Costco Is Tapping Into A Stronger Consumer. Is The Dividend Stock A Buy Now?

Costco Wholesale (NASDAQ: COST) has been a market-outperforming retailer in a growth-driven market. Technology is the only sector that has outperformed the S&P 500 over the last five years. But Costco has done even better, with the stock up 238% in the last five years compared to a 193% gain in the tech sector and a 92% gain in the S&P 500.

Costco's strong performance is based on solid fundamentals and investor optimism. Costco reported earnings last week, with management sharing some encouraging news about the state of the consumer. Here's what's driving Costco and whether the dividend stock is a buy around its all-time high.

Costco's elite business model

Retailers large and small have faced numerous challenges over the last few years. The COVID-19 pandemic disrupted supply chains and threw a wrench in forecasts. More recently, inflationary pressures have squeezed margins and weighed on consumer spending.

Companies with a more staples-focused product mix rather than a discretionary product mix have generally fared better. For example, Walmart is at the top of its game, and the stock just hit a new all-time high on Friday, while Target's margins are still below normal levels.

Costco's membership-focused business model puts it in a league of its own. Roughly half of its operating income comes from membership fees, and the other half comes from merchandise sales. This business model gives Costco predictable cash flow. It also shifts the focus from squeezing every ounce of profit out of every sale to fostering a quality brand that resonates with members. The ultimate goal is to make members happy, so they shop at Costco more often and renew their membership.

The word "value" was mentioned 39 times on Costco's recent earnings call. The company stressed its pricing power and ability to give consumers a great deal and a varied product mix. Costco can essentially afford to make very little profit or no profit on some items if it feels it enhances the customer experience.

For example, Costco's $1.50 hot dog and drink combo is an example of a loss leader. Costco isn't trying to make money on that one offering, but rather use it to satisfy customers and get them in the store. Given Costco's performance and its stock price, the decision to keep the hot dog cheap is clearly not having a detrimental affect on the company's fortunes.

An uptick in discretionary spending

Costco sells various discretionary items -- from electronics to appliances, furniture, and more. On Costco's third-quarter fiscal 2024 earnings call, CFO Gary Millerchip said the following on consumer spending trends: "As inflation has leveled off, our members are returning to purchasing more discretionary items. And growth in the category was led by toys, tires, lawn and garden, and health and beauty aids."

Discretionary spending helped drive a 7% increase in sales for the first 36 weeks of fiscal 2024 compared to 2023. However, Costco noted the figure is positively impacted by 0.5% to 1% based on a shift in the fiscal calendar. Costco also noted that e-commerce made up 14.9% of total sales in fiscal 2024 compared to 14.7% in the first three quarters of fiscal 2023.

In sum, higher consumer spending on discretionary goods and cooking from home are excellent trends that benefit Costco.

Valuation concerns

There are stocks that are in favor -- and then there are market darlings like Costco. Despite its moderate growth, Costco fetches a sky-high price-to-earnings (P/E) ratio of just over 50. Costco is a textbook example of valuation expansion.

COST PE Ratio data by YCharts

In the chart, you'll notice that the more recent the time interval, the higher the median P/E ratio. Big gains can be made in the stock market when a company grows earnings and the market is willing to pay a higher price for the stock relative to its earnings. Both factors have been at play with Costco.

For example, if Walmart had Costco's P/E, it would be worth around $940 billion, not its current $530 billion. Costco has more than double the P/E of other top retailers like Home Depot and nearly triple the P/E of Lowe's.

Costco is a phenomenal business. But its valuation is cause for concern given Costco is only generating mid- to high-single-digit sales growth.

An inconsistent dividend

Costco has a unique dividend program. It pays a rather small ordinary dividend and then the occasional special dividend when its cash position reaches a healthy level. While receiving a sizable special dividend is rewarding, income investors are typically looking for steady payments or to supplement income in retirement. A special dividend somewhat defeats that purpose. The money would arguably be better used buying back stock, especially considering special dividends are taxed as dividend income.

Costco's current quarterly ordinary dividend is $1.16 per share -- good for a forward yield of just 0.6% based on Costco's roughly $810 stock price. Costco paid a special dividend of $15 per share in January. Prior to that, its last special dividend was $10 per share in December 2020 and $7 in May 2017. The pattern suggests investors can expect a special dividend every three to four years. Even so, the special dividend isn't a particularly high yield -- $15 per share isn't even a 2% yield at the current price.

Pass on Costco

Costco's business model and effective management make it a unique retailer that isn't necessarily a bellwether for the industry. It's good that Costco is seeing an uptick in discretionary spending, but assuming other retailers will see a similar trend would be a mistake.

I'm usually a big fan of paying up for quality rather than finding a bargain bin deal, but Costco's growth isn't high enough to justify the low dividend yield and expensive valuation today.

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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale, Home Depot, Target, and Walmart. The Motley Fool recommends Lowe's Companies. The Motley Fool has a disclosure policy.