Technically, beating the market only requires that your stock do better than the average (as represented by the S&P 500). So by that measure, Costco Wholesale (COST 0.17%) has beaten the market so far this year by only falling 18.5%, compared to the market's 19.3% decline. Costco has been a long-term market outperformer (up 148% over five years compared to the S&P's 43% gain), which leaves many investors wondering if it can finish ahead this year and do it again in 2023.
While I remain a long-term investor with confidence in Costco, there could be some potential issues with the company and the stock that might lead to underperformance next year. Let me explain.
Business is good, but there are warning signs
One of the primary reasons the bulk warehouse giant manages to outperform the market so regularly is that the warehouse club retailer does so well at retaining its members. Its membership renewal rate is 92.5% in the U.S. and Canada. With that level of predictability, it's easier to grow the company responsibly and manage expenses.
Costco also reported decent sales growth for the first quarter of fiscal 2023 (ended Nov. 20). The company grew U;S; revenue by 9.3% year over year, or 6.5% once higher gas price revenue was stripped out. Globally, Costco was weaker, with revenue up a non-adjusted 6.6% year over year.
More recent figures though reveal a concerning trend. Costco provides investors with monthly sales updates, and they show:
| Month | U.S. Revenue Growth YOY | U.S. Adjusted Revenue Growth YOY |
|---|---|---|
| September | 11.2% | 8% |
| October | 9.2% | 6.1% |
| November | 6% | 4.6% |
Data source: Costco. YOY = year over year.
Investors will need to keep an eye on the U.S. revenue trend, as it could indicate how consumer sentiment is changing and how the rest of the holiday shopping season went for Costco. Judging by November's numbers, December could be another challenging month for the company.
If Costco's revenue growth slows or stagnates, the stock could see some pressure because it is currently priced for perfection.
A premium valuation for a premium business
Costco's price-to-earnings (P/E) ratio is substantially higher than some of its retail peers.
COST PE Ratio data by YCharts
Furthermore, 35 times earnings is a high price to pay for any company that isn't growing at a fast rate or that isn't fully optimized for profits. Costco doesn't meet either of those criteria, so the valuation is concerning, especially during a rising interest rate environment.
Admittedly, Costco has always traded at this premium due to its unparalleled execution. For starters, Costco's earnings have basically marched straight up in the past decade.
COST EPS Basic (TTM) data by YCharts
That performance isn't common, and Costco's high valuation, in part, reflects investors' confidence that the company will continue this trend.
I'm not predicting that Costco will fail or slip up, but with the U.S. potentially heading toward a recession, consumer sentiment may force Costco's hand. If revenue or earnings fall, I wouldn't be surprised if Costco's valuation gets reduced, sending the stock down. Say Costco reverts to the P/E ratio of 30 that it traded at for the better part of the past decade; that would imply a 14% downside to the stock.
Once again, I'm not saying this will happen, but with the economy's direction and long-term history against companies that trade at a high valuation, 2023 doesn't look promising for Costco. Still, analysts project earnings per share to come in at $14.47 this fiscal year (2023) and $15.83 in 2024 -- both trending up.
I remain a long-term shareholder of the stock because I don't think there is much to gain by trading in and out. Say it takes a dive; it will likely start its recovery when least expected. Or Costco could experience the slowdown I referred to and just move sideways. Of course, it may defy either of these thoughts and continue upward.
The point is, I don't know what the market's opinion will be in 2023. What I do know is that Costco is a strong business with great leadership, and over the long term, it will be an outstanding investment.
