I'll admit it. I love shopping at Costco (NASDAQ:COST). But that doesn't necessarily mean I love the stock. My main concerns are its recent performance and its valuation. So hang on to your shopping cart. This bear is about to roam through the stores.
Same-store sales in August increased by a disappointingly small 2%, well below the 5.6% rise analysts expected. The company played the weather blame game, citing hot temperatures in California as the reason for slow traffic. OK, so the state experienced some hot weather. But even putting the weather aside, when 36% of a company's U.S. stores are located in one state, as is the case with Costco in California, it's going to experience the pain of not being geographically diversified, no matter what.
And while the weather was heating up in California, the housing market was cooling down. Couple that with the rising cost of gas -- and we know how much people love to drive -- and you get a 4.5% drop in consumer traffic in the state.
I'll concede that excluding last month, comps growth has been decent this year so far, the third quarter brought 7% growth in same-store sales. But on a 12-month rolling basis, profits have slid 3.3%. And gross, operating, and net profit margins on the same basis have also been inching their way down.
Further, Costco's operating profit of 2.5% is significantly lower compared with those of competitors. Target (NYSE:TGT) boasts an 8.7% margin and Wal-Mart (NYSE:WMT) has a 5.8% margin. Only rival BJ's Wholesale Club (NYSE:BJ) is worse off, with an operating margin of 1.9%. However it does have an advantage over Costco, in that it accepts coupons from manufacturers and accepts a wider range of credit cards. Costco takes only American Express.
One of the culprits of the slimming gross margin is the company's Executive Membership plan, which costs $100 a year and saves consumers 2% on the merchandise they purchase. At my local Costco, employees walk around the registers scanning cards to try and encourage you to upgrade. But to be honest, I really don't see how the 2% adds up to the extra $50 in membership fees. I'm not sure how alluring this promotion really is.
While I think it's good for membership-club retailers to offer their customers an upgrade to a premium membership, I'm pretty sure it isn't optimal for the company when the idea is causing margins to get pinched. Management has faith that the negative impact will dwindle over time, but I'll believe it when I see it.
Not only are margins slipping, but the company has also issued additional debt. It can easily handle the debt -- in fact, it can pay its interest 45.1 times over with its operating income -- but the higher interest expense inevitably eats away at the bottom line, which could be part of the reason earnings were flat year over year, at $0.49 per share last quarter.
What does this leave us? Well, we have a company that has struggled lately to grow its bottom line, despite a pleasant shopping environment and compelling products. I realize that one month does not make a trend, but given the current economic worries, the sluggish August sales could be the start of a trend of slowing growth.
It always helps to invest in what we know, and a lot of people are familiar with Costco. But we must distinguish between a company and an investment. I want to invest in high-quality companies that make me like not just what's on the shelves but also what's in the financials. Costco doesn't accomplish that task.
So do yourself a favor. Shop at the stores, but leave the stock to rest on the shelf.
Check out the other arguments in this Duel, and then vote for a winner.
