In the summer of 2012, Costco traded at $78 per share. It was earning $4 per share in profits and was trading at a valuation of 19.5x earnings. The stock had climbed ten-fold over the previous twenty years, and had increased almost 100-fold since its 1982 initial public offering. Its sales per store were astounding, as it was one of the only brick-and-mortar retailers that had reported same-store sales growth of at least 5% annualized. It was generating almost $700 million in cash from its members who have to pay an annual subscription fee (that is now $60) in order to join. The dividend, having been initiated in 2002, had risen in every year of its existence and only consumed 27% of the annual profits. And it was sitting on nearly $10 billion in cash. It seemed to meet all the criteria of a wonderful business trading at a fair price.
Over the past seven years, Costco has been one of the rare retailers that has drowned its investors in cash dividends while simultaneously growing the business at a 9% rate. Since the company limits itself to only growing in locations that make great sense, and since the stock repurchases are somewhat limited, Costco often finds itself with huge amounts of cash piling up on its balance sheet. Even today, the company only pays out 30% of its cash as profits and has $7 billion in cash in the proverbial bank.
Between 2012 and 2019, Costco shareholders collected $13.18 in regular cash dividends. For a retailer with a low starting dividend, that’s a solid 17% cash back on one’s investment.
But the real kicker? When Costco has found itself overflowing with cash, it has returned it to its shareholders. This has meant special dividends of $7 in December 2012, $5 in February 2015, and $7 in May 2017. That additional $19 means that each share of Costco purchased at $78 in 2012 has since generated $32.18 in dividends, or approximately 41% of the purchase price just seven years ago. Considering that Costco is still only paying out a fraction of its profits as dividends and has since seen its share price climb to $266, it is one of the rare examples outside the tobacco sector of high dividends and capital growth walking hand in hand.
To me, the success of Costco provides an important lesson in recognizing that balance sheet considerations eventually matter. From 2007 through 2012, Costco’s stock price barely budged from the $50s to the $70s. It seemed like a sleepy business to many.
To the analytical observer, however, it was clear that Costco was both growing its business at a high single-digit rate and retaining billions of dollars of cash on its balance sheet that would eventually be put to work. If the $19 in special dividends over the next five years couldn’t specifically be anticipated, there was still a sufficient basis to recognize that some massive forms of wealth generation awaited, be it in the form of large share repurchases, acquisitions, or a more ambitious international growth strategy.
Right now, Costco has 85 million members that are charged annual membership fees of at least $60 per share which puts $5 billion in cash into the pockets of Costco’s treasury for improving its competitive advantage and rewarding shareholders each year. As it takes action to become a better business, it will be able to raise the membership rates in the years to come. Same-store sales growth remains in the 4-6% range each year, and new locations continue to keep earnings per share growth in the 8-11% range.
Right now, the stock trades at 33x its expected earnings for this year, which is the highest valuation in the past twenty-five years. Existing shareholders will probably continue to earn high single digit returns from this price point, but I imagine most investors will need to wait for the P/E ratio to come down to around 20 or so before initiating a position. Still, it is often best to perform the analysis ahead of time so that when you get your price, you are ready to strike.
In the meantime, the lesson about how strong businesses have strong balance sheets that create extra wealth for shareholders remains important (even though it can be easy to forget when interest rates are low). Right now, there are nine companies in the United States that are sitting on $100 billion or more in cash. You better believe each of those companies will be doing some interesting things to create wealth in the years to come. While it would be too formulaic for my tastes, I expect an investor could do well by saying: “I will purchase one stock each year, and I will select the most attractively valued of all the businesses sitting on $100 billion or more in cash right now.”
For those Costco special dividends, the average reinvest price was $114.32 per share. Each share of Costco that existed prior to the 2012 special dividend has now created .16 in additional shares. For someone with 100 shares on an initial $7800 investment in 2012, the special dividend alone has created 16 shares that resulted in $1,900 being sent from the Costco treasury to the shareowners, and due to the rapid rise in the price of the stock over the past seven years, those 16 shares are now worth $4,256.
With reinvestment, a Costco shareholder has received in market value of new stock from the special dividends an amount that already exceeds half of the capital that he put into the investment just seven years ago.
The cash on corporate balance sheets is one of the most overlooked sources of future wealth that is identifiable among publicly traded securities. For people who take fundamental balance-sheet analysis of securities seriously, I expect that great wealth will find those who can accumulate shares in those businesses with both a strong earnings per share growth rate and an attractive cash balance. It is common sense that manifests itself in intermittent rewards that are easy to overlook due to their sporadic nature.