Over the past few months, Costco Wholesale Corporation (NASDAQ:COST) shareholders have learned how the rest of the market lives. Following the financial crisis, COST stock has had a basically uninterrupted bull run. Costco news seemed continually positive, earnings rose steadily and dividends rose each year, with special dividends only adding to the good COST news.
The ride’s become a bit bumpier of late, however. COST stock has gapped down three times just since February. A new all-time high above $180, reached in June, was undercut by two key pieces of non-Costco news.
First, Kroger Co (NYSE:KR) cut its guidance, raising fears of deflation-fueled margin pressure across the grocery sector. The very next day, Amazon.com, Inc. (NASDAQ:AMZN) acquired Whole Foods Market, adding to margin concerns.
Costco stock would lose 15% of its value in just three weeks, with another rally snuffed out by a sell-off after Costco earnings last week. COST now is back within shouting distance of year-to-date lows around $150. It’s been a volatile year so far for Costco stock — and I expect that volatility to continue.
Impacts Beyond Costco News and Costco Earnings
The biggest reason I expect choppy trading in COST going forward is that the grocery space, as a whole, has a lot of uncertainty. It’s going to take some time for investors to sort out the impact of Amazon’s entry into the space. The less discussed, but more important, deflationary trend in grocery overall continues, though it appears to have moderated somewhat of late.
COST bulls might argue that overall grocery prices aren’t a major mover for Costco stock. After all, roughly 70% of the company’s profit comes from membership fees. And, of course, Costco also sells gasoline and general merchandise.
But the impact of pricing and growth elsewhere is a big deal for Costco. If Kroger and Wal-Mart Stores Inc (NYSE:WMT) are cutting prices, the relative value offered by a Costco membership changes. If Walmart’s Jet.com continues to grow, it could potentially take share from Costco in warehouse-size products (including non-food items). The reason grocery stocks have fallen so much since June — KR is down about 30% for instance, as is smaller SUPERVALU Inc. (NYSE:SVU) — is that margins are so narrow that pricing pressure has a major bottom-line impact.
That’s true for Costco, with an operating margin of just 3.19%, as well. Take 10 or 20 basis points off that figure from lower pricing or lower membership fee growth, and even mid-single-digit sales growth leads to Costco earnings going nowhere. That’s a potentially big problem for a stock trading at around 27 times those earnings.
The issue in the near term, then, is that Costco stock isn’t just going to move on Costco news or Costco earnings. Every quarter from Walmart, Amazon, and Kroger will be affect COST. That really hasn’t been the case in the past: Costco dominated its warehouse niche, Costco earnings and the Costco stock dividend grew accordingly and COST stock followed. External factors didn’t really influence the stock. They will now — at least for the near future.
What to Do With COST Stock
Volatility isn’t necessarily a bad thing, particularly for a long-term investor. And that volatility very well may provide an opportunity in Costco stock.
Fellow InvestorPlace columnist Tim Biggam argued recently for a bullish put spread in COST — an idea that makes some sense. With volatility higher, option prices have followed. Hedged positions — including just selling puts at a much lower strike price — can lower the entry point if COST stock takes another leg down. If it doesn’t, premium income can replace the Costco stock dividend payment.
I’d like that strategy better than simply buying COST stock at the moment, because I do think more downside is going to come at some point. The 27 multiple is lower than the 30x+ Costco has typically delivered the past few years, but it’s not exactly cheap either. And while I don’t think margin pressure is going to lead Costco into bankruptcy, the margin concerns are real.
If pricing pressure drops Costco earnings growth to the mid- to high-single-digits, that earnings multiple likely compresses. In that scenario, COST could fall another 15-20% relatively easily, even assuming a still-healthy 22-24 multiple.
And for investors who believe in the long-term case for COST stock, the point is that there’s likely to be another sell-off in the next few quarters. There’s going to be a lot of news coming out of the space, a lot of data to digest. And there’s going to be — possibly — some sort of correction in the broad market.
Any of those events could bring Costco down further and provide a better entry point for the long-term investor.
In this way, too, the increased volatility in COST can create an opportunity — it just requires some patience.
As of this writing, Vince Martin has no positions in any securities mentioned.
