Many investors would agree that Costco Wholesale (COST +0.21%) is a wonderful business. It has an impressive track record of steadily growing revenue and earnings, possesses a cost advantage in the retail sector, and operates a successful membership model that drives customer loyalty.
These favorable traits have led to tremendous returns. In the past decade, its shares are up 395%, beating the Nasdaq Composite by a sizable margin.
However, investors would probably be more well-informed in their understanding of the business if they also knew about Costco's biggest bear case. Let's take a closer look at this top retail stock and what investors should keep in mind.
A steep valuation
A stock that has performed as well as Costco has in the last 10 years, and even more so in recent years, is something every investor seeks for their portfolio. But right now, the shares are extremely expensive.
As of this writing, the stock trades at a trailing price-to-earnings (P/E) ratio of 40.1. That's a premium to Costco's five-year historical average of 37.4, which indicates to me that there is little margin of safety if someone were to go out and buy shares right now. In other words, the optimism and favorable perspective about this business seem to be fully priced in (and then some).
It would be accurate to say that most everyone knows how great of a business this is. As I alluded to earlier, Costco has done a wonderful job at growing its revenue and income at healthy rates in the past. Sales and diluted earnings per share (EPS) have risen at compound annual rates of 8.7% and 11.8%, respectively, in the past 10 fiscal years . And this has translated to strong stock price performance.
The business benefits from having a cost advantage, which I believe is the key source of its economic moat. Due to its tremendous scale, as demonstrated by fiscal 2023 net sales of $238 billion, Costco is the world's third-biggest retailer. This means it can flex its bargaining power over its suppliers, obtaining favorable unit costs. And these savings get passed to shoppers in the form of low prices.
What's more, Costco is able to drive customer loyalty thanks to its membership business model. Having access to low prices and high-quality merchandise is worth the $60 annual fee for the basic membership option. Customers love this, as shown by the worldwide renewal rate of 90.4%. "We ended [the] fourth quarter with 71.0 million paid household members, up 7.9% versus a year ago," CFO Richard Galanti said on the fiscal Q4 2023 earnings call.
NASDAQ: COST
Key Data Points
Growth outlook
It's kind of funny that a business which sells merchandise at the lowest prices around has a very expensive stock. Consumers have long been in love with what Costco offers, so it's not a surprise that investors have been drawn to the company's shares.
But Costco's P/E ratio is really only justified if the company possesses sizable growth prospects over the next five years. This is a mature business these days, so it's likely not worth the premium valuation.
To be fair, the management team is still focused on opening more warehouses -- 23 net new locations in the last fiscal year to be exact -- which is a primary driver of the expansion strategy. Costco now has 861 warehouses across the globe. But executives do think over the next 10 years the business could open 150 more stores in the U.S. alone, adding to its 591 today. That domestic outlook, coupled with international growth opportunities, particularly in China, is definitely encouraging.
Wall Street consensus forecasts call for 5.8% revenue growth and 10.5% gains in diluted EPS annually over the next five fiscal years. These might seem like strong estimates on the surface. But these figures indicate that shares are trading at 24.4 times fiscal 2028 EPS projections of $23.30. To me, that means the stock is clearly expensive right now, making the prospect of market-beating returns much more difficult to achieve from this point forward.
