- Costco stock has a current PE ratio of 28 and a PB ratio of 6.32, which make is slightly overvalued in my eyes, especially compared to its competitors.
- Value investors will slowly start to exit this stock if these ratios continue to increase.
- Although this business model seems proven, I think it would come under pressure if the world economy entered a recession.
- Near term investment will hike capex to $3 billion over the coming year.
- This is good for the long term, but it will keep the company from returning lots to cash to shareholders through big dividends and share buybacks.
Many investors are looking at Costco (NASDAQ:COST) at the moment due to its excellent share price performance over the last 5 years (+136%) and also strong gains of 7.43% year to date. This company definitely has momentum behind it as this is evident in its most recent numbers. When you overlook the strong dollar and weak oil prices (which should be temporary) , the company's comparable-store sales growth both in the US and internationally was 6%. This is much better than competitors like Sam's Club and other defensive retailers which bodes well for the company going forward. The main metric this company goes by in terms of growth is its membership sales which again were up 6% in its most recent set of earnings at the end of September. This was impressive when you take into account that the company's portfolio of units only grew at 3% so productivity definitely seems to be increasing. Presently the company has 469 clubs in the US and just under 200 internationally. Compare these numbers with Walmart (NYSE:WMT) and it is definitely apparent that the company has ample runway for strong growth in the years to come. Furthermore the company's strong balance sheet is another attraction for investors, in that they believe the company will be able to scale meaningfully from here. The company's current debt load of $6.2 billion is not significant when you take note of the company's strong cash position of $6.4 billion. However, the stock price in recent times has probably still gone beyond the fundamentals. Here's why.
On the surface, one would think that this company is set up for impressive growth going forward. However when you delve deeper, you start to realize that strong growth may not be on the horizon just yet. Furthermore income investors can get far better yields than Costco's present yield of 1.05%. So why I am refraining from investing at the moment? Lets discuss.
Firstly we have to look at Costco valuation. It presently is trading at over 28 times earnings which is high when you compare it to Wall-Mart for example, which is trading for less than 14 times earnings. Costco seems to be a little bit too overvalued for me here to peek my interest especially when you consider that the share price has practically doubled since 2011, but net income and especially sales (which is just up 25% in the same time period) haven't been able to follow suit. This happens a lot with stocks which have consistent sales and profit growth. Future earnings gets priced into the stock which is why the stock in my eyes is over valued. We can see out-performance also priced into Costco shares when you see its price to book value which is a key metric when valuing companies. Its present price to book value is 6.32 which is close to its 10 year high. Price to book ratios work well as a valuation ratio in this industry because the company in question derives practically all of its income from its assets (Warehouses) and only $3.5 billion came from online purchases in the company's previous fiscal year.
As you can see from the chart below, Costco's price to book ratio has been basically matching the movement in the share price (see chart) especially since mid 2014. Basically the less steep the correlation, the more productive the company is, in making increasing profits from its assets. With a P/B ratio approaching its 10 year high, I think its prudent to stay on the sidelines for now..
Secondly I believe investors are staying long this stock because they think a recession would not inherently affect this company. This may be partially true because the company's membership renewal rates were not inherently affected in the recession of 2008. However this sector is becoming hugely competitive and the environment has totally changed since the recession of 2008. Investors have to remember that 75% of the company's revenues come from its membership fees which has to be a risk in itself. However the business model makes sense. The company receives cash up front, stocks its shelves straight from manufacturers at practically no margin and grows the business through its membership fees. These fees which cost roughly $55 and $110 each year are justified in the eyes of the consumer when the bottom line prices of the products are taken into account.
However if the world goes into recession, you will undoubtedly see price wars among the major retailers. Costco has to be at a disadvantage here, in that it asks its customers for money up front. Annual revenues of around $115 billion, producing annual net incomes of $2.5 billion income shows you how volume intensive this business is. The company needs the volume to grow because margins are so tight. I just think because of its business model, it may suffer more than traditional retailers if a downturn ensued.
Finally because of the success the company has had in the last decade with its business model, the management is stating that investment in the near term will be elevated to take advantage of the company's upward trend. 32 stores are scheduled to be opened in 2016 which should add an extra $5.4 billion to the company's revenues. The company also will invest more into its e-commerce efforts as the company currently only offers online ordering capability in the US, UK, Canada and Mexico. All of these cap-ex investments will definitely affect the bottom line - at least in the near term. The company has the balance sheet to scale meaningfully but a $3 billion investment expected for the next 12 months is bound to affect profits in the short term. Here is where the company would attract more long term investors if the dividend yield was better. Astute investors know that profits will probably be subdued for the next 12 months at least and getting paid just a 1.05% yield for waiting doesn't seem to be a great investment at this juncture. The company's business model is proven and should do very well over the long term but for reasons cited above, it may be better to stay on the sidelines at least until the heavy e-commerce investment is done and the stock comes back to a more attractive valuation.