Costco (NASDAQ:COST) stock has been an out-performer among retail stocks. In the last 12 months, COST stock has surged by over 65%. The rally has been backed by positive fundamental developments.
However, at a forward price-to-earnings ratio of 40.5, investors will think twice before fresh exposure to the stock. I believe that gradual accumulation can still be considered. While valuations look slightly stretched, there are several factors for the valuation premium.
First and foremost, the world is going through uncertain times. Inflation, geo-political tensions and possibility of rate hike can create multiple headwinds for the markets. In such a scenario, defensive stocks tend to witness flow of funds. COST stock, with a beta of less than one, is worth considering for a defensive portfolio.
Furthermore, the U.S. economy is largely consumption-spending based. A key part of consumption expenditure is retail spending. It’s therefore a priority of policymakers to ensure actions that keep retail spending robust. Costco is relatively immune to economic shocks.
On top of these factors, COST stock offers investors a healthy annualized dividend pay-out of $3.16. Considering the company’s growth, dividends are likely to increase in the coming years. As a matter of fact, Costco initiated dividends in May 2002. Since then, dividends have increased at a CAGR of 13%.
Costco is a Cash Flow Machine
A big reason to like Costco is the company’s capability to generate robust cash flows. For fiscal year 2021, the company reported operating cash flow of $8.9 billion. Further, as of December 2021, Costco had $12.3 billion in its balance sheet.
There are two important reasons to believe that the company’s cash flow will continue to swell.
First, as of Q2 2022, the company reported 114.8 million total cardholders. In U.S. and Canada, the company had a robust membership renewal rate of 92%. This is important as Costco generated $4.0 billion in membership fees in the last 12 months, up from $3.14 billion in 2018. As member cardholders continue to increase, membership fee income will also swell.
It’s also worth noting that Costco has just two warehouses in China. If growth in emerging markets gains traction, member households will increase significantly. The U.S. is home to 300 million people while China is home to 1.3 billion.
Furthermore, Costco has positive metrics in terms of average sales per warehouse. In 2012, the company’s average sales per warehouse was $155 million. The average sales per warehouse have increased to $217 million in 2021. Importantly, the older the warehouse, the higher is the sales. With 74 warehouses added since 2018, there is visibility for revenue upside per warehouse.
It’s also worth mentioning that Costco has ramped-up e-commerce sales after the pandemic. Omni-channel sales solutions will also help in boosting the revenue per warehouse. For the first two quarters of 2022, the company’s sales growth was 10.5%. For the same period, the e-commerce sales growth was 12.9%.
Another important point to note is that Costco opened 16 warehouses in 2020. Last year, the new warehouses increased to 22. With the pandemic possibly shifting to an endemic, there might be a case for aggressive investments in new warehouses.
Bottom Line on COST Stock
Like most retail companies, Costco has been boosting its omni-channel sales capabilities. With ample financial flexibility, the company can aggressively invest in supply-chain ramp-up and new warehouses.
It’s also likely that membership fees will be increased this year. Costco CFO Richard Galanti, responding to an earnings call question, said a price hike was possible in 2022, “especially in light of companies like Amazon and Netflix raising their fees” earlier this year. He noted that in June, it will be five years since the warehouse network last raised its fees, $5 to $60 a year for Gold Star members.
These factors are likely to ensure that revenue and earnings growth remains robust. I want to come back to the valuation since COST stock trades at a forward P/E of slightly over 40.
Recently, Wells Fargo reiterated an “overweight” rating on the company. Telsey Advisory Group has also raised the price target for the stock to $615. This would imply an upside potential of 17% from current levels of $525. I would still remain cautiously optimistic on the valuation front and consider staggered exposure to the stock.
Leaving aside the potential valuation premium, the business model is robust. Importantly, there is ample headroom for growth in international markets.
On the date of publication, Faisal Humayun 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.