In a reprise of a recently completed Electronic Arts Duel with fellow Fool Alyce Lomax, I'm going to contend that discount-warehouse retailer Costco (NASDAQ:COST) is a great company but not the best investment at current levels.
I spend a lot of my time trying to find great companies trading at fair prices to provide a margin of safety in case operating results don't turn out as rosy as expected. There's definitely a fine line to draw in the sand in reaching a conclusion whether to invest in a company or hold off for a more compelling opportunity, but I believe it's best to err on the side of caution.
My credibility would immediately be shattered if I tried to argue that Costco was a lemon of a company. I mean, along with Target (NYSE:TGT), it's one of the few retailers to successfully go head-to-head with retailing giant Wal-Mart (NYSE:WMT) in opening big-box stores and focusing on providing the lowest cost possible for its merchandise. The landscape is littered with companies that failed to outduel Wal-Mart on price, be it former archrival Kmart, Toys "R" Us in the toy industry, or Albertson's in the grocery realm.
Costco has figured out that selling less is more as it focuses on higher-end items that consumers are willing to purchase in bulk. In the process, it increases volume, and that volume allows Costco to sell products with a lower markup and charge a membership fee that consumers are happy to pay for access to their favorite wine, consumer electronics, and snacks. Wal-Mart also sees the beauty in this model but has been less successful in rolling out its Sam's Club warehouses, while BJ's Wholesale Club (NYSE:BJ) is a distant third in the space and stands as evidence that the model is not foolproof.
In other words, price is important in retailing. Well, it's even more important when making investment decisions. So how much would an investor have to pay to acquire a share in Costco? Based on yesterday's close, the stock could be had for $52.13, but is that a good deal or a rip-off?
One of the primary ways I try to discern whether a stock is a steal is to take a stab at calculating the implied growth, or the growth rate necessary to justify the current stock price.
Like other growing companies, Costco reinvests most of its cash flow back into opening new stores and maintaining the current ones, so free cash flow is a bit more difficult to calculate. A recommended way to discern what is maintenance versus growth capital expenditures is to look at depreciation and amortization levels, as Whitney Tilson explained in a Foolish board post a few years back.
Long story short, my estimation of last year's free cash flow is very similar to next year's projected earnings for Costco -- $2.57 per share. I therefore estimate that the company will have to grow cash flow more than 11% per year for the next 10 years just to justify the current stock price.
That just happens to be how fast Costco has grown over the past five years, so I think I am on the right track. The problem is, I think the next 10 years will prove more difficult as competition intensifies and the number of new locations for Costco to open its doors diminishes. And since this is already the expected growth, any shortfall will cause the stock price to falter.
Overall, it's a close call on Costco. Maybe I'm being too picky, but holding out for a lower stock price and bigger margin of safety seems to be the most prudent move. After reading Alyce's bullish introduction, you'll be the one to decide whether to leave Costco out in the cold or whether it could qualify as one of the best buys for 2007 and beyond.
- Read the bull argument
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Wal-Mart is an Inside Value pick. Electronic Arts and Costco are Stock Advisor selections. Try out these or any of our other newsletter services free for 30 days.
Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.
