Why I bought Costco Wholesale stock

Recently, I bought Costco shares. The following is my analysis as to what made me click on the buy button.

Quick Facts

  • Industry: Consumer Goods
  • Segment: Discount Stores
  • 15 year return (ROE): 12.08%
  • 15 year Industry segment return: 6.9%
  • 15 year S&P 500 return: 9.6%
  • Type of buy: Defensive
  • Dividends: $1.85 paid out annually(on a TTM basis)
  • Payout ratio: 32.1%

Payout ratio – Generally anything above 60% is unhealthy for the company. The ratio essentially tells us how equipped is the company to be paying out dividends compared to its net income. Obviously you can’t be paying more dividends or a significant portion of your net income in dividends, as the latter indicates a matured business or few to none opportunities for a given corporation.

 

Why I bought this?

  • Price
    • The company stock went down approximately 11% in the last 3 months. Now, the questions I asked to myself were the following:
    • Did something significant change in their business to warrant a price drop of a company that has been returning approximately 12% in a 15-year period to its shareholders?
      • The market reacted this way due to a market correction and because of Amazon buying Whole Foods led to this decline.
    • Amazon’s buy of Whole Foods, how likely is it to impact the business of Costco?
      • Considering how it’s a discount store, the business models are different.
        • Amazon already had made inroads to the grocery business. However, Costco is not traditionally into grocery business.
        • Whole Foods is basically the same idea of a high end grocery food chain.
        • Thus, it’s unlikely to impact the moat Costco enjoys.
        • Worst case scenario: People would still flock to this discount store if the economic environment worsens and look for better deals on the dollar for their day to day needs.
  • Business Model
    • Traditional brick and mortar discount store. At the same time it sells merchandise on Alibaba website in mainland China.
    • Last year their e-commerce business grew by 15% for the revenues.
    • Have tremendously increased the warehouse locations in the past 10 year period.
    • Operating online sites for countries like U.S., Canada, U.K., Mexico, Korea, and Taiwan. Currently operates in eight countries outside U.S., with more in plan.
    • Well diversified business operations with additional business revenues provided by gas stations, pharmacies, car-washes, etc.
    • Have been expanding their business overseas (Taiwan, South Korea, Spain, Mexico).
    • Reinvesting in its business – $2.6B and $2.4B for the year of 2016 and 2015 respectively. This is a good sign.

 

  • Fundamentals
    • It has managed to return an above 10% return on a 15 year period.
    • Consistently managed to maintain a gross margin of 34% in the past 10 year period. This tells me the management is efficient and know what they’re doing.
    • Operating Cash Flow has been increasing consistently in the past 10 years. This again makes me trust the leadership and reinforces my faith in the management.
    • Shares outstanding: This is a grey area. The shares outstanding has consistently increased since 2007. Generally, this is not a good sign as the company is looking to issue more debt through its equity.
      • However, considering the near zero rate environment in the past 10 years along with a higher return per share in those 10 years, I am comfortable and this is not a deal breaker for me (more on this later – see maturity comment bullet under market cap).
    • Market Cap: It has a market cap of $66 B. Usually I refrain from buying companies with huge market cap. However, $66B is what I consider a mid-size corporation. There is plenty of room to grow.
      • Worst case scenario: I would still be okay with the company returning the past 15 year S&P 500 return of 9%, if the prevailing view is this company has matured.
      • However, I don’t think this company has matured. Why? Usually the matured companies have a solid business operations and they have essentially exhausted the resources to earn shareholders a return by investing in their business or investing somewhere else. They respond to this situation by buying back shares which would inflate the EPS for a given year, and then drive the stock prices up. Considering the shares outstanding have increased for this company, I don’t think this stock has hit that maturity level.
  • Risks
    • Their net-income has hit a ceiling over the past few years, as it has declined in the past year. Overall, this has largely been due to a decline in gasoline prices and exchange rate impact.
    • Worst case scenario: I am okay to have a piece of ownership in a business that has done well over a period of 15 years and wait for the 2-3 years issues to sort out when looking at the bigger picture and a longer time horizon.
    • Competitors: Amazon, Walmart, Home-Depot, Target, and other such ecommerce and or discount stores.
    • It’s a low margin business. I am not too worried about this considering how the management has delivered the performance consistently in the past 15 years.

Conclusion

Overall, I feel comfortable holding this stock. It’s a defensive stock that has returned an above 10% in the past 15 years to the shareholders. Although, I try and pick out growth stocks, I feel the price drop in the past 3 months along with a solid track record is adequate for me to shake off the short term concerns surrounding this stock.

If there is any stock that you would like me to analyze, please share your thoughts in the comments section.

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