Costco Wholesale Corporation (COST): This Retailer Is a Bit Too Expensive

Costco Wholesale Corporation (NASDAQ:COST) has been a Wall Street darling for many years, with the stock relentlessly climbing higher over the past decade. Growth has been strong as the warehouse-club model has grown in popularity over the years. But does Costco Wholesale Corporation (NASDAQ:COST) deserve the valuation which it trades for, or has the stock become overheated?

The basics of Costco

Costco is a very different company than most other retail stores. While supermarkets typically charge a considerable premium over wholesale prices Costco keeps that premium to about 15%, ensuring lower prices for its customers. While big-box stores like Wal-Mart Stores, Inc. (NYSE:WMT) and Target Corporation (NYSE:TGT) pay their workers as little as legally possible the typical Costco worker makes about $45,000 per year as of 2011.

This all leads to lower margins for Costco Wholesale Corporation (NASDAQ:COST) compared to Wal-Mart Stores, Inc. (NYSE:WMT) and Target Corporation (NYSE:TGT), but the business model is superior in many ways. Wal-Mart Stores, Inc. (NYSE:WMT) has been facing criticism regarding its extremely low wages, with some workers recently going on strike demanding higher wages and better working conditions. They say that any publicity is good publicity, but I don’t think that holds in this case.

Costco charges a membership fee, the standard rate being $55 per year, which allows customers to buy products at its stores. Most of the company’s operating profits come from these fees, and with renewal rates around 90% in the United States earnings should be fairly consistent and predictable. Costco Wholesale Corporation (NASDAQ:COST) only accepts cash, debit cards, and American Express cards, meaning that the typical customer is likely more financially stable than the average consumer and thus better equipped to withstand economic weakness.

Another strong quarter

Costco recently reported strong third quarter earnings. Comparable store sales rose 6% in the U.S. year-over-year and 5% overall, and revenue jumped by 7.8%. Diluted EPS rose 18% to $1.04 on net income of $459 million.

Like I said above, membership fees account for most of the operating profit. Of the $722 million in operating profit reported for the quarter $531 million of this was from membership fees, about 74% of the total. These fees grew by 11.8% year-over-year, outpacing revenue growth considerably. Since this is where most of the profits come from, this is great news for the company.

The balance sheet remains strong even with the addition of some debt. Total cash and investments total $6.5 billion compared to debt of $4.9 billion. At the end of last year Costco Wholesale Corporation (NASDAQ:COST) paid a special dividend of $7 per share which was financed by a $3.5 billion debt offering. Although the interest rates were low on the debt this seems like a strange action to take. I’m generally not in favor of taking out debt to finance dividends or buybacks for that matter – I wrote about a particularly bad case of this a while back. Why not instead pay a higher regular dividend, making the stock more attractive to dividend investors?