Does the Secret to Costco's Success Make the Stock a No-Brainer Buy?

Costco has been able to consistently grow its revenue and earnings over the years.

Costco Wholesale (COST -0.07%) is not only a consumer favorite, but also a top choice among the investment community. Its shares have rocketed 222% higher in the past five years, an impressive gain that beats the Nasdaq Composite Index.

This top retail enterprise can credit solid revenue and earnings growth for its shares rising so much. And management’s focus on selling products at low prices is a key differentiator.

But a closer look at Costco’s operations reveals another secret to its success. And this just might make the stock a no-brainer buy for your portfolio.

Not a typical retailer

There might be no industry out there that’s as competitive as the retail sector. Barriers to entry are low, and consumers are free to shop among a nearly unlimited number of sources. This makes it difficult to stand out.

But Costco has built a successful empire by selling quality merchandise at low costs in a warehouse-style setting. Its goods are usually marked down to a lower price than rivals offer. And this has made it the world’s third biggest retailer.

This alone doesn’t make Costco’s retail operations unique. It’s the company’s thriving membership program that might be the secret to its dominance.

Not just anyone can shop at a Costco location. You must be a member, and the basic plan costs $60 per year. A $120 option, the Executive Plan, has added perks. After growing its member base by 7.8% in the third quarter (ended May 12), the total now sits at 74.5 million.

This is Costco’s recurring and predictable revenue stream. In the latest fiscal quarter, membership fee income grew 7.6% year over year to more than $1.1 billion. This pales in comparison to merchandise sales of $57.4 billion. But given that memberships generate high margins, they have an outsize impact on the company’s bottom line.

This is precisely how Costco can encourage customer loyalty that is a rarity in the retail sector. And most importantly, these memberships help drive repeat purchase behavior, supporting strong same-store sales gains. On a global level, the membership renewal rate usually exceeds 90%, indicating healthy customer satisfaction.

At the end of the day, it’s all about finding ways to grow the revenue base, and this is what comes from Costco’s scale advantages. As the business increases net sales, it can better negotiate pricing with its vendors. In a virtuous cycle, these savings are then passed to shoppers in the form of low everyday prices.

It’s all about patience

It’s not hard to figure out why Costco is a favorite among investors. It posts consistently solid financial results, regardless of what the economy is like. During the third quarter, same-store sales were up 6.6%, with diluted earnings per share soaring 29%. Costco looks like a top consumer shopping destination when inflationary pressures are high.

This is a business that can help any investor sleep well at night, particularly when you consider the membership model I mentioned earlier. However, it’s important to consider the stock’s valuation, which greatly reduces the likelihood that adequate returns will be achieved in the years ahead. Shares trade at a price-to-earnings (P/E) ratio of 53.1. This represents a massive 54% premium to the trailing 10-year average.

It’s accurate to say that the market is extremely bullish about Costco’s prospects. But given its tremendous size today, it’s reasonable to assume that growth going forward will slow down.

Therefore, the best thing prospective investors can do is to add Costco to the watch list for now. Practice patience and wait for a much more attractive entry point before considering buying.

Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy.

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