Sometimes, investors ignore successful stocks for a lack of a promising growth profile. Maybe cash flows look too stable, or, with a market capitalization in the tens of billions, a company seems too large for investors to conceive of further growth. Perhaps an organization with great potential operates in a low-margin industry and, heaven forbid, pays a dividend, signaling that it may not really be in growth mode at all.
Stock market pricing can be deceptive in this way. Companies with deep competitive advantages and extreme scale are often steadily and quietly rewarded for their dominance. Take retailer Costco (NASDAQ:COST), for example, which has all the listed strikes against it. It’s a massive, dividend-paying stalwart in a sector — wholesale club shopping — that generates low-single-digit profit margins. In fact, for the past several years, Costco has averaged a paltry operating margin of roughly 3%, and a net profit margin of just 2%.
Yet Costco, with its current market capitalization of $153 billion, has a stock that’s outpaced a slew of fellow “megacap” stocks in recent years, many of them hailing from higher-growth industries:
COST data by YCharts
Note that Costco’s total return has more than doubled that of the S&P 500 index over the last 10 years — it’s averaged a cool 65% total return annually during this period. The stock currently trades at nearly 37 times forward one-year earnings.
Just what do investors prize so much in this retail discounter? Certainly, the company’s advantage of massive scale (only Walmart‘s Sam’s Club and BJ’s Wholesale Club are large enough to provide significant competition) provides support for its premium valuation.
More to the point, while its margins may be anemic, at Costco’s size, slim profitability nonetheless translates into huge profits in dollar-based terms. Over the past trailing 12 months, the shopping club behemoth has captured $161 billion in sales, allowing it to book $3.7 billion in net income and nearly $7 billion in operating cash flow.
But perhaps the most persuasive reason Costco has appreciated so swiftly over the years is its dual promise of enormous corporate profits and relative safety. For many investors, the company is a proven, defensive consumer staples play that helps leaven overall portfolio risk.
Image source: Getty Images.
The premise of profits and safety has certainly played out in 2020, as Costco’s shares have delivered a 19% total return year to date as of this writing, and are close to tripling the S&P 500’s 7.5% total return to date.
In other words, during a pandemic — the ultimate test of consumer goods stocks — Costco has proved its mettle. The retailer will report on its fiscal fourth-quarter earnings later this month, but since it releases sales figures monthly, we already have a bird’s-eye view of the quarter. From the revenue side, the results look formidable:
|Total company sales||11.5%||13.2%||13.2%|
Data source: Costco Wholesale.
Note that double-digit sales and comparable sales increases have been fueled by a COVID-19-driven explosion e-commerce sales, an area once thought to be Costco’s Achilles’ heel against retail competitors.
Of course, none of this means that Costco is risk-free, or that one can’t quibble with recent results. For example, the pandemic surprisingly hasn’t generated as much in the way of new members as one might expect. The company’s membership revenue grew just 5% year over year in its fiscal third quarter. Compare that with BJ’s Wholesale Club, which improved membership revenue by nearly 11% in its most recent quarter.
Yet even with slower membership growth, Costco can still unlock advantages provided by its balance sheet strength and supply chain capabilities. For example, CFO Richard Galanti explained in Costco’s most recent earnings call that U.S. sales of big-ticket “white goods,” like appliances, mushroomed from $50 million four years ago to $600 million last year. Thanks to COVID-19, white goods sales are on pace to cross $1 billion this year. Investments like the company’s $1 billion purchase of last-mile delivery specialist Innovel earlier this year will only increase its ability to generate meaningful revenue from this market opportunity.
In short, Costco’s business model will provide ample fuel for steady, rising dividends for the foreseeable future. Though its 1% dividend yield has may seem meager, this stems from stellar stock appreciation. Costco is unlikely to resume some of the huge special dividends it’s paid out in recent years, as my colleague Jeremy Bowman explains, but its regular quarterly dividends should nonetheless provide a handsome return: They’ve increased at a compounded annual growth rate (CAGR) of 13% over the past 10 years.
Finally, Costco’s low payout ratio of 31% indicates ample capacity to maintain its double-digit dividend CAGR. Stability and growth in benign as well as rocky conditions make Costco an ideal dividend stock, one that income investors shouldn’t hesitate to add to their holdings.