- Dollar has weakened meaningfully due to dovish comments from the Fed. This will help Costco's international markets.
- Uncertainty is low with respect to Costco cash flow due to the up-front membership business model.
- Costco stock is slightly overvalued. Buyers will enter aggressively at the $140 level.
The Fed's decision to hold off on its expected interest rate hike caused the dollar to sell off meaningfully against other currencies. I have always stated in my writing that the US could not continue a tightening cycle while the rest of the world embarked on easing measures (more QE and negative interest rates). History will eventually inform us if the Fed's dovish comments will end up as the catalyst that caused the dollar to break down from its current levels.
Commodities are definitely sniffing more weakness in the greenback. Just look at gold and oil's action yesterday. Oil is trading at close to $40 a barrel of crude and gold is approaching $1,300 an ounce. Dollar weakness is also bullish for US equities and the S&P 500 (INDEX:SPAL), but investors need to remember that a rising stock market does not necessarily mean a strengthening economy. The Fed has blamed volatility in the markets for its decision to scale back interest rate hikes but recent economic data out of the US (except jobs) is the real reason why the Fed has slowed its expected tightening cycle. In scenarios like we have at present, investors who still want equity exposure should be looking at stocks that have strong fundamentals and that will benefit from meaningful dollar weakness. Being recession proof would be another enormous advantage. I believe Costco (NASDAQ:COST) ticks all the boxes and in this article I will outline why.
Costco Continues To Grow In Face Of Headwinds
First of all, the company's net warehouse count was up at 698 at the end of its second fiscal quarter of 2016. 210 of this number are international warehouses meaning 30% of Costco's entire top line will benefit from current Forex tailwinds. Furthermore, now with oil prices back in bull mode, Costco will be able to make greater margin on its gas sales as its competitors will have no option but to hike prices from here.
Also, many US multinationals have been suffering with revenue growth since mid 2014 due to the rising dollar but not Costco. The company saw growth in net sales again (up by 2.6% to $27.6 billion) in its latest fiscal quarter as a result of new warehouse openings, e-commerce growth and higher traffic within its existing stores. All these metrics are bullish for Costco going forward despite posting a slight deceleration in earnings last quarter. The fall in earnings per share ($1.24 in latest quarter compared to $1.35 in Q2-2015) was mainly due to higher costs such as higher payroll, higher IT costs and higher compensation which will all turn out to be temporary. For example the retailer will see profitability being slightly affected in the near term due to wage hikes which incidentally are the first increases Costco has implemented since 2007. Nevertheless, analysts are expecting robust earnings growth next quarter ( EPS of $1.27 which would be a 10% rolling increase) and I think it will beat this if the dollar continues to unravel.
Membership Revenue Is A Key Driver For Costco
On an annual basis, this company is still charging ahead boosting net income to $2.38 billion in fiscal 2015 from $2.06 billion a year earlier. The obvious reason is the company's membership income which rose again last quarter by 3.6% to $603 million (see chart)
Renewal rates are exceptional (91% in the US and 88% internationally) and that is where the real value is in this business. Costco can simply roll out its infrastructure (one off capex commitment for each store) and generate on average $165 million per club (as it did in fiscal 2015) and have that income coming in on auto-pilot every year. This holds distinct advantages compared to other retailers.
Firstly, this offers huge cash flow visibility as the retailer collects income up front before it has to shell out for products and secondly the retailer's membership model means the company can thrive on extremely low margins (operating margins of around 3%). Furthermore, don't be fooled by the 1.04% yield or $1.60 dividend the company currently pays out. In fiscal 2015 for example the retailer paid out a special dividend of $5 which meant over $6.50 per share was paid out to shareholders in this time period. If we take an average share price of $130 in fiscal 2015, the dividend yield worked out to be around 5%. Equity is still more than twice the company's interest bearing debt so I see no obstruction to the company borrowing again if it wants to reward shareholders through a special dividend.
Costco Stock Offers Downside Protection
Protecting the downside is key in investing. I can't see Costco stock breaking down due to the predictability of its financials and the competitiveness of its products. One could actually assume that sales could go up in a recession as customers would attempt to take advantage of their memberships by buying the maximum products possible at the cheapest price. Currently though I see the shares around 10% over valued. The stock has an earnings multiple of 29.5 and forward earnings multiple of 24.6. More buyers would definitely step in around the $140 mark.
To sum up, Costco stock ticks all the boxes if the investor in question wants some of the upside in equity markets but is very cautious of downside risk. Membership growth will drive this stock forward and dollar weakness will act as a tailwind in international markets. Investors have been undecided recently due to negative earnings growth in its 2016 fiscal second quarter. However, I see recent higher costs as being temporary which, in my opinion, will be confirmed in the forthcoming quarters.