Dueling Fools Below Costco
The Bear Argument

By Rick Aristotle Munarriz (TMF Edible)
March 8, 2000

Fans of Costco have grown used to big things. Big stores. Big products. Big gains. And, of course, big numbers. Unfortunately, I also see big changes. No, not in the cavernous warehouse decor or gargantuan bulk offerings. Those will remain mammoth-sized. What I do see is a maturing company. Weaned off its go-go years, I don't think Costco will be capable of delivering the big numbers of the past. Naturally, it will cough up those big gains in the future.

Let me take you back to last week. I imagine Chris is still there, tossing streamers and tooting noisemakers. Costco had what seemed like a great quarter. Or did it? The warehouse club giant reported a stunning 14% growth in same-store sales. With that kind of leverage, one would figure that the company must have smoked estimates? Nope. The 19% earnings growth was in line with estimates. Well, sales then. They must have gone through the roof. Right? No, up just 17%.

How can this be? This company does everything right and it only musters top- and bottom-line growth in the teens?

The thing is, all is not well here. For starters, the major catalysts at the unit level were high-ticket luxury items like jewelry and computers. That is not sustainable. Alan Greenspan will make sure it is not sustainable.

Missing, too, is any kind of economy of scale. A bigger Costco should have been more efficient. Sorry, sold out of that line item, too. Sales rose 17% and merchandise costs? 17%. Selling, general & administrative tabs? 17%.

I'm not much of a blackjack gambler, but I know that the house stands on 17. It seems Costco does, too. Once the company's comps return to normal levels, it is quite possible that margins will get discounted too.

So why are giddy investors paying more than 40 times earnings for Costco? Even when the company is running on all cylinders, it can't justify half that multiple.

Costco was a great growth story. Now it is just a solid, mature concept. Hey, there is nothing wrong with that. For a company, it is a very respectable feat. For a stock, you just don't pay 40 times for what Costco's future holds.

Over the next six months, the company is set to open 13 new stores. On top of the company's 304 existing units, that is less than 9% in annualized box growth. Wall Street is a bit too smitten for its own good here. While it expects earnings growth to slow to just 16% next year, that is assuming either continued blowout performance at the unit level (which is unlikely) or dramatic margin improvement (which is also unlikely).

Looking back, Costco reported 35% in annualized earnings growth over the past five years. Looking ahead, I'm sure Costco would prefer if you kept looking back.

Maybe that way you won't notice Costco's ritualistic missteps. Over the next six months, the company plans on replacing 2-4 existing locations. Site selection is supposed to be an integral part of any food retailer. For an operation like Costco, where the huge warehouse clubs get built deserves to be an even bigger consideration. Yet Costco is always fixing up its botched executions. Seriously. An expense fixture in every Costco income statement reads "Provisions for impaired assets and warehouse closing costs."

Don't let this happen to you. Realize that a quality maturing company is worth a realistic multiple as it enters the golden years. Realistic is not what Costco is fetching right now. So be careful or you might find yourself reporting "provisions for impaired assets" too.

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 This Week's Duel

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