Just about a year ago, a glance at Costco Wholesale Corp. would have shown a not-inexpensive stock that was poised to lose Jim Sinegal, the co-founder and chief executive officer responsible for building the company's culture and driving its performance.
Mr. Sinegal, as promised, retired this month, just as he was named Morningstar's CEO of the year. And Costco stock isn't any cheaper, having returned 17 per cent in 2011 and reaching all-time highs in December.
It trades at roughly 21 times forward earnings, a not-insignificant price for a massive company. It now has $91-billion (U.S.) in annual sales, the most of any company in Washington State (sorry, Seattle-area runners-up Microsoft and Amazon).
The key question, then, is whether Costco will continue to have a premium valuation among retailers with Mr. Sinegal gone and with increasing difficulty producing high-level growth.
First, a disclosure: I have the warm and fuzzies for this company. I love shopping there, and I believe in the quality of its "Kirkland Signature" brands. I also believe that its policy of giving employees good wages and benefits is both the right thing to do and good business sense. If I subscribed to the notion of buying stock in companies you know and love, Costco would be the biggest holding in my portfolio.
But I don't own any shares; my feelings run headlong into its valuation and my sense there's not a lot of room for error.
In the latest "Costco Connection" member magazine, the company's cover article on Mr. Sinegal's retirement starts with the story of a Costco buyer who negotiates a $7-per-pair savings on a big order of jeans. Rather than take some or all of the savings as profit, Costco passes it along entirely to the customer in a $7 price cut.
The magazine says Costco's goal is to price products roughly 14 to 15 per cent above cost – a margin that's then almost entirely eaten up by selling costs. Indeed, in the company's first fiscal quarter, membership fees of $447-million made up the bulk of the company's $543-million in operating profit. (Costco's operating margin is 2.5 per cent, and its net profit margin is 1.5 per cent.)
"Longer term, Costco has earned a premium valuation from its willingness to run a patient business model and … 'under-earn' for the sake of strong consumer and employee loyalty," says David Schick of Stifel Nicolaus, who has a "buy" rating and $90 target price on the shares. "Equity owners, we believe, appreciate the theoretical earnings per share at Costco is much higher than what is printed."
Not many stocks hit all-time highs as investors appreciate "theoretical," not actual, earnings. But there are many other compelling financial metrics about the Costco retail machine.
For one, the company generates its sales from just under 600 locations, meaning the typical store brings in $150-million in sales a year.
Deutsche Bank Securities Inc. analyst Charles Grom estimates the company produced $1,079 worth of sales per square foot in calendar 2011 – 65 per cent more than Sam's Club and more than triple Target's number.
Still, the company's same-store sales growth is at the top of the general-merchandise retail industry. And renewal rates for Costco membership – in essence, what its customers pay for the privilege of shopping there – are expected to remain near 90 per cent despite recent price increases of 10 per cent.
That leaves Costco believing there's room to grow, particularly internationally, where margins are slightly higher. (One caveat: With about 80 locations in Canada versus 430 in the 10-times-larger U.S. market, the company has arguably saturated this country.) Mr. Grom of Deutsche Bank says Costco has plans to expand its store base to 1,000 "clubs" over time, with 50 per cent of its planned expansion outside the United States.
But what about those pesky margins, which seem to leave little room for error? Mr. Grom, who has a "buy" rating and an $89 price target, says he believes that new CEO Craig Jelinek "could ease up" on Costco's strict pricing policies, "creating merchandise margin upside." UBS Securities LLC analyst Robert Carroll, who has a "neutral" rating and $87 price target, disagrees, saying a change in Costco's views on product markup is "not likely."
That makes Costco an admirable company with a wonderful shopping experience, but also a stock that is no sure bet to replicate its past gains. As long as the company sticks to Mr. Sinegal's mission, however, it's also not a good stock to bet against.
Now, if you'll excuse me, I need to go buy a two-litre jar of mayonnaise.
Special to The Globe and Mail
David Milstead