Wait For Costco Stock To Dip Before Buying

  • Growth in membership fees is reducing which is a worrying sign.
  • If the trend of cheap gas and dollar strength continues, Costco's international growth will slow.
  • Fundamentals and financials are extremely strong. Cash flow growth is the primary reason for Wall Street's high valuation.

For the first time in three years Costco stock fell by more than 5% because its first quarter earnings per share and revenue both came in under analysts expectations. What was interesting though was the scale of the miss. EPS came in at EPS came in at $1.09 a share compared to the lofty $1.17 estimated on average. Furthermore, revenue came in at $27.22 billion which again was softer than analysts expectations ($27.7 billion) despite the figure being up from $26.87 billion reported in the same fiscal quarter twelve months ago. The question that investors are asking now is, is this a blip or a sign of things to come? It's probably only a blip as the fundamentals and business model of this company are excellent. Costco in my opinion has a wide moat primarily due to to its ability to turn around its relatively small range of products (compared to other large cap retailers) in rapid quick time. This enables the retailer to bargain hard with its suppliers due to huge volumes of repeat orders every quarter. The retailer then passes on these savings to the customer which builds its brand in the market place as a cost leader. However it asks for a membership fee in return and these fees are the predominant driver of the company's profits (just over 70% of operating profits). Growth rates in this metric have been robust up to now, but things may be changing in the near term for a number of reasons. Let's discuss.

First of all, this business model as eluded to above is all about membership fees and how fast they are growing. Up to now, growth had been robust but $593 million was the figure reported for the company's first fiscal quarter last week which was a good 25 million+ below wall street consensus. Existing customers can only do so much is terms of same store sales. Costco needs vibrant membership fees growth which definitely is going in the wrong direction at the moment (see chart)
Furthermore the lower membership growth rates go, the more aggressive Costco will become in its advertising and promotion efforts. Realistically the company hasn't had to advertise meaningfully up to now (only in store) but this will change drastically if the downward trend continues and this could hurt the company because of its business model. Why? Well firstly, it is using its fuel as a loss leader to get you in-store but if you live a good distance from the warehouse, buying fuel there doesn't make sense due to the fuel you will waste in going there and coming back (besides probably waiting endlessly during peak hours). Secondly and this is key and could hurt this stock in a recession. The business is model is "members only" which means before the customer buys a thing, he or she needs to fork out a membership fee. Furthermore we saw already in the great recession that net income levels and operating margins dropped illustrating the stock is not recession proof.

Secondly Costco bulls will state that outside factors (cheap gas and a strong dollar) are the main reasons why Costco is facing some headwinds presently, and this is true to a large extent when you look at the numbers. When you take out gas sales and measure in-house sales on a currency neutral basis, total comps actually jumped by 6%. Furthermore existing customers seem to content with their experience as membership renewal rates are at all time highs. Moreover e-commerce sales jumped by 30% as a result of higher traffic levels and lower bounce-rates (shoppers becoming more sticky on the site). However in saying all the above, the underlying trends of cheap gas and dollar strength could be with us for a while, which will hurt this company's growth levels. With crude oil at $37 a barrel due to unprecedented supply from both OPEC and non OPEC producing countries and with the Fed expected to raise interest rates in the US, it is doubtful that these trends will change any time soon.

In saying all of the above, Costco stock has always traded pretty expensive. With a price to earnings ratio of 30 and a forward price to earnings ratio of just over 28, there is a lot of future growth priced into this stock and for good reason, when you look at the company's financials. Costco's business model enables it to collect membership fees and income from product sales up front which consequently pay for supplier's inventories long after the money has been collected. This business model does wonders for the company's cash flow levels. Operating cash flow reached $4.3 billion in the last fiscal year which means the company can keep charging ahead on its cap-ex side through the opening of more warehouses. In fact 32 new warehouses, is the expected number for next year which may fall if global economic activity contracts but it is still a big increase compared to its historic warehouse opening numbers. Costco has all the ingredients to be a long term value creator for shareholders. Operating margins rose to 3.1% in fiscal 2015 which was up from 2.9% in its 2014. Top line numbers continue to enjoy strong growth and bottom line figures have the potential to grow more especially if the retailer can penetrate further its private label brand "Kirkland" to make up more of its overall sales. The numbers don't lie which is why I can never see this stock trading at a heavy discount. Furthermore if indeed the global economy slows down and the company decided to slow down its capex investments, there is no reason to believe why this company wouldn't increase its share buyback rate which again would keep the stock elevated.

To sum up, I believe Costco stock valuation will remain elevated despite having its price to earnings and price to sales ratios at historic highs. Its operating cash flow continues to increase meaningfully which means the company can plough ahead with its capex commitments unhindered. Its near term challenges are the low oil price and the strong dollar which could mean a drop in the share price in the near term. However this business model is proven and unless a heavy recession grips the world economy in the near term, Costco stock should still grow meaningfully from these levels.

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  • 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.
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  • I do not have any business relationship with the companies mentioned in this post.
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