Shares of Costco Wholesale (NASDAQ:COST) took a hit the day Amazon.com, Inc. (NASDAQ:AMZN) announced its $13.7 billion acquisition of Whole Foods Market, Inc. (NASDAQ:WFM). COST stock fell about 12% from $180 to sub-$160 in about five trading sessions.
Was the drop warranted? I don’t know that it was, given Costco’s business model is more defensible than a standard grocer. For instance, I would worry more about Kroger Co (NYSE:KR) or Sprouts Farmers Market Inc (NASDAQ:SFM). Even worse, Target Corporation (NYSE:TGT) has felt the AMZN pinch on merchandise and will feel even more on its grocery aisles.
Thanks to generating so much high-margin revenue from its memberships, Costco has a buffer on the rest of its business. That’s something companies like TGT or KR can’t say.
Costco, though, has a unique business model. Its wholesale prices, bulk products and “exclusivity” make it a place shoppers enjoy going. That’s a great thing in the current retail environment. But will it hold up?
The Problem for Costco
Getting excited to drop into Costco on the weekend is a real thing for its shoppers. While that remains as true today as it did several years ago, COST’s exclusivity is not the same. In fact, consumers who only carry a Costco membership fell to 8% this year from 14% in 2013. While 14% wasn’t a large market share to begin, its more-than 40% decline is something to consider. This is according to a research report by Cowen.
Something else to consider? 64% of Costco members also have an Amazon Prime membership, up massively from just 28% in 2013. Additionally, the analyst notes less frequent Costco visits among these customers, likely due to the membership overlap. That’s not a good sign and certainly poses concerns for Costco going forward.
What makes matters worse? Its valuation. While analysts expect 8.3% earnings growth this year and more than 11.4% in 2018, it’s not cheap. COST stock trades with a trailing price-to-earnings (P/E) ratio of 28.5. It has a forward (P/E) ratio of 25.5. While COST stock is certainly worth a premium thanks to its roughly double-digit earnings growth and unique business model, that valuation is questionable in my eyes.
Revenue growth of 8% this year and 5.7% next year is good for a retailer. But again, it’s questionable whether COST stock should trade at 25 times forward earnings estimates.
Taking It One Step Further
Since 2015, Costco’s P/E ratio range has been between 27.50 and 31.5. However, between 2011 and 2015, COST stock had a P/E ratio range of “just” 22.5 to 27.5.
So what are we getting at here?
It’s completely possible Costco maintains its valuation and trades higher from here. However, given the changing retail landscape, it could very well back to its lower valuation ways. Using the “lower P/E range,” we get a price range of $130 to $158. At the midpoint, we’re somewhere around $144.
One more important factor to consider is growth. While the company was trading with a pretty consistent valuation from 2011 to 2015, earnings were growing in the mid- to high-teens. However, COST stock did not garner its “higher P/E range” because growth was accelerating and investors were valuing it at a higher level. In fact, its growth rate was slowing while its stock was climbing, thus its valuation went higher.
The Bottom Line for COST Stock
I’m not trying to predict the end for COST stock. It’s one of the few retailers that has an identity while many others face new crises on a seemingly daily basis. It’s monthly same-store sales figures are impressive. So is its earnings and sales growth. I’m just having trouble justifying its valuation at almost 30 times earnings.
The one thing that would change my mind? If Costco made faster strides in the e-commerce landscape to better compete with its foes.
I think the valuation needs to come down. Perhaps that lower valuation comes in the form a sideways stock for the next 12 months. Maybe it’s in the form of a correction.
Additionally, $150 has been huge levels of support over the last few years. So too have $130 and $135.
I’m not sure how it will pan out for COST stock, but I know how I would play it. I would be long COST over $150 and out on a close below that level. I do not prefer to buy near current levels, but would rather wait for a pullback closer to $150. At least this way investors have a limited-risk setup.