Should I Buy Costco Stock? 3 Pros, 3 Cons

by Dan Burrows | May 24, 2012 12:33 pm

Should I Buy Costco Stock? 3 Pros, 3 Cons

Costco Wholesale‘s (NASDAQ:COST[1]) stock popped Thursday after the retailer said fiscal third-quarter earnings jumped 19%, topping Wall Street’s forecast[2], helped by higher gas sales and a rise in membership fees.

Budget-conscious consumers have been flocking to the wholesale club looking for bulk deals and discounts, leading to a string of better-than-expected reports. Costco has now beaten Wall Street’s profit forecasts for three quarters in a row and exceeded top-line estimates for seven consecutive quarters, according to Thomson Reuters data.

That has helped drive significant outperformance for Costco shares ever since the market bottomed out three years ago. The stock has more than doubled since March 2009, beating the S&P 500 Index by a handsome 25 percentage points.

Should you buy Costco’s stock in light of the latest earnings news? To decide, let’s look at the pros and cons:

Pros

The Right Prices at the Right Time: Costco is a dominant wholesale club based on the breadth and quality of its merchandise, note analysts at Zacks Investment Research. “The company’s strategy to sell products at heavily discounted prices has helped it to sustain growth in beleaguered economic conditions as cash-strapped customers continue to reckon Costco as a viable option for low-cost necessities,” the analysts write.

Same-Store Sales Strength: Sales at stores open at least a year — a key measure of a retailer’s health — rose 5% in the latest quarter, helped by both domestic and international growth. Even after adjusting for gas-price inflation and the unfavorable effects of a stronger dollar, same-store sales rose 5%, comprised of a 4% gain in the U.S. and an 8% increase overseas.

A Buoyant Balance Sheet: “The balance sheet remains very healthy, with $4.8 billion of cash on hand,” writes Guggenheim analyst John Heinbockel in a report to clients. Although the company did use $900 million to retire relatively low-cost debt in March, “conservatism does prevail, however, with an estimated $200 million of share buybacks occurring in the third quarter,” the analysts note. Furthermore, Costco carries just $1.4 billion in long-term debt.

Cons

Valuation: Costco’s merchandise may be cheap, but its stock looks pricey at current levels. With a forward price-to-earnings ratio (P-E) of more than 19, shares are 45% more expensive than the broader market. Moreover, the stock trades at fair value to its own five-year average on a forward-earnings basis, according to data from Thomson Reuters Stock Reports, and a 7% premium by trailing earnings.

Stiff Competition: Cash-strapped consumers have plenty of options when it comes to discounters and wholesales clubs. Costco competes with Target (NYSE:TGT[3]), Wal-Mart (NYSE:WMT[4]), Wal-Mart’s Sam’s Club and privately held BJ’s Wholesale Club, among others. “Aggressive pricing to gain market share and drive traffic amid stiff competition may depress sales and margins,” Zacks notes.

Tough Comparisons Ahead: Costco is coming up against strong year-over-year sales and same-store sales results. It also faces more pushback from a strengthening dollar, which hurts international revenue, and weaker gas prices.

Verdict

Costco shares are too expensive at current levels, given margin-eroding competitive pressure, tough comparisons, easing gas prices and a stronger dollar. “In light of the shares’ current P-E multiple and the market’s myopic focus on [same-store sales], this could cause the shares to drop into the upper $70s,” Guggenheim’s Heinbockel says. “We would be more inclined to be aggressive with them at that level.”

Agreed. Costco doesn’t warrant its premium valuation. Investors should act the way the retailer’s customers do and wait for the stock to go on sale before buying it.

Endnotes:
  1. COST: http://studio-5.financialcontent.com/investplace/quote?Symbol=COST
  2. earnings jumped 19%, topping Wall Street’s forecast: http://investorplace.com/2012/05/costco-q3-profit-up-revenue-misses/
  3. TGT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TGT
  4. WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT

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