Costco’s shareholder returns will be boosted by the company’s remarkably shareholder-friendly capital allocation policies.

Costco current pays a quarterly dividend of $0.50 per share which yields 1.1% on the company’s current stock price. Costco is a low yield dividend stock but has grown its dividend at a fantastic rate over meaningful time periods.

COST Costco Wholesale Dividends

Source: ‘Costco Today’ Investor Presentation

Note: The above slide is slightly outdated – Costco’s recent dividend increase means their annual dividend payment is actually $2.00 (not $1.80 as indicated above).

Costco’s shareholders also benefit from the company’s occasional special dividend payments.

For instance, the company recently announced a $7.00 per share special dividend. The company decided to take advantage of its growing cash pile and rock-bottom interest rates to issue a new fixed income security and use the proceeds, along with existing cash, to return capital to its shareholders.

Looking further back, Costco has paid $19 per share of special dividends since 2013. I would not be surprised to see similar special dividend payments (on occasion) in the future.

To sum up, Costco’s future shareholder returns will be composed of:

For expected total return of 9.1%-11.1% before the effect of valuation changes and any future special dividend payments.

Final Thoughts

Costco has many of the characteristics of a fantastic investment – brand loyalty, strong earnings growth, and defensible competitive advantages.

However, the company’s valuation is well into nosebleed territory. A 33.3 price-to-earnings ratio is exceedingly high for any company and means that operational perfection is being priced into Costco’s stock price.

Thus, investors are better off shopping for other, more reasonably priced retailers on the stock market right now.

Thanks for reading this article. Please send any feedback, corrections, or questions to support@suredividend.com.

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