How Risky Is Costco Wholesale Corporation?

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Many of its retailing peers are setting multiyear lows right now, but Costco (NASDAQ: COST) seems to be trading in a different market. Its most recent dip caused the stock to fall below the broader S&P 500 for the year, but it is still up solidly over the trailing five-year period.

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On one hand, that relatively strong performance reflects the fact that Costco isn't as exposed to many of the awful business trends that are pinching peers like Target (NYSE: TGT) and Kroger (NYSE: KR). On the other hand, its steep price premium means the stock has a long way to fall if the business stumbles.

Below, we'll look at whether that pricing risk is worth signing up for as an investor.

Less volatility than your average retailer

Costco's operating results are less volatile than most retailers for a simple reason: It isn't actually a retailer. Most of the company's earnings come from subscription sales, not product markups, after all. And those fees, unlike prices for goods like groceries and apparel, tend to rise regardless of the competitive selling environment. 

Yes, Costco can go years in between membership fee hikes, but it hasn't yet needed to lower its core subscription fee to keep attracting new customers. Kroger and Target both recently slashed their annual earnings forecasts as they moved to increase price investments in a bid to protect market share. Costco, in contrast, just raised its membership fee by 10%.

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The warehouse club setup translates into small but steady earnings growth that makes Costco an unusually dependable investment. Net income hovers around 2% of sales and has doubled over the last decade. Rival retailers have endured both more volatility and lower growth over that time.

Financial priorities and valuation

Costco has $5 billion of long-term debt on its books, which amounts to a comfortable two times the past year's net profits. Its annual operating cash flow is $4 billion and provides plenty of resources to fund an aggressive store expansion strategy in addition to any other important priorities like e-commerce. 

So far, management has decided to take a conservative approach to the online sales threat. But recent moves by Amazon to elbow deeper into the grocery market might force the warehouse giant to dedicate more cash to this sales channel, and that could result in lower earnings over the short term.

The retailer's dividend policy isn't as generous as some of its peers, but Costco still ultimately delivers most of its excess cash to investors -- usually through sporadic special dividends. Management is taking advantage of the low interest rate environment to fund these payouts through added debt.

An important risk to owning a high-performing business like this is paying too high a price. There's no denying that Costco is valued at a huge premium to other big retailers. Its price-to-earnings multiple is more than double Target's and Kroger's and far ahead of Wal-Mart's (NYSE: WMT). The premium holds on a revenue basis, too, given that investors have to pay 0.56 times revenue for Costco's shares compared to 0.47 times for Wal-Mart.

That valuation gap implies more modest returns for Costco shareholders ahead that could turn yet lower -- if membership renewal rates fall from their perch at near 90%.

In exchange for that premium, though, shareholders get to own a retailing business that's better insulated from e-commerce threats and less susceptible to short-term swings in shopper behavior.

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Demitrios Kalogeropoulos owns shares of Costco Wholesale. The Motley Fool owns shares of and recommends Amazon and Costco Wholesale. The Motley Fool has a disclosure policy.