As one of the strongest retailers in the United States (not to mentioned one of the best-liked), Costco (Nasdaq:COST) already has a lot going for it. Not only is Costco already an exceptionally efficient retailer in terms of generating sales per square foot, the company still has ample organic expansion potential in the U.S. and abroad. The down-side to this story is not too surprising - Costco's success and popularity are well-known among investors, and the stock doesn't offer a compelling bargain relative to expected above-average growth rates.

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A Mixed, but Generally Positive, Start to the Fiscal Year
As Costco gives the Street frequent updates on its business, there aren't typically too many large surprises with the company's financial performance. Nevertheless, the company usually manages to squeeze out a few extra pennies relative to the average sell-side estimates.

Revenue rose more than 9% this quarter, as net merchandise sales rose 9.6% and membership fee income rose 14%. Merchandise sales were pushed by 7% comp-store growth, or 6% excluding gasoline and currencies impact. Overseas comps were slightly higher, increasing 9% as opposed to the domestic comp growth of 7% (including gasoline and currency impact).

Gross margin was the one place where there was a little hiccup this quarter, as the gross margin increased just six basis points (BPS) and missed the average sell-side estimate by about 11 BPS. Costco management runs a relatively tight ship, though (despite paying higher wages and benefits than most retailers), and the company recaptured some of that lost merchandise margin through SG&A. Operating income rose 18% and operating margin rose about 18 BPS from last year.

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Grabbing More of the Retail Pie
Looking at the recent comp store sales trends at other retailers like Walmart (NYSE:WMT), Target (NYSE:TGT), Kroger (NYSE:KR) and a host of department stores, it's hard to argue that Costco is not continuing to gain share in the overall retailing space. While I think consumers often overestimate the savings they garner by shopping at warehouse clubs, I nevertheless believe there is a strong habit among many Costco customers to do more of their core shopping there and then splurge at places like Whole Foods (Nasdaq:WFM).

I do wonder, though, if Costco's growing strength is looked upon so favorably by vendors. There's a physical limit to what can fit in a Costco store, so management turns over slow-selling merchandise quickly and shelf position is valuable. That gives more leverage to Costco, and that cannot be something that the likes of Kellogg (NYSE:K) or Kraft Foods (Nasdaq:KRFT) are thrilled to see (not that there's much that they can do about it).

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Plenty of Capital to Continue Expansion
While Costco did announce a sizable special dividend of $7 per share (the ex-dividend date has since passed), the company is not limiting their expansion options to any meaningful degree. The company will still have more than enough cash to continue opening stores in the U.S. and abroad.

The Bottom Line
With double-digit returns on capital and share-gaining comp growth, there's a lot to like about Costco. Unfortunately, the company is too big, too well-known and too good at execution to be any sort of hidden gem.

Even allowing for above-average long-term revenue growth (better than 6%) and ongoing free cash flow conversion improvements such that free cash flow grows at a high single-digit or low-teens rate, the shares are not cheap. With fair value in the mid-to-high $90s, I'd continue to hold Costco shares if I already owned them, but it's harder to make the case for taking a new position today unless you are prepared to hold these shares for quite some time.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Tickers in this Article: COST, WMT, TGT, KR

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