Costco Wholesale Corporation (NASDAQ:COST) was a big loser early this month on word that Amazon.com, Inc. (NASDAQ:AMZN) had agreed to buy Whole Foods Market, Inc. (NASDAQ:WFM). COST stock fell off a shelf, from $180 each to $166 overnight, and kept tumbling for a week to below $160, going as low as $157 on June 23.
But even a dead cat can bounce, and Costco is far from dead.
Costco shares were up by as much as 2% in early trade on June 26, four times the market’s early gain of 0.5%.
Is it time to go long on the discount warehouse again? Nicholas Chahine thought so the moment the correction was in. He suggested a strategy on COST stock using options to minimize downside risk, adding that he remains a fan of both shares and the company.
I’m not quite so sure.
What’s Up?
The stocks of many major companies have become volatile recently, jumping and falling on news before the implications are understood.
In the case of Costco, we have the halo effect of its low-margin warehouses – gross margins under 15% — hitting the reality of Amazon, which already sports margins of about 30%, buying another high-margin business in Whole Foods.
Assuming the deal goes through, Whole Foods will immediately add $15 billion to Amazon’s annual top line and $500 million to its annual net income. That’s better profitability than the parent company, which had about $750 million in net income on $35 billion in revenue during its most recent quarter.
Costco’s profitability, meanwhile, is in line with that of Amazon. It earned just $700 million on revenue of $28.6 billion for its most recent quarter, meaning its earnings were less than it took in from membership fees.
I called COST stock a loser on this deal, because both the Amazon-Whole Foods combination and Costco are aiming at the same upper-income consumers. I do not think AMZN is about to buy COST.
Costco and Amazon are targeting the same customers in different ways. We are highly educated people who understand the difference between the business models. We go to Costco monthly for bulk goods, and let Amazon break bulk for us. The roughly $220 per year we spend to get the best deals from both keeps us loyal, and the only danger to this status quo is aging, as I pointed out last year.
Buy or Sell COST Stock?
If you believe the economy is going to grow steadily, both these stocks remain core holdings. After its recent fall, Costco’s price-to-earnings ratio is just 28. That’s close to the S&P 500 average of almost 26.
It is that average which concerns me. In past decades, an S&P 500 P/E of 15 was considered high. In normal times, before 1990, the current rate would be a sell signal. But the number grew to 45 before the dot-com bubble burst, and went to 123 during the 2008 crisis, as the average stock lost money.
The Shiller P/E ratio, which is also widely followed, is flashing a sell signal at nearly 30. It is today very close to the level it attained at the time of the 1929 stock market crash. The Shiller ratio is inflation-adjusted over 10 years, and reflects long-term earning power.
This is the real reason I have turned bearish on COST stock.
Costco is a good company. It will rebound after a fall. But I see a hard fall coming for the whole market, which is why I sold out of the company in December, when it was just a little higher than its current price. As much as I love AMZN, I’m inclined to look for an exit there, too.
But if you’re not worried about a hard market fall, or you are young enough not to need your money for a decade or more, this is a good opportunity to buy Costco shares.
Dana Blankenhorn is a financial and technology journalist. He is the author of the historical mystery romance The Reluctant Detective Travels in Time, available now at the Amazon Kindle store. Write him at danablankenhorn@gmail.com or follow him on Twitter at @danablankenhorn. As of this writing he owned shares in AMZN.
