Investors are beginning to see the impact of inflation and supply-chain headaches on earnings throughout the retail sector. Retail stalwarts like Walmart and Target reported significant drops in profitability due to increased costs on freight, labor, and supply-chain disruption.
Bulk retailer Costco Wholesale (COST 0.63%) reports in the coming days, and investors seemingly are pricing in bad news; the stock is down more than 20% over the past month.
I'll detail what investors should look for in Costco's upcoming earnings report and whether long-term investors should jump on this dip.
Pay attention to the top line
Costco is likely to talk about significant cost increases throughout its business when it reports earnings for the third quarter of its fiscal 2022. Both Walmart and Target have struggled with higher costs and have seen margins get severely pressured to remain as price-competitive as possible.
Instead, investors should look to see that revenue is meeting (or beating) expectations. Both Walmart and Target beat analyst estimates on revenue, implying that demand for products is healthy, but cost pressures have hurt the bottom line.
The high-inflation environment is a known variable that these companies can't help, so panicking doesn't make much sense. It would be more concerning if Costco's results showed that consumers are going elsewhere altogether via a miss on revenue estimates.
Healthy financials to endure short-term pain
Context is necessary when a company faces challenges outside of the business itself. In other words, inflation will probably hurt Costco, but is the company financially able to endure that pain? You can see in the chart below that Costco has a sizable cash position of nearly $12 billion, roughly twice what the company is producing in annual free cash flow. Investors can probably sleep well feeling that Costco is financially stable.
Additionally, operating margins have steadily increased over the past three years. This could take a hit, but investors can see that the business has become increasingly profitable over time, which could mean that it will bounce back as inflationary challenges fade over time. It might be more concerning if Costco's profit margins were already declining before factoring in a challenging environment.
Is the stock attractive today?
Even if Costco is fundamentally sound enough to endure a potential recession or short-term pressure on margins, these are not ideal scenarios for the company. The stock's premium valuation is proving vulnerable. The stock is down 20% over the past month, likely in sympathy with cost-related info from Walmart and Target's recent earnings reports.
The stock's declining price-to-earnings (P/E) ratio has come down to roughly 34. It has traded at a P/E mostly between 24 and 32 until 2020, so investors could argue that the valuation has come down to Earth but isn't yet a bargain.
Costco has grown steadily over the past decade; earnings per share (EPS) have increased an average of 13% annually. One could reasonably expect a little more growth for such a P/E ratio, but Costco's strong brand and financials could be playing a role in its valuation. Remember that the S&P 500 is currently trading at a P/E of 20, so Costco still enjoys a sizable premium over the broader market.
A long-term investment horizon would help let the stock grow into its price tag, or perhaps investors will continue trading the stock to a lower valuation over the coming weeks and months. A dollar-cost averaging strategy can help you build a position slowly if you're concerned with where the stock may go in the short term.
Editor's note: This article has been corrected. Costco did not raise the price of its hot dog and soda combo.