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Tickers in this Article: COST, WMT
Costco (COST) dominates a growing portion of warehouse club retailing. This business has historically operated with around 3% margins, but COST has earned returns on invested capital well in excess of its cost of capital.

As the consumer gets squeezed, the attraction to quality items at low prices becomes stronger, and thus COST is expected to see a rapid rise in business. COST also has the additional attractiveness of being a one stop place to shop.

Busy consumers can purchase food, clothing, TVs and computers at low prices, all under the same roof.

As consumers shift their shopping and spending habits, COST is well-positioned to be a leader.

COST operates approximately 490 warehouses in the U.S. and six other countries with an average of 139,000 square feet of space. COST has approximately 48 million club members.

COST has steadily grown its revenues through a combination of new store openings and same store sales growth. Over the past 5 years, COST has averaged 12% sales growth with new store growth contributing about 6%.

The comp store sales are better than its chief competitor, Wal-Mart's (WMT) Sam's Club. COST warehouses typically generate 50% more sales on average than Sam's Club stores. This is chiefly attributed to better merchandising. COST's management are extremely capable retailers.

COST's also has less employee turnover, which produces better customer service. This comes at a price of higher SG&A expenses. COST pays its employees about 70% higher wages and provides much better benefits (COST workers pay 10% of health premiums versus 23% at average retailer). COST has gotten some relief in SG&A expenses as new legislation in California's onerous workers compensation laws have been re-written with more favorable aspects to business.

COST uses its high quality merchandise and customer service to provide strong membership renewal, which provides a solid and growing income stream for COST. This strong base helps to keep traffic flows at COST high. Additionally, traffic has been helped by the addition of other high quality brand-name products and private label merchandise.

The key driver going forward for COST, however, will be a change in consumers spending habits. Although it is not expected that consumers will stop spending, it is expected that convenience and pricing are at the top of their list. Club warehouses like COST, with its high level of customer service, are well-positioned to take advantage of this trend.

In addition, to the low prices of name brand products in electronics and computers, COST also offers a wide selection of fresh and packaged foods, and private label products in clothing and general merchandise. The addition of these products serves two purposes; it allows customers to buy quality merchandise and provides COST with higher margins.

This Christmas season should give investors confirmation of this trend. It has been stated numerous times that consumers are tapped out. Sales keep growing and the holiday season usually brings out the consumer spender. COST's business model has been developed to provide one stop shopping with great prices and service for consumers. That trend will grow as the consumer's wallet shrinks as we approach an economic slowdown.

The main risks to COST are increased competition from Sam's Club and BJ's Wholesale (BJ). Sam's Club is the bigger threat as they now begin to focus on small businesses, which has traditionally been the domain of COST. BJ's is a lesser threat as they are currently have a much smaller geographical footprint.

Financially, COST is strong with about $630 million in debt and nearly $3 billion in cash. COST has also been aggressively buying back stock. Consensus EPS estimates for August 2007 are $2.59 and $2.93 for 2008. COST is selling at around PEG ratio of 1.5x with a projected 13% earnings growth rate. COST, on a price/sales basis, is trading at 0.42, which is a 28% discount to the industry average. COST's returns on capital are also the envy of the industry. COST is not the cheapest on a P/E basis, but investors could be surprised by an acceleration of earnings as consumers spending habits continue to shift towards COST's business model.

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