Once in a while in relationships I ask (myself) whether the reasons I’m attracted to a partner are still valid. If not, it may be time to move on. I do the same with my portfolio. And each time I’ve taken stock of the stocks COST is that one stock that’s given me second thoughts.
COST operates on razor-thin margins. I mean, discount warehousing is almost a “margin-free” business anyway – buy high and sell low - but COST’s policy of no more than 4% markup on any of its big-ticket items means that operating profit margins are always in the 2% zone - compared with Target’s 8% and Wal-Mart’s 6%.
So despite the very low margins why am I attracted to COST and are these reasons still valid? I got into COST because of 4 main reasons: CEO mentality, Treatment of employees, High net-worth membership clientele, and International expansion.
I’ve read interviews with the CEO and listened to him on earning calls. He’s got a good head on his shoulders. Not only does he have skin in the business, he’s prepared to endure short-term pain for long-term gain. He holds a long-term view of the stock - to the chagrin of some on Wall Street - and spends a lot of time in the stores, not in some C-suite or corner office overlooking the waterfalls.
An analyst once commented that it’s better to be a COST employee than a shareholder or investor. Wall Street is generally not happy that COST pays its employees much more than the industry average. Of course this bites into income but the tradeoff is higher worker productivity and low turnover – the firm has one of the lowest employee turnover rates in the industry.
Have you ever visited a COST parking lot? It’s filled with luxury cars – the type of cars that park themselves! The highest level of membership at COST is Executive - there's also Gold and Business - and according to the firm at the end of fiscal 2006 executive members, who fork out $100 in annual membership fees, represented 23% of its primary membership base and generated about 45% of all sales. That’s 45% of almost $60 Billion; do the math!
On the Q1 fiscal 2007 earnings call last Thursday the company revealed that Gold membership stood at 17. 7 million, up from 17.2 million year-on-year, and that more members were spending more at a faster rate. But the icing on the cake is that more members are switching to executive membership. As long as COST continues to pack the wealthy in it will be able to operate on tight margins.
Finally there is COST’s international ambition. When I was searching for a discretionary stock to add to the folio, Target was the first firm to come to mind. But I quickly switched to COST when I discovered that Target had no plan to expand overseas soon. No thanks.
An international presence helps to cushion weaknesses in domestic sales and also brings foreign currency exchange income. International operations – 133 of its total 504 warehouses - already represent 18% of sales. Four new international stores will open before the end of this year with more to come in calendar 2007.
All told, COST remains attractive to me for the same reasons I got into it. Sales have grown by an annual average of 12% over the past four years; membership continues to grow; employees are some of the best paid in the industry; and the boss is fanatical about the discount warehouse business. The stock doesn’t move in giant leaps but it has appreciated about 24% over the past five years, versus 25% for the S&P500. COST is a tortoise, not a hare. That's the big deal. I’m still down with it.
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