Always putting the customer first... From a 'clone' to the world's largest warehouse club chain... Members are better than customers... A top 'Five Clues' dominator... Unlocking a classic 'trade up' winner for the years ahead... It's still a great buy today...

Editor's note: Longtime readers know it's one of our founding principles...

Give you the information we would most want to have if our roles were reversed.

It's what our founder Porter Stansberry strived to do from Day 1 in 1999, when he launched our company using a borrowed laptop and sitting at his kitchen table... It's what I (Corey McLaughlin) aim to do every day here in the Digest... And it's what all of our editors and analysts set out to do each month across our universe of roughly two dozen publications.

My colleague Dan Ferris excels at following this mantra in his Friday Digests as well...

Dan is one of the best in the business when it comes to his financial prowess. At the same time, he possesses the uncanny ability to mix in humor and a philosophical mindset to share his message with readers in a way that few others do. It's understandable and relatable.

In short, Dan's No. 1 goal with the Friday Digest each week is to provide our more than 525,000 readers with the most important financial – and life – knowledge at any given time.

That brings us to today's essay...

As Extreme Value analyst Mike Barrett alluded to in yesterday's Digest, we're doing something outside the box to end the week. Instead of a traditional write-up, Dan is "unlocking" the March issue of Extreme Value to give Digest readers an inside look...

As you'll see, earlier this year, Dan and Mike recognized a rare opportunity to invest in a world-class business at an extreme value. They've been watching this company for years... and they finally got a chance to act after nervous investors fled for the exits to start 2021.

Dan and Mike nailed the timing of their recommendation... Just two months later, this stock is back near an all-time high. Subscribers who followed their advice are already up 16%.

Fortunately, despite this rapid rebound, you haven't missed the boat... As Mike explained yesterday, this company is poised to be a big winner as the "Great Society 2.0" unfolds.

We've also updated the valuation section of the issue with the latest data. It will help you to see how the opportunity could potentially play out in the weeks, months, and years ahead.

Plus, it isn't the only successful example of Dan and Mike's approach in recent months... In January, they realized that the market was underestimating the true growth potential of another company. Their research paid off... The stock is up roughly 50% in four months.

Our point is... this is critical research that every Stansberry Research subscriber should see. By sharing this content today, we're doing what we would want if our roles were reversed.

And with that, we turn today's Digest over to Dan...

Unlocking a Classic 'Trade Up' Winner for the Years Ahead

By Dan Ferris and Mike Barrett, Extreme Value

In the early 1980s, Jeff Brotman went to San Diego to check out an unusual discount shop that was shaking up the retail sector.

Jeff was the son of a successful Seattle-area clothing retailer. He had grown up in the industry. But at nearly 40 years old, he had never seen anything like this bustling business.

The store was housed on Morena Boulevard in a converted airplane hangar built by Howard Hughes. There were no frills and no "backroom." The store looked like a warehouse... Customers walked through aisles that were wide enough for a forklift, browsing merchandise that was stacked in pallets up to the ceiling.

The concept of combining storage and retail spaces was revolutionary in the industry. And it saved a fortune on labor costs. (Typical retailers had to fill a warehouse or backroom, then pay employees to open boxes and restock shelves.)

The store was called Price Club, after its founder Sol Price. Just like any other club, you had to pay a membership fee to join. It sounds outrageous, right? Paying a fee for the privilege of going grocery shopping.

But people were more than willing to pay $25 a year for the right to buy oversized jars of mayonnaise and big boxes of laundry detergent because it made them feel like they belonged to something exclusive... and because they could buy everyday items in bulk for deeply discounted prices.

Jeff and his father agreed there was nothing like it in the Pacific Northwest. They had to create one just like it in their hometown.

So Jeff met Price's protégé Jim Sinegal in 1982 and knew he'd found the man to lead the new business. In 1983, the two raised $7.5 million from investors and built the first Costco Wholesale (Nasdaq: COST) warehouse store in Seattle.

Sinegal said in a 2017 presentation that their initial ambition was simply to get 10 stores and that "the idea was to clone the Price Club. We didn't want to do anything fancy... Let's just do what they're doing and do it well."

Costco eventually acquired Price Club, and the Morena Boulevard store is still in operation.

Today, Costco is the largest warehouse club chain in the world and the third-largest retailer of any kind, after Walmart and Amazon.

We've been watching Costco for years. Today, it's finally cheap enough for us to recommend.

Costco has 804 warehouse stores worldwide, with the overwhelming majority in the U.S. (558) and Canada (103). There are 39 stores in Mexico, 29 in the U.K., 27 in Japan, 16 in Korea, 14 in Taiwan, 12 in Australia, 3 in Spain, and one each in Iceland, France, and China.

Its real estate holdings total roughly 120 million square feet, with its warehouse stores averaging 146,000 square feet each. It employs 275,000 people in 12 countries.

The company has 108 million cardholders and enjoys an 88.5% membership renewal rate worldwide. In 2020, it earned $3.5 billion in membership fees. Including memberships, Costco did roughly $167 billion in revenue last year.

Comparable sales grew 8% in fiscal 2020, but some specific product areas grew even more as a direct result of the COVID-19 lockdowns... Global TV sales were up 14% last year. Global PC sales were up 53%, global alcoholic beverage sales were up 17%, global produce sales were up 16%, and global meat sales were up 21%.

COVID-19 lockdowns have been a boon for Costco. But the pandemic is (hopefully) coming to an end, and investors are losing interest in the stock. Shares are down 16% from their 2020 highs on expectations that as society slowly regains some semblance of normalcy, the pandemic-related spending surge will likely subside.

This pessimism sets us up for an underappreciated growth story. Even at pre-pandemic levels, Costco is the model of robust financial health and hits every essential financial clue we look for when identifying a great business.

All the recent sell-off does is give us a rare opportunity to invest in a world-class business at an extreme value. (Editor's note: The stock is up 16% since this initial report in March. But as we've noted, it's still trading well within the recommended "buy" range today.)

The Guiding Principle

Costco's immense success comes from the guiding principle that exemplifies the core of its business model. The No. 1 priority was set down by Sol Price years before Costco was founded, and it has never wavered...

Always put the customer first.

Many key practices stem from this primary guiding principle.

Costco is known for having the lowest prices. Two anecdotes about this come readily to mind.

In Portland, Costco didn't carry sugar for about two years because every supermarket in the city was selling it below cost. The company didn't want to sell anything it couldn't offer at the lowest price in town.

On another occasion, many years ago, Costco listed Calvin Klein jeans for $29.99. It was an incredible deal. The jeans flew off the shelves so quickly, Costco couldn't keep them in stock. On its next order, the manufacturer lowered Costco's price by $7 per pair. The warehouse could have continued to sell the jeans to its customers for $29.99 and pocketed the difference. Profit margins would have shot through the roof. But that's not the Costco way. It put the customer first and lowered the price to $22.99.

In Sinegal's words, "We pass the savings on to the customer, every time. Do you know how tempting it is to make another $7 on a pair? But once you do it, it's like taking heroin. You can't stop."

Today, Costco doesn't sell any goods for more than 14% over cost (15% for Costco's private-label Kirkland brand).

Costco has – as a Goldman Sachs analyst first said years ago – established absolute price authority. Customers have no doubt they're getting great prices at Costco.

There are three key components to how Costco is able to keep its prices so low and keep customers coming back over and over again...

First, the company doesn't try to be all things for all people, like a Walmart or an Amazon.

Costco offers a narrow selection of supersized merchandise in a wide range of product categories. Walmart and Target have about 140,000 to 150,000 items per store. Costco has about 3,700. A typical supermarket has more than 300 different types of cereal. A typical Costco has 12.

By keeping product offerings low, Costco can focus on providing one thing – competitive value. In other words, giving members the most quality at the lowest possible cost.

That's how it sells more wine than any retailer in the world. That's also how it sells more than a billion rolls of toilet paper a year (its single best-selling item), enough to wrap around the Earth 1,200 times.

Second, Costco's inventory creates a "treasure hunt" atmosphere, especially in luxury goods. If you see a Coach handbag that wasn't there last time, you'd better buy it now because it might not be there next time.

Third, the very nature of a membership system assures quality, loyal customers...

Members Are Better Than Customers

Making customers "members" – and charging them an annual fee to get in the door – is a key part of the strategy to drive higher foot traffic.

Membership creates exclusivity... and brand loyalty. One adoring Costco fan, who maintains a Facebook page under the name "Costco Connoisseur," boasts of having visited 244 different warehouses in 37 states and five countries.

Costco's exceptional brand loyalty is also evident in its Net Promoter Score ("NPS"). This industry metric measures a customer's willingness to return for another purchase and to recommend the company to friends and family. NPS scores range from -100 to 100. Anything above 50 is considered excellent.

Costco's latest score is 79. Three of Costco's primary competitors have far lower NPS scores – Target (43), Amazon (25), and Walmart (-4).

In addition to brand loyalty, Costco's membership program creates something even more important when it comes to driving foot traffic – a "sunk cost" that customers can only justify by increasing the frequency of their shopping trips. As Kusum Ailawadi, a professor of marketing at Dartmouth College, puts it, "You'll say... I'm going to make sure I get my money's worth by shopping in the club store every chance I get."

And to make the membership fee even more palatable, Costco offers a money-back guarantee on the membership fee, as well as on in-store and online purchases. This and its liberal return policy keep customers coming back into the club over and over again... where the sunk-cost membership fee starts working on their psyches.

Great Employee Experience = Great Customer Experience

Costco also knows that to keep its customers happy, it has to first keep its employees happy. The company pays an average hourly wage of $23.64 in the U.S., far above that of other retailers. And it offers premium industry-leading benefits, for which roughly 90% of employees are eligible.

Employee turnover is very low, at just 7% after one year (versus industrywide retail turnover of roughly 60%). About 36% of Costco employees have been with the company for 10 years or more. (Employees even get free Thanksgiving turkeys.)

When asked about his greatest achievement shortly after retiring in 2011, Sinegal said it was "the fact that Jeff Brotman and I built a team that's capable of running a business this size. There's a management team that's in place that is very, very good and that has enabled us to sustain the business for a long time."

At almost 38 years old, Costco is still young and strong with satisfied employees and devoted customers. And it's a model of robust financial health...

A Top Five-Clues Dominator

In Extreme Value, we use the "Five Essential Financial Clues" to help us identify great businesses. A great business doesn't necessarily have all five clues present. But the best ones tend to have more of them than lesser-run companies. Costco is a five-clues beast...

Gushes Free Cash Flow

The value of a business comes from the cash it can generate in excess of all taxes, expenses, and capital expenditures. This number is called free cash flow ("FCF"). The best businesses tend to generate more cash than they know what to do with.

And as you can see, Costco's FCF has tended to rise over time. As revenues continue to rise (more on that later), FCF will also continue to rise.

Consistent Margins

In capitalism, it's normal for competition to erode profit margins – sometimes to zero. A consistent margin is an economic anomaly, sometimes indicating that a business provides goods and services that customers can't get elsewhere.

The fanaticism of Costco's customer base leads to some of the most consistent margins we've ever seen. The company consistently earns 12% to 13% gross margins and about 2% net margins. This consistency is perhaps one of the great achievements in modern business history.

Costco's margins are razor-thin by design. It wants to pass as much value to the customer as possible. Other retailers tend to look at an item they sell for $20 and wonder if they can sell it for $21 or more. Costco looks at the same item, which it might sell for $15, and wonders how to get it down to $14 or lower.

We expect the margins to stay razor-thin, the company to remain consistently profitable, and the customers to remain addicted.

Good Balance Sheet

There are two kinds of good balance sheets. The first is when a company has more cash than debt. The second is when a company has more debt than cash but makes enough income to service its debts many times over.

Lately, Costco has the first kind of good balance sheet. But over time, it has fluctuated between the two. As of its latest balance sheet, for the quarter ended February 14, the company had $9.3 billion in cash and short-term investments and $7.6 billion in debt.

There's ample room to add more debt if management decides to do so. Net income in three of the past four years was more than 30 times debt and other financial obligation payments.

So if Costco borrows a few billion more in the coming months and years, we wouldn't bat an eye because it has more than enough resources to service the extra debt.

Shareholder Rewards

Shareholder rewards include dividends and share repurchases. Costco is a fairly typical corporate share repurchaser. It spent nearly $2 billion on repurchases in 2007, near the top of the housing bubble when all stocks were getting expensive... and just $70 million in 2009, when stocks were all cheap.

But over the long term, the share repurchases have definitely created value for shareholders. Since it started buying back shares in 2005, Costco has spent roughly $9.2 billion to repurchase and retire 131.3 million shares at an average cost of right around $70 per share. As of yesterday's close, the stock trades for $328.65 per share.

Costco has paid a regular quarterly dividend since May 2004. It has raised the dividend every year since. Costco occasionally also pays special one-time dividends. It has paid special dividends between $5 and $10 per share four times in the past eight years. We could see a similar payment sometime in the next few years, as the company outperforms current tepid revenue growth expectations. In the meantime, the regular dividend will continue to grow. (Note: The following chart does not reflect special dividends.)

Consistent Return on Equity

If a business were a bank account, return on equity ("ROE") would be the interest rate you'd earn on all the money you left in it.

Costco has consistently earned more than 20% ROE since the fiscal year ended August 2015. Overall, ROE has roughly doubled since 2011. That's what you get with a business whose primary requirement is that it continues to sell massive volumes of goods.

Now let's see how cheap Costco is compared with the expectations baked into the current price...

What's It Worth?

Our valuation model involves the careful analysis of three forward-looking inputs – revenue growth, operating margins, and FCF margins over the next five years. Let's look at each of them in greater detail.

Revenue Growth

Extreme value occurs when pessimism reaches an extreme, causing the gap between intrinsic value and share price to widen and the margin of safety to expand. That's the time to buy.

Costco was a pandemic winner last year. But with the pandemic waning, investors are becoming more pessimistic. That's excellent news for us.

Since last March, member spending at Costco warehouses has surged. Stuck at home week after week, they diverted disposable income that might otherwise have been spent dining out or taking vacations to buy things they use and consume at home. That's why Costco enjoyed the unusually large sales growth in TVs, computers, alcoholic beverages, and other items that we noted earlier.

As society slowly regains some semblance of normalcy this year, the 2020 spending surge will likely subside. Investors are already abandoning the stock. And that sets us up for yet another underappreciated growth story.

Costco's share price implies just sales growth of 2.5% per year beyond the next 12 months. Our view is that this world-class retailer will grow sales far faster than that (on average, about 8% per year) for three reasons...

1. Comp sales will eventually revert to normal but remain strong.

3. Costco Logistics is creating new opportunities for big-ticket sales.
4. New warehouse clubs will continue to be built.

No. 1: Comp Sales Will Eventually Revert to Normal but Remain Strong

Like most retailers, same-store (or "comp") sales is the key driver of Costco's top-line growth. Once a new store ("warehouse club," in Costco jargon) opens, there are basically two ways to grow sales...

1. Increase store "traffic." (Attract new customers to the store and get existing customers to come more often.)
2. Sell those customers more products per visit. (Increase the average "ticket" or sales receipt amount.)

During Costco's just-ended fiscal second quarter, for instance, comp sales rose 13% year over year ("YOY"). The company did a great job of attracting more customers AND boosting the spend per visit.

Next, let's evaluate how important growing the average ticket is to comp sales.

Because the data behind average ticket are highly proprietary, investors aren't given much to work with. But using what data are available gives us a sense for just how valuable it can be when customers spend more per visit.

In the following table, we summarize the change in comp sales since 2015, along with the reasons given by management in the company's annual and quarterly filings. Notice how comp sales accelerate as the commentary for average ticket improves. This suggests that getting members to spend more per visit generally has a greater impact on comp sales than rising store traffic does...

Intuitively, this makes sense. If Costco can entice a hypothetical member who typically comes to a warehouse club three times a month and spends $100 per visit to make an extra trip, comp sales rise $100.

But if it can persuade this same customer to spend $50 more per trip, comp sales rise $150 ($50 more per trip x 3 trips = $150).

When you combine the two – four trips per month at $150 per trip – comp sales rise $300, with two-thirds of the increase attributable to growing the average ticket.

Costco has gotten much better at enticing members to come more often and to spend more when they do. Importantly, this trend was well underway long before the pandemic arrived.

No. 2: Costco Logistics Is Creating New Opportunities for Big-Ticket Sales

One obvious way to grow the average ticket is to persuade members to purchase more big-ticket items, like appliances, furniture, and fitness equipment. But the decision about where to purchase these items often comes down to delivery and installation. Where can I get it at the best price – including delivery – and have it installed or set up as quickly as possible?

With this in mind, Costco identified a new opportunity last year... It set out to create the best-in-class delivery and installation experience for its members. In the words of CEO W. Craig Jelinek, the goal is to provide "faster delivery at a better price."

To accomplish this, Costco acquired "last mile" provider Innovel Solutions in March 2020. Included in the deal were 11 distribution and fulfillment centers and more than 100 final-mile cross-docking centers. These are specialized facilities where products headed for the same destination can be consolidated into fewer transport vehicles, thereby improving supply-chain speed and efficiency.

Innovel Solutions – now rebranded "Costco Logistics" – provides final delivery and installation for big and bulky items to about 90% of the U.S. and Puerto Rico. More recently, it also provides "white glove" (installation) capabilities for items with special transport and/or setup needs, like heavy glass tables.

By acquiring Innovel Solutions, Costco now controls its last-mile destiny. Most importantly, it gives members one more very good reason to buy big and bulky products from Costco that they used to purchase elsewhere. We expect this capability to add incremental sales growth over the next few years.

No. 3: New Warehouse Clubs Will Continue to Be Built

There are currently 804 Costco warehouse clubs around the world. Management expects to add between 20 and 25 new clubs per year for at least the next five years. (Due to the pandemic, it only added 16 new locations in 2020.)

If the average store size and sales rate stay the same, Costco should boost its club fleet by about 14% and increase sales by almost 3% per year over the next five years – surpassing the implied growth rate of 2.5%.

As new stores are added, some "cannibalization" (new stores taking sales from existing stores) occurs and will likely continue. The impact on the top line is negligible and is built into our comp-sales estimate.

Two other factors impacting revenue growth include gasoline sales and foreign-exchange adjustments. (Sales transacted in currencies other than the U.S. dollar can be lower or higher when converted into dollars for financial reporting purposes.) Both factors can be volatile, but neither had much impact in fiscal 2019 and 2020. Our valuation model assumes this will continue.

In summary, over the past five fiscal years, sales growth has been as high as 9.7% and averaged 7.5%. For the last full fiscal year prior to the pandemic, sales grew 7.9%.

After considering the three items just discussed – a reversion to pre-pandemic comp sales trends, new opportunities being created by Costco Logistics, and the ongoing addition of new warehouse clubs – we estimate comp-sales growth to be 5% per year, on average. Logistics and new clubs should add another 3% per year on average, for a total estimate of 8% per year.

The big disparity between our sales-growth estimate (8%) and what's implied in the share price (2.5%) is the primary source of extreme value in Costco.

Operating Margins

As the Portland sugar and Calvin Klein jeans anecdotes demonstrate, no retailer has more integrity than Costco when it comes to keeping product markups as low as possible. Just check out how much lower Costco's gross margin (basically, the difference between what it pays for goods and the price it charges for them) is than its primary competitors...

Costco's 59.7 million members know the company is fully committed to passing on the savings to them... And they're happy to share their affinity for the brand with friends, family, and coworkers. This influential "word of mouth" advertising in turn means Costco has to spend far less on traditional marketing than its competitors.

Check out how much less Costco spends on sales, general, and administrative (SG&A) costs relative to its primary competitors...

The operating margin is the gross margin minus SG&A spending. What we refer to as "operating efficiency" in the next table is a measure of how much of the gross margin falls to the operating margin line. (The higher this number, the better.)

For instance, over the past 12 months, Costco's operating margin was 29% of its gross margin – or 29% operating efficiency. Over the past five years, it averaged 25% operating efficiency. None of its peers have demonstrated that level of operating efficiency over either period...

In summary, we expect Costco to continue earning, on average, a 13% gross margin – something it has been doing for more than six years. We also expect SG&A expenses to remain around 9.5% on average, resulting in an operating margin of 3.5%.

Free Cash Flow Margins

FCF is operating cash flow minus capital expenditures ("capex").

Prior to the pandemic, Costco's operating cash flow was about 4.2% of revenue. The current margin (4.9%) is benefiting from lower income taxes and from surging sales causing cash flow to rise faster than expenses. These benefits will eventually recede, so we're modeling a return to the pre-pandemic 4.2% operating cash flow margin.

Management's capex projection this year is $3.2 billion, or about 1.7% of revenue. This anticipates the construction of 21 new warehouse clubs. We're modeling for 22.5 new warehouse clubs per year (midpoint of management's 20 to 25 per year goal). We also anticipate some incremental capex related to the new Costco Logistics program. Overall, we're forecasting capex at 2% of revenue beyond this year.

This ultimately translates into an FCF margin of 2.2%, right in line with the pre-pandemic margin.

Putting It All Together

Running the above numbers through our valuation model produces an intrinsic value estimate of $500 per share. Alternatively, you can think of intrinsic value as being the highest price a knowledgeable buyer would pay for the entire business today.

At roughly $380 today, Costco shares currently trade at a discount of around 25% to our intrinsic value estimate, or the highest price the enterprise would command in a sale transaction.

Now, let's evaluate the reasonableness of this estimate against the market data that are available...

Our $500 figure translates into an enterprise value to earnings before interest, taxes, depreciation, and amortization ("EBITDA") multiple of 26 times.

The best comparable is Inspire Brands' recent acquisition of Dunkin' at 26 times EBITDA. Like Costco, Dunkin' is a well-known brand with a fiercely loyal following. Growth expectations were lower than Costco's (3% for Dunkin' versus 8% for Costco), but margins were higher (high double digits versus low single digits).

Keep in mind, Costco's slim margins are actually a formidable competitive "moat." That's because the prospect of earning such low margins discourages additional competitors from entering the market.

Dunkin's balance sheet was also loaded with debt at the time of sale. It had net debt of about 5 times EBITDA. This contrasts sharply with Costco's net debt of -0.2 times EBITDA. (The minus sign indicates Costco has net cash of $1.6 billion, a vastly superior position.)

Something else to keep in mind about Costco... Its 59.7 million members pay an annual fee that currently totals around $3.5 billion. A high renewal rate (88.5% worldwide as of the second quarter of 2021) and margin (our estimate is 70% after taxes and administrative expenses) really make this an annuity.

On a net basis, we figure membership fee income totals about $2.5 billion, or basically about half of Costco's annual FCF. In other words, Costco's FCF generation is far more durable than you'd expect for a company earning just a 2.2% margin.

Finally, we note that over the past year, a number of high-quality, growing, and consistently profitable companies have traded at multiples between 23 and 30 times. While they operate in different industries, this multiple range is generally reflective of what the best enterprises (of which Costco is one) command when being acquired.

In the final analysis, our intrinsic value estimate of $500 per share is well-supported by the available market data. But never forget... although it's highly informed, this is ultimately an estimate. For a sufficient margin of safety, we urge you to spend no more than $400 per share.

As noted earlier, we've been watching Costco for years. Rarely does the gap between intrinsic value and share price widen as much as it has recently. Don't miss the opportunity to acquire a world-class business being temporarily sold off by nervous investors.

We will not use a stop and are adding Costco to our "Crown Jewels" category. That means unless there's a change in our investment thesis, we have no intention of selling, no matter how deep shares might sell off. Price pullbacks should be viewed as an opportunity to improve your cost basis and boost your position size.

Good investing,

Dan Ferris and Mike Barrett

Editor's note: Dan and Mike recommended Costco at the perfect time – and as we've shown, plenty of upside potential remains. And it's far from the only great buy in Extreme Value today...

The publication's May issue just went out to current subscribers about an hour ago.

In it, Dan and Mike highlighted a brand-new recommendation that's an underappreciated growth story just like Costco. It comes with a 35% margin of safety. But unlike Costco, this company is a small-cap stock that 99% of investors have likely never heard of.

Plus, Dan and Mike just raised the maximum recommended buy prices on five other "Crown Jewels" in their model portfolio – two of them substantially. That's noteworthy since many stocks have pulled back in recent days... It speaks to the bright growth outlooks of these companies.

So as you can see, it's a phenomenal time to join Extreme Value if you're not already a subscriber. And even better, right now, all Digest readers can claim instant access to all of the research in Extreme Value at 33% off the regular price. Get started right here.