Costco Wholesale Corp. Stock Will Rise Despite Its Lofty Valuation

  • Costco's numbers are illustrating that not all retail stocks are being affected by the e-commerce boom.
  • The shift to Visa and a likely hike in membership fees will keep earnings elevated.
  • Although the stock is expensive compared to historical averages, a company like Costco will always sell at a premium.

Stocks like Costco (NSDQ:COST) will always sell at a premium. The company's financials are just too strong despite the strong dollar environment it has been operating in over the last two years. For a retailer to double its top line in 10 years ($60 billion in 2006 to $116 last year) illustrates why the market has this stock trading with a present earnings multiple of 29.2. Earnings per share have more than doubled going from $2.3 to $5.29 but what really attracts investors to Costco is its cash flow visibility which is one of the highest in this sector. Why? Well, the upfront payment business model enables Costco to collect membership fees from customers well before suppliers need to get paid. This model really is at the crux of how the company has been able to grow so fast by opening 25 to 40 new warehouses every year. Let's go through why I still like Costco and why I believe $170 a share is a distinct possibility in the near term.

Also read: Costco Stock Has Great Fundamentals But An Expensive Price Tag

Firstly, in terms of the company's third quarter results, there was nothing out of the ordinary that would suggest that a pullback in the share price is on the cards. The company reported a beat on the bottom line but revenues of $26.8 billion came in below analysts expectations ($27.1 billion - see chart) due to the strong dollar as well as lower gasoline prices. However, this didn't stop investors from pushing the stock up by 6% after earnings were released as astute investors took note of the fact that this quarter's top line number was 2.6% higher than the same quarter of 12 months prior. Other positives that came out of third quarter earnings were primary memberships (up by 7%), and renewal rates (solid at 90% in the US and 88% internationally).

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These figures should convince investors that Costco's business model is here to stay despite the growth we are seeing in e-commerce. Its cost advantage (where it can sell at wholesale prices instead of retail) is powered by its no-frills warehouse model ( where the theme is self-service and less staff) and its superior productivity (because it only focuses on 3,800 active items which increases its bargaining power) has longevity in my opinion. All the company needs to do is work its plan by opening new units every year and use its loss-leading capabilities (cheap gas) to continue to sign up new members every quarter.

Also see: Buy Costco Stock On A Pullback

Another reason why I like Costco at this moment in time is that the company is expected to raise its membership fees anytime now, which makes up roughly 75% of its operating profits. Operating margins have climbed to 3.1% in recent quarters and a 10% hike in both the gold star and executive star memberships would drive margins closer to the 3.5% level. Furthermore, the switch to Citi Visa card (taking place on the 20th of June) has the potential to increase transaction sizes as the cards have a better rewards program than the Amex card which was the standard at Costco. In fact, all but one tier of cash back rewards will increase which should prompt more customers to put more purchases on the card and enable Costco attract more members. Disruption fears are overblown in my opinion as all cardholders should have their new card well in time before the new system goes live this month.

So what's the best way to play this from an investment standpoint? Value investors will observe that its earnings and sales multiples are well above its historic averages despite the excellent growth prospects the company has in front of it. So here is how one can get the stock cheaper or get paid by entering into a contract that gives one the right to buy the stock at a cheaper price. The $145-January 2017 cash secured put is selling for around $600. By selling this put, one will be either long the stock at $145 or will collect the entire premium if the contract is held until expiration. Being long at $145 will bring its valuation metrics back in line and even if you are not assigned, the premium received would vastly outperform the dividends you would have collected if you had held the stock from now.

To sum up, Costco may be overvalued from a valuation standpoint but its third quarter earnings illustrated that its multi-year rally is far from finished. In fact, it could easily break through its all time highs of $168 a share if the Citi Visa card change gains traction and e-commerce sales continue to grow. Investors who are mindful of its high price to earnings ratio could sell cash secured January 2017-$145 puts to have some long deltas on this stock

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Author's Disclosures & Disclaimers:
  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
  • I am not being compensated for this post (except possibly by Amigobulls).
  • I do not have any business relationship with the companies mentioned in this post.
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