Valuentum Exclusive Analysis for the Discerning Investor

Symbol Keyword

Image Source: Fiscal Year 2017 Annual Report

By Alexander J. Poulos

Costco Wholesale

We continue to be impressed with the differentiated business model successfully implemented and flawlessly executed by Costco Wholesale (COST). Costco is and will continue to operate as one of the very best in the retail industry due in large part to its keen focus on delighting its membership base with low prices (as evidenced by Costco operating at a puny 11.33% gross margin). Costco can operate at such razor-thin margins in large part to its reliance on membership fees to augment its overall profitability. Costco retains the allure of exclusivity while appealing to each member’s thriftiness with an ever-changing assortment that incorporates a bit of “the thrill of the hunt” that has made TJX comp (TJX) so successful.

Membership fees account for nearly 20% of Costco’s overall profitability in 2017, but we remain impressed with the company’s ability to push forth an increase with no discernible impact on membership renewal rates. Costco has posted a net jump of 9 million total cardholders since 2015 (90.3 million in 2017 versus 81.3 million in 2015), and we believe the leap in memberships underscores the deep value perceived on the part of the paying public—easily the most concrete testimonial of the power of the Costco. Yes, in essence, you have to pay for the pleasure of shopping at Costco which stands in stark contrast with the vast majority of the rest of the retail sector.

The investment landscape for Costco is not without its challenges as the long gaze of Amazon (AMZN) has begun to encroach its way onto Costco’s turf. We believe the entire retail landscape has reached a critical inflection point where the differentiated model of purchasing solely in a physical store or solely on an e-commerce platform has blurred even further. The new model will revolve around same day delivery with the physical store base perhaps acting as a mini-warehouse (or staging area) for a fleet of (more than likely) independent contractors to fulfill customers’ request and complete the critical last mile delivery.

The evolution of shopping we strongly suggest is the impetus for the recently-announced deal where Target (TGT) snapped up privately held Shipt for $550 million in cash. Target expects to operate Shipt as an independent entity with the expectation to expand the Shipt platform to include Target as a shopping destination. Currently, Shipt shoppers fulfill grocery orders for its members at the local well-established supermarkets and deliver the request to the customer's door in one hour. Shipt members pay a yearly $99 membership fee to belong to the service (another example of the Costco membership model at work) which coincidentally recently added Costco as a destination.

We’re generally pleased to see Costco’s management team is not sitting idly back as the landscape evolves. Our criticism of Costco is based on the severe underinvestment in its e-commerce capabilities—an error that is now being rectified, in our view. One of the prime reasons offered for the underinvestment revolves around the uber profitability of the “four walls” as the treasure hunt environment allows for impulse buys especially if you layer in an extensive amount of product sampling at Costco.

Costco Serves as the Model for Amazon

We cannot help but note some critical similarities between Costco and the retail division of Amazon. While outside of the relatively recent acquisition of Whole Foods—Amazon has remained tethered to the e-commerce end of the retail landscape, masterfully building out its dominant platform. We believe Amazon has emulated the Costco model with its intense focus on low prices, yet offering a slew of benefits to the those that purchase a Prime membership which entitles a member to expedited shipping and exclusive deals.

The continued dominance of Amazon in the e-commerce realm has hastened a seismic shift in strategic positioning for retailers. We believe the most impressive change is currently underfoot at Walmart (WMT) as the company is rapidly evolving the methods in which it serves the needs of its core customers--along the multiple platforms whether e-commerce, in-store shopping or via curbside pickup.

The Re-ascendance of Wal-Mart?

We remain impressed with the rapid shift in the strategic positioning of Walmart as the business is in the midst of a critical evolution of its core competencies. Walmart is undertaking the arduous task of meeting the competitive threat of Amazon on its home turf through a dramatic augmentation of its e-commerce platform. Walmart began the daunting task in August of last year via the acquisition of Jet.com along with additional bolt-on acquisitions such as Bonobos along with strategic partnerships with venerable names such as Lord & Taylor. We view the Lord & Taylor deal as emblematic of the rapid change in the retail space where once-fierce rivals are willing to join forces to combat a much more significant threat.

Dealmaking alone will not serve as a panacea unless tangible results are posted. On this score, Walmart in our view has hit a proverbial home run posting stunning US e-commerce growth north of 60% in the first half of 2017 thus dispelling, in our view, the myth that Walmart is incapable of competing in the virtual world. Walmart has guided for 40% e-commerce growth in 2018 (off of a base of $11.5 billion), which in our view demonstrates the traction Walmart is making via its ambitious platform.

The pushback from the bears (those betting on a decline in Walmart’s stock) is the revenue is puny for a behemoth such as Walmart—the argument may have some merit, but we believe the more valid counter-argument is the growth underscores that the current management team “gets it.” We feel the recent announcement to change the legal name of the company to Walmart Inc. (from Walmart Stores, Inc.) further emphasizes the vision the team has—the retail landscape has forever been altered with a physical storefront serving a vital portion yet it is not the entirety of the sales platform.

At its current earnings run rate, the strategic investments are not feeding through to the bottom line as earnings are estimated to flatline in the fiscal year 2018 versus 2017, but we are not overly concerned with the relatively weak earnings growth (even if wage pressures may be looming). Walmart is enormously profitable with a stellar credit rating—the move to e-commerce underscores the current team is well aware of the changing retail landscape and will not allow itself to be disrupted.

Dividend Consideration

We remain constructive on both Costco and Walmart as we believe they will be long-term survivors in the coming shakeout in the retail sector. That said, we are not in a rush to add either to the Dividend Growth Newsletter portfolio or Best Ideas Newsletter portfolio, as each is trading well above its fair value. The recent dividend history at Walmart is hardly inspiring either, with anemic annual bumps. We do not believe Walmart will become a high-yield entity—if it does, then we view this as a sign the overall business may in decline such as with the mall-based retailers. Instead, we believe Walmart has taken the necessary steps to evolve and thrive. In any case, the dividend should serve as a key portion of the overall investment thesis for the company. Shares yield ~2.1% at the time of this writing.

Costco remains a unique story in the retail sector as the company continues to be classified as a retailer, but is valued similarly as a franchiser with very predictable cash flows. The market has consistently awarded Costco an above-average multiple in large part due to the ease of predicting the business earnings as Costco has remained relatively impervious to an economic downturn. We believe the highest compliment in business is emulation as we feel Amazon has stolen a page out of the Costco operating model in building out its Prime membership model.

The dividend growth prospects for Costco are more favorable than Walmart as Costco’s overall payout ratio is far less than Walmart’s. Costco’s relatively better dividend growth prospects are, in our view, also reflected in the Dividend Cushion ratio (2.6 for Costco; 1.6 for Walmart). We also remain intrigued with the special dividend history of Costco as the company has paid out $19 per share in special dividends since 2012 in a somewhat irregular manner. The lumpiness may not appeal to retirees who favor a predictable quarterly income stream, but the special dividends have been upside otherwise not expected. This may be a philosophical tendency at the company: Costco operates the company in a unique manner consistently paying above industry wage to its employees while maintaining its image as a good shepherd of shareholders by returning excess cash on the balance sheet back to stakeholders. Costco yields ~1% at the time of this writing.

We’ll continue to monitor the evolution of the retail landscape with a keen eye for emerging trends that may threaten the entrenched players. We’re very comfortable with the overall stellar performance of our recent idea in the retail sector, the dollar store operator Dollar General (DG), which we feel remains immune to the threat that is Amazon. Dollar General’s shares are approaching the mid-$90s, after having been added to the Best Ideas Newsletter portfolio, in April 2017, at under $70 per share. The company yields ~1.1% at the time of this writing. We’ll be looking to beef up our positions in the Dividend Growth Newsletter portfolio in 2018, but we’ll only be looking to do so at the right price.   

Independent contributor Alexander J. Poulos is long Amazon and Walmart.