Trade of the Day: Costco (COST)

Wait for COST to confirm the ascending triangle before buying stock or calls

   

With the stock trading just below its all time high of nearly $106 and an important technical pattern coming to a juncture, is now the right time to invest in Costco (NASDAQ:COST)?

The Model

In addition to pioneering the wholesale/warehouse membership concept in San Diego in 1976, COST has made a science of inventory, turnover, and cost control. The average supermarket or discount store will stock between 45,000 to 140,000 SKUs (distinct products). But despite its size (average 143,000 sq ft), the typical COST warehouse stores only 3,600 SKUs. In its finely tuned science of maximizing revenue per square foot of floor space, COST limits its inventory to only the fastest-selling models, sizes and colors.

COST also avoids holding a reliable supply of products customers know they can find each time they visit. Instead, COST initiated the concept of the “treasure hunt” which, combined with steep discounts on larger quantities, spurs members to buy on the spot when they find items they want rather than procrastinate like they might at another retailer.

In a nutshell, this is COST’s mantra: offering low prices on a limited array of premium merchandise in a wide range of categories that constantly shifts to generate high sales volume and very fast inventory turnover—all in a no-frills warehouse.

Memberships – The Secret Sauce

COST does a lot of things differently than typical retailers like Dollar Tree (NASDAQ:DLTR) or Walmart (NYSE:WMT) and that includes charging people to shop there.

COST has two primary forms of membership: Gold Star (for individuals) and Business members. The company has approximately 67,000 members. These memberships are vital to COST’s cash flow and net income. Their operating margins are stable but also notably lower than their peers because they sell their goods almost at cost. Most  profit comes from membership fees—in fact, they accounted for about 97% of Q2’s net income. Retaining current members and growing the membership base are therefore key metrics in evaluating COST’s future path.

Despite a 10% increase in membership fees initiated in November 2011, renewal rates have continued to rise, coming in at 93.9% for the U.S. and Canada and 86.5% internationally. Both rates are coming in at or near all time highs, indicating both rising consumer confidence and loyalty to the COST brand. Executive members made up 38% of COST’s primary membership base. However, they account for approximately two-thirds of total sales.

Store Expansion

An interesting feature of Costco warehouses is that they get better with age. As its local membership base grows, so do annual sales and revenue/sq ft. Mature warehouses serve as the backbone to COST’s pricing power. However, international business has been expanding at a 15% clip compared to 5% growth in the U.S. with a significant proportion of new signups in Q2 coming from Australia and Asia. So it makes sense that out of the 14 new stores the company opened during the first half of FY 2013, 10 of them were abroad. For the year, COST expects to open 28 stores, double the number of stores opened last year.

U.S. operations account for 72% of total sales; Canada, 16%; and other international, 12%. This mix, however, is likely to skew towards a greater contribution from Asian and Australian markets. The company recognizes that its U.S. geographic coverage, while not yet to the point of saturation, leaves less room for strategic growth that does not cannibalize existing store sales.

Private Label and Product Expansion

Private label brands accounted for 20% of COST’s total merchandise at the end of Q2 2013. COST’s premium private label brand, Kirkland Signature, carries higher margins than name-brand merchandise although it sells for lower price points. COST plans to increase penetration of Kirkland Signature to the mid to high 30% range.

COST is also expanding into finance and mortgages, partnering with First Choice Bank and 10 other lenders. This new arm, headlined by its mortgage financing site Costcofinance.com, offers a summary of competitive quotes to its customers. These lenders in turn pay Costco to market their services. It has also partnered with Aetna (NYSE:AET) to offer health insurance. The Costco Health Insurance Program offers five different Aetna health plans with major medical benefits and dental coverage.

COST’s unique model engenders member loyalty that allows it to offer a unique product range unlike any other retailer.

Now or Later?

3 20 13 cost 300x264 Trade of the Day: Costco (COST)
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Their earnings report was solid and the remainder of 2013 looks encouraging, especially with the U.S. consumer picking up steam, but COST is not at a bargain price. The combination of these price patterns has created an ascending triangle formation, one that is near an inevitable end.

This ascending triangle was formed on the underside by the long term uptrend and a flat resistance level at about $104 overhead. On November 28, 2012, COST announced a special dividend of $7 – that accounts for the brief spike above the resistance level. And while the stock has not been able to break above its resistance, it has continued to put in higher lows along the way. This constricting pattern has wedged the stock into a corner. Ascending triangles are typically bullish patterns, so look for a break above resistance to confirm a continuation of the uptrend.

If the stock fails the ascending triangle, there is significant support at $94-$95 – this would be an ideal entry point for long term investors. A break to the upside, however, could see a short term technical move to the $110-112 range.

A little bit of patience will allow this ascending triangle pattern to dictate whether the ongoing uptrend or a pullback will take control in the near term.

 

Recommendation: Buy COST on a break above $105 following a breakout from an ascending triangle pattern which could deliver $8-10 of near term gains.

Option Alternative: Buy to open COST May 105 calls when the stock breaks above $105.

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John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.


Article printed from InvestorPlace Media, http://investorplace.com/247trader/trade-of-the-day-costco-cost/.

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