Replying to a question from a Member of his Inner Circle, Pat McKeough looks at Costco, one of North America’s leading big box retailers. Costco has built its steadily growing business on the membership fees it charges and its ability to buy directly from manufacturers and keep its prices low. Pat looks at how well Costco is likely to sustain its growth in the face of stiff competition from other warehouse chains like WalMart. He also examines an interesting deal Costco has just made with Visa.

Q: Pat: What are your thoughts about buying Costco shares?

A: Costco Wholesale Corp. (symbol COST on Nasdaq; www.costco.com) owns and operates warehouse-sized stores that sell a wide variety of consumer goods.

The company charges its customers an annual membership fee, usually $55 a year, to shop in its stores. It has 687 outlets, including 481 in the U.S., 89 in Canada, 36 in Mexico, 27 in the U.K., 23 in Japan, 12 in South Korea, 11 in Taiwan, seven in Australia and one in Spain. It also sells products online in the U.S., Canada, the U.K. and Mexico.

Costco plans to open up to 32 more outlets in the next year. About half will be outside the U.S., including a second store in Spain and its first location in France.

The company buys most of its inventory directly from manufacturers, which lets it sell for less than traditional retailers. Food accounts for roughly half of its sales.

In its fiscal 2015 fourth quarter, which ended August 30, 2015, Costco’s revenue rose 0.7%, to $35.8 billion from $35.5 billion a year earlier. Same-store sales fell 1%. However, if you exclude the negative impact of foreign currency rates and lower gasoline prices, same-store sales gained 6%. Costco operates discount gas stations at around 70% of its outlets, and nearly 30% its customers buy gas and shop on the same trip to the store.

Earnings rose 10.0%, to $767 million, or $1.73 a share, from $697 million, or $1.58.

Growth stocks: New 10-year agreement with Visa will cut Costco’s credit card fees

The company plans to spend $2.8 billion to $3.0 billion on new stores and other improvements in fiscal 2016, up from $2.4 billion in 2015.

Costco can easily afford these outlays: as of August 30, 2015, its long-term debt was $4.9 billion, or just 7% of its market cap. It also held cash and investments of $6.4 billion, or $14.66 a share.

The company faces strong competition from discount stores like Wal-Mart and Target, as well as other warehouse-store chains, such as Sam’s Club (which is owned by Wal-Mart). That means Costco is unlikely to raise its prices as long as its purchasing costs stay low. This hurts its profit margins but helps it hang onto customers. In fiscal 2015, its member renewal rate was 91% in the U.S. and Canada and 88% worldwide.

Costco recently announced a new 10-year deal with Visa Inc. (symbol V on New York) and Citigroup (symbol C on New York).

Under the agreement, which takes effect April 1, 2016, Costco will only accept Visa credit cards at its U.S. warehouse stores. In addition, Citigroup will offer Costco members a new co-branded Visa card with an enhanced loyalty rewards program, though shoppers can also use Visa cards issued by other banks.

This new arrangement will cut the fees Costco pays under its current deal with American Express (symbol AXP on New York).

The company will probably earn $5.64 a share in fiscal 2016, and the stock trades at a high 27.7 times that estimate. The $1.60 dividend yields 1.0%.

Inner Circle recommendation: HOLD

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