Note from Daily Trade Alert: The following article first appeared in The Growth Stock Advisor, a premium newsletter offered by Investors Alley.

Most of us are very familiar with Costco Wholesale (COST), the third-largest global retailer.

The company operates a chain of membership-only, no-frills warehouses aimed at budget-conscious consumers that like to buy in bulk.

Costco sells everything from groceries and household goods to large electrical appliances and gasoline.

With an average size of 146,000 square feet, the company’s stores are certainly not your typical supermarket.

Costco follows a lean approach throughout its business, which keeps costs down and prices low.

The company buys products directly from manufacturers and has the goods delivered straight to its warehouses and depots.

And because these products are displayed on their original racks and pallets in large quantities, this reduces the labor needed in store to stock the shelves.

Costco also offers a smaller selection of products than its competitors. It typically has about 3,700 stock-keeping units (SKUs), whereas other supermarkets may have tens of thousands of SKUs. This strategy concentrates the company’s buying power in order to get better prices from its suppliers. It then passes these savings on to its customers.

Costco: A Closer Look

The majority of Costco’s stores are in North America. This region accounted for 87% of its revenues ($169.3 billion total sales) and 83% of the company’s net operating profit in 2020. There is still plenty of room to expand in the market because Costco has “only” 660 North American warehouses operating currently. Including its international stores, it has 803 warehouses.

Costco’s management is well aware that there is room to grow, so the company continued to open new locations last year despite the difficult retail landscape caused by the pandemic. Costco opened a net 13 new warehouses through August (versus an average of 25 over the past five years), and it plans to open 20 to 22 new stores this year.

New warehouses have yet to cannibalize sales from existing locations, which are still on a growth path. For example, stores that opened in 2012 had seen their annualized sales per warehouse rise by more than two-thirds by 2020, from $105 million to $173 million.

Yet, many on Wall Street do not like the company. They usually point to its low profit margins— was 11.6% in the latest quarter.

But that shows they do not understand Costco’s very unique business model, which is to deliberately keep its prices as low as possible to lure in customers.

In effect, it is a retail version of a perpetual motion machine. Any savings gotten through Costco’s massive purchasing power is returned to its customers in the form of lower prices. This, in turn, encourages growth and extends the company’s scale advantages with suppliers even more.

Costco can do this is because most of its profit comes from its membership fees—which are pure profit—rather than what it earns from selling actual products.

And this profit center is growing: Costco currently has 107.1 million cardholders (59.1 million households). It uses a subscription model where customers pay an annual fee to access its stores: $60 for a standard membership and $120 for an executive membership. Costco’s paid household membership base of 59.1 million at the end of November was up from 54.7 million a year earlier.

Executive members, who get a 2% discount on certain purchases, account for almost two-fifths of Costco’s total membership. These people are Costco’s bread and butter—they typically shop more frequently and spend more than regular members.

While executive members are the most loyal of the company’s customers, Costco enjoys a high level of customer retention broadly. Its membership renewal rate is 91% in North America, and 88% globally. This loyal customer base represents what Warren Buffett would likely call a competitive moat.

And of course, membership fees are a big plus because they allow for a predictable earnings stream, smoothing out any sales volatility.

What the Future Holds

Another reason I’m so optimistic about Costco is that it has barely scratched the surface on e-commerce.

Costco has partnered with Instacart in North America for same-day grocery delivery. And it bought last-mile logistics company Innovel for $1 billion last year to boost its ability to deliver bulky goods such as furniture and fitness equipment.

These moves should accelerate its e-commerce push even more. Already, in the latest quarter, e-commerce sales surged by 86% year on year to around 7% of total sales.

Pantry-loading—which has also helped Costco over the last year—will likely wane as the coronavirus vaccines roll out. But its long-term track record of customer stickiness bodes well for holding onto its newer members after the pandemic.

Costco is sitting on over $4 billion of net cash and has a good track record of free cash flow generation.

Investors are not likely to be bowled over by the dividend yield of 0.8%, although it is growing at a compound annual growth rate of 13%. Keep in mind, though, that Costco is well-known for handing out special dividend payments from time to time. In fact, it paid out a $10 special dividend in December 2020!

Reflecting its strong performance during the pandemic, Costco’s shares have risen by about 21% over the last 52 weeks and are currently trading at 33 times consensus 2022 earnings.

That’s pricier than rival retailers Walmart (WMT) and Target (TGT), with PEs of 25 and 22 respectively. But I believe the strength of Costco’s membership-based business model justifies the premium.

Costco is a buy at any price up to $385 a share (remember that you can buy fractional shares). For now, it is a 4-star stock, but I will make it a 5-star stock when I see more progress being made on the e-commerce front.

— Tony Daltorio

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Source: The Growth Stock Advisor