Should I Buy Costco? 3 Pros, 3 Cons

by Will Ashworth | March 13, 2013 1:34 pm

Should I Buy Costco? 3 Pros, 3 Cons

Costco (NASDAQ:COST[1]) jumped more than three bucks in early trading Tuesday after announcing solid earnings and revenue growth in its second quarter. Unfortunately, investors lost some of that enthusiasm by day’s end, as the stock closed up just 1.3% on the day.

Is now a good time to buy? Or is the stock ready to take a breather after delivering a three-year annualized total return of 23.6%, almost double that of the S&P 500?┬áHere are the pros and cons of owning one of America’s biggest retailers:

Pros

Comparable Sales: Costco continues to do a good job building revenues at its stores open at least one year. In the second quarter, excluding inflation in gas prices and the effects of foreign currencies, its comparable sales were up 4% internationally and 5% in the U.S. Overall, for the first half of the year they’ve increased by 5% across the company. Despite rising gas prices and the payroll tax hike, Costco managed to boost February same-store sales by 6%, putting both Walmart (NYSE:WMT[2]) and Target (NYSE:TGT[3]) to shame.

Earnings: After you take out the 14-cent tax benefit from Costco’s special dividend payment in December to the employee’s 401k plan, it earned $1.10 per share in the second quarter, 22% higher than in Q2 2012. For the entire first half it earned $2.05 per share (excluding the benefit), a 27% increase year-over-year. Its second-quarter earnings performance was its 13th straight quarter of double-digit growth. Analysts were predicting $1.06 per share in Q2, which means it beat expectations by 8%. Most important, its earnings growth in Q2 was its best over the past 13 quarters.

Membership fees: There’s no secret to Costco’s success. It drives prices down as far as it possibly can without losing money; what’s left over after paying overhead, interest expense and taxes is generally about what it collected by selling memberships to its customers. In the second quarter its membership fees increased by 15% to $528 million. I went back and checked every second quarter over the past decade, and this year’s membership growth was the best on record. If you think it’s run out of growth — think again!

Cons

Long-term debt: On Dec. 18, Costco paid a special dividend of $7 a share, which amounted to $3.05 billion paid out to shareholders. I’m all for special dividends. I like them more than regular ones. However, it issued senior notes in early December for $3.5 billion (albeit at very low interest rates) to make the subsequent special dividend payment. As a result, its net cash position went from $4.2 billion at the end of its first quarter in November to $781 million at the end of February. With almost $2 billion in annual free cash flow, it likely could have made the special dividend without borrowing a penny.

Share price: The stock is closing in on an important milestone — it’s only about 2.5% lower than the all-time high-water mark of $105.97, notched back in December. Historically, its current valuation by several metrics is rather high. For instance, its current stock price is trading at 3.6 times its book value per share, a multiple it hasn’t seen since 2007 — and rarely, if ever, before that. Compared to the S&P 500, its price-to-book ratio is 64% higher. It would take Costco 9.3 years to earn back one share of its stock based on its current growth rate. That’s more than two years longer than Target and 13 months longer than Walmart.

Expanding head office: According to the Puget Sound Business Journal, Costco is currently negotiating with the city of Issaquah to add 1.5 million square feet to its head office. It currently operates out of a mixed-use development that is almost completely built out. While it’s obvious Costco is still growing, I wonder why this wasn’t announced while Jim Sinegal was still CEO. Is it possible that current boss Craig Jelinek is more of a free spender? Will it lead to the opening of the floodgates? I doubt it. But with so few warts, I’ve had to reach a little.

Verdict

I believe Costco’s business model is about as smart as they come. By using razor-thin margins to attract customers, the company never has to worry about traffic to its stores. As long as people continue to buy in bulk, I don’t see how it can stop growing.

Is its stock expensive? Probably a little. But if you hold for the long-term the evidence suggests you’ll be handsomely rewarded.

Since 2000, Costco has experienced three big declines in its stock price, with an average drop of 38%. That’s once every four years. Therefore, history suggests it will happen again between now and the end of 2016. I can’t tell you exactly when it’ll happen. Will it be tomorrow? Not after its latest results. But it will happen.

Should I buy now? Absolutely. Just remember to keep some cash in reserve for that three-month stretch when history repeats itself; because it always does.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.

Endnotes:
  1. COST: http://studio-5.financialcontent.com/investplace/quote?Symbol=COST
  2. WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT
  3. TGT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TGT

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