What: Warehouse giant Costco Wholesale (NASDAQ:COST) tumbled nearly $7 per share, or more than 4%, in Thursday's trading session after Deutsche Bank hit the company with a downgrade.
So what: According to Deutsche Bank's covering analyst, Paul Trussell, despite Costco's core fundamentals being expected to remain strong, he and his firm see it struggling with negative foreign currency translation and lower gas price headwinds over the next 12 months. Deutsche Bank believes these headwinds could negatively impact traffic trends and push its same-store sales into the red. As such, Deutsche Bank took its rating to "hold" from "buy," including a price target reduction from $147 to $142 per share.
Now what: The big question here is whether Deutsche Bank's downgrade holds water.
Personally, I have conflicting views. On one hand I'd suggest that based on valuation alone Deutsche Bank's downgrade makes sense. Even after yesterday's close Costco was valued at 26 times forward earnings despite the real prospect of delivering organic growth in the 6%-7% range. That works out to a PEG ratio in excess of three, which is high for a retailer.
On the flip side, foreign currency woes and weaker gas prices may not be as bad as Deutsche makes them out to be. While Costco can't escape the strength of a strong dollar -- as was evidenced in its January sales figures, where international comparable sales fell 4% from the prior year -- currency movements don't truly affect the long-term business model. Investors should be able to look past currency moves and see that Costco is consistently growing by the mid-to-high single digits.
Additionally, weaker gas prices will put more disposable income in consumers' pockets, potentially encouraging shoppers to spend more and stay longer in Costco warehouses. True, falling gas prices could tighten the noose around Costco's already razor-thin gas margins and pressure sales comps, but over the long term this isn't a material concern.
So, to answer the initial question, I do believe it's wise for Costco shares to take a breather in the interim on a valuation basis, but I don't believe Deutsche Bank's concerns will adversely impact Costco's long-term strategy. Translation: If you're still holding Costco there doesn't appear any reason to yell "fire."