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Can Costco Keep the Momentum During Retail’s Tumultuous Time?

By Ryan Downie - Dec 10, 2019 at 11:27AM

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Shares of the retail warehouse are performing well — and for good reason. Are valuations too rich for the climb to continue?

Costco Wholesale (COST -0.54%) is a discount warehouse retailer with 772 stores, nearly one-third of which are located internationally. It has also begun to roll out a mobile app and e-commerce capability to align with evolving consumer tastes. Customers must pay an annual membership fee, enabling the store to offer goods at very competitive price points. As a result, membership fees generate a small percentage of total revenues, but a majority of profits.

Costco stock is up 44% year-to-date to near its highest level since the mid-2000s, and this performance can be attributed to several bullish characteristics. The retailer has produced consistent profits with above-average growth for years. A pilot location has been successfully opened in China, and that market might offer fantastic growth opportunities moving forward. Costco also offers great value for customers, placing it in an advantageous position during recessions, because people tend to shift consumption toward discount chains when household budgets get tight. Recurring membership revenue is also less correlated to shifts in consumption habits across economic cycles, and the membership model helps retain customers and establish a competitive moat.

A salesperson carries a large package in a warehouse store

Image Source: Getty Images

Costco stock is undeniably expensive

Shares trade at a 34.2 forward price-to-earnings ratio. Defensive retail stocks cluster around a 17 forward P/E, and discount stores such as Walmart (WMT 0.32%)Target (TGT -0.54%)Dollar General (DG -0.46%), and Dollar Tree are all in the 17 to 23 range. Close competitor BJ's (BJ -0.37%) has a forward P/E ratio of only 14.5. Costco's price-to-free-cash-flow is a speculative 38.9, and its EV/EBITDA of 19.9 is only slightly better, at roughly double the industry average. The stock's 0.88% dividend yield is far exceeded by Walmart and Target.

Why does the stock trade at a premium?

Costco has delivered excellent growth, with the top-line rising 8.75% on average over the past three years. However, forward estimates only modestly exceed those of peers. Analysts are calling for 7% annual sales and earnings growth. Target and Dollar General both have more bullish consensus forecasts. While Costco has a healthy growth outlook, it is not sufficient to explain the departure in valuation. 

Costco does have impressive efficiency and financial health metrics. The business only supports a narrow 3.1% operating margin, but this has remained stable, and the company is still able to deliver an impressive 17.1% return on invested capital, which is 330 basis points above the industry average. Costco also maintains an efficient 11.85 inventory turnover ratio, which is substantially higher than Walmart, Target, and BJ's. Its debt to equity of 0.45 is also among the lowest in the peer group, limiting the risk that the company will incur a high cost of capital or restrictive lending terms in the event of a period of poor financial results. 

Investors are justifiably excited about Costco's stability and efficiency while navigating an economic environment where almost every retail company is feeling pressure from increased competition. While many brick-and-mortar stores are faltering and Amazon.com is rapidly taking market share, Costco continues to attract customers and grow, which is all accomplished through efficient financial stewardship by its management.

In many ways, this is a classic example of a premium company commanding a premium price. While it is difficult to assail Costco's operating performance, the valuation does create risk for investors. Sustained fundamental success is already assumed in the price, and any hiccups could result in declines in share prices. Costco's narrow-margin business model could be threatened by tariffs if they continue to rise. In that case, Costco may have to find alternative sourcing for some of its goods, change the availability of its offering, or attempt to pass the costs along to customers—none of which are appealing options.

Competition from the likes of Amazon and Walmart are always going to exert pressure on margins, and recent earnings reports have indicated that overhead is growing more rapidly than revenue, which is not a trend that can continue. Costco is a compelling story for investors seeking a retail stock that departs from many of the common characteristics plaguing the sector. But it is not appropriate for the particularly risk-averse investor.

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Stocks Mentioned

Wal-Mart Stores, Inc. Stock Quote
Wal-Mart Stores, Inc.
WMT
$124.12 (0.32%) $0.40
Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
COST
$481.75 (-0.54%) $-2.62
Target Corporation Stock Quote
Target Corporation
TGT
$149.61 (-0.54%) $0.81
Dollar General Corporation Stock Quote
Dollar General Corporation
DG
$246.76 (-0.46%) $-1.14
BJ's Wholesale Club Holdings, Inc. Stock Quote
BJ's Wholesale Club Holdings, Inc.
BJ
$65.19 (-0.37%) $0.24
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$113.22 (-2.78%) $-3.24
Dollar Tree, Inc. Stock Quote
Dollar Tree, Inc.
DLTR
$157.13 (-0.05%) $0.08

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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