Capital Allocation Makes Costco an Excellent Long-Term Buy

Costco (NASDAQ:COST) is not known for being a high-yielding dividend stock. It currently yields 0.6%. Of the 393 S&P 500 stocks that yield more than zero, COST stock has the 32nd-lowest dividend yield.

Costco (COST) logo on a sign on a Costco store.
Source: ARTYOORAN / Shutterstock.com

Nonetheless, if you invested $10,000 in Costco’s December 1985 IPO, today you’d have $3.3 million, a compound annual growth rate of 17.5%. The S&P 500 over the same period has an 8.8% CAGR, precisely half the wholesale retailer. 

While the company’s business model is legendary, I don’t think it gets enough credit for the way it allocates capital. Unfortunately, it’s not as easy as it looks. Just ask Warren Buffett. 

There are so many reasons to own COST stock. Capital allocation is one of them. Here’s why.

The 5 Levers of Capital Allocation     

There are five ways a company can use excess cash: acquisitions, pay off debt, pay dividends, repurchase shares and invest in the business. All of these can play a role in reasonable capital allocation.

However, when abused, they can become nooses around the shareholders’ necks. 

Let’s consider all five ways to use excess cash.

Acquisitions: Some companies live to make acquisitions. Constellation Software (OTCMKTS:CNSWF) is a Canadian software company that’s made more than 650 acquisitions since its founding in 1996. Granted, many of them in the early days were small purchases. However, ultimately, Constellation became a top-performing stock on a global basis.

Unfortunately, most companies don’t know how to make acquisitions, squander opportunities or overvalue potential synergies and cost savings. 

How many acquisitions has Costco made? Not many. 

Its most recent was in March 2020, when it paid $1 billion for Innovel Solutions, a company specializing in delivering heavy items such as fridges and sofas. A last-mile specialist provides the retailer with a “white glove” service a cut above the competition. 

Its biggest acquisition was its 1993 merger with Price Club. After that, Costco shareholders owned 52% of the combined business. That set it on its way. The third acquisition was in 2015. It paid $760 million to buy out its 50/50 partner in Mexico.   

But that’s pretty much it. Most of the heavy lifting has been internal. 

Debt repayment: In the latest quarter ended Feb. 13, Costco had $6.66 billion in long-term debt. That’s about 11% of its total assets and less than 3% of its market cap. During the quarter, it repaid $800 million of its debt. That was about 43% of its free cash flow in the quarter. 

Costco’s balance sheet is a fortress. 

Pay dividends and repurchase shares: In Q2 2022, Costco paid out $350 million in dividends and repurchased $115 million of its stock during the quarter. That’s not a whole lot. Over the past three fiscal years (August year-end), it’s repurchased $939 million of its stock. That’s 28% of its $3.38 billion in debt repayments over the same period. 

Companies often overpay when buying back their stocks. By not doing much, it avoids the whole problem. 

The one thing it did on this front in fiscal 2021 was to pay a $10 special dividend, doling out $4.43 billion to shareholders. Special dividends are the way to go when cash is flush. It’s capital allocation 101. 

Investing in the business: In 2021, Costco spent $3.59 billion acquiring land, buildings, and equipment for new and remodeled warehouses. It plans to spend between $3.8 billion and $4.2 billion in 2022. At the midpoint of its spending plans, it represents 74% of its 2021 free cash flow. 

One thing that doesn’t get mentioned with capital allocation is the commitment to human capital. I’ve always found that the public companies whose stocks perform the best are often those growing the number of employees. In Costco’s case, Between fiscal 2019 and 2021, it increased the number of employees by 34,000 or 13%.

On March 1, 2021, it permanently increased wages for hourly and salaried warehouse employees. The cost to the company is $400 million annually. Even if it doesn’t show up on the cash flow statement, that’s a capital allocation decision. 

The Bottom Line on COST Stock

I decided to write about Costco’s capital allocation because I happened to read an article suggesting that once the supply chain issues disappear, Costco will drop another special dividend on investors. If they do, that’s great.  

On the company’s latest conference call, Chief Financial Officer Richard Galanti said that the fifth anniversary of the last price hike for Costco members is this June. In addition, a hike will create even more cash flow, requiring more capital allocation decisions.

It’s my experience that Costco gets an “A” regarding capital allocation. It’s just another reason I love COST stock.      

On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.


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