The Sell-Off In PriceSmart Stock Makes Sense

PSMT stock - The Sell-Off In PriceSmart Stock Makes Sense

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Warehouse retailer PriceSmart (NASDAQ:PSMT) recently reported third-quarter number that disappointed investors. Revenues beat consensus estimates, but earnings missed the mark, and net profits were actually down year-over-year due to margin compression.

In response to those numbers, PSMT stock fell more than 10%.

In the big picture, this post-earnings sell-off in PriceSmart makes a ton of sense. PSMT is one of those companies that gives monthly sales updates, and those monthly sales updates have been really good as of late. It is also one of those companies that has struggled with margins recently. But investors figured that improving top-line numbers would flow into improving bottom-line numbers, and PSMT stock had rallied from $80 to above $90 in the two months leading up to the the Q3 report.

The Q3 report hit the tape. Top-line strength didn’t flow into bottom-line strength. Margins were still weak. Naturally, PSMT stock dropped.

From this perspective, the sell-off in PSMT stock makes a ton of sense. Unfortunately, I also think it makes a ton of sense for this stock to keep dropping due to margin concerns.

Here’s a deeper look.

The PriceSmart Narrative Is Improving, But Not By Much

For those who don’t know, PriceSmart is essentially the Costco (NASDAQ:COST) of Latin America. The company operates around 40 warehouses in the Central America, South America and the Caribbean. The warehouses look just like Costco warehouses (big stores with lots of stuff all packed together) and the business model is just like Costco’s business model (membership model with razor-thin margins).

Costco is a great business with solid and stable long-term growth prospects. Same with PriceSmart. The long-term growth narrative of this company as the Costco of Latin America has a ton of visibility, clarity, and stability.

Right now, the top-line narrative supporting PSMT stock is actually improving. Top-line club sales growth, which had fallen to around 3%-4% over the past two years versus a 7%-8% average over the past five years, is finally coming back into the picture. Net warehouse club sales rose 5.6% this quarter, 5.7% last quarter, and 4.1% two quarters ago. Moreover, June warehouse club sales rose 5.9%, so the whole revenue growth narrative is actually picking up momentum.

But, a lot of of that renewed sales growth is being driven by price discounting.

While sales growth has come back into the 5%-plus range, margins have struggled. Operating margins have fallen from a historically average 5% to 5.5% range to just over 4% year-to-date. Thus, reinvigorated sales growth has come with drastic margin compression.

Eventually, this should normalize. PriceSmart is investing big into its business right now. Those investments are pushing big sales growth, and big sales growth will allow for operating leverage. But promotional pricing remains a headwind for margins going forward, and a return to 5.5%-plus operating margin peaks seems unlikely.

In grand total, then, the PriceSmart growth narrative is a tale of two cities. Revenue growth looks great but margins remain under pressure.

PriceSmart Stock Has Overshot Itself

The unattractive thing about PSMT stock is that it isn’t priced appropriately considering the margin headwinds.

The days of 7%-8% revenue growth are over for PSMT. Back then, the company’s warehouse base was growing by two to four new locations per year. Today, the unit growth rate is somewhere around one or two new locations per year. Thus, even if comparable sales growth does return to peak form, overall revenue growth won’t return to 7%-8% due to slower unit growth.

With that said, over the next several years, revenue growth should run around 5%-6% per year. Operating margins should be able to return to around 5% to 5.5% as sales growth sparks operating leverage, but prospects of 5.5%-plus operating margins seem bleak given the company’s promotional pricing growth strategy.

Under the assumption that sales growth returns to form of around 5%-6% per year and margins bounce back to a historically normal 5% to 5.5% range, I think that PriceSmart can net around $5.10 in earnings per share in five years.

A growth-average 20-times forward multiple on $5.10 implies a four-year forward price target of $102. Discounted back by 10% per year, that equates to a year-end price target for PSMT stock in the mid-to-upper $70’s.

Bottom Line on PSMT Stock

When it comes to PSMT stock, you have a tale of two cities. On one end, revenue growth is returning to form. On the other end, revenue growth is returning to form because of promotions, and that is killing margins.

Eventually, this will all normalize. Revenue growth will remain strong. Margins will bounce back. But PriceSmart stock seems overpriced at present levels considering that reality. As such, I wouldn’t be surprised this stock to continue to trade weakly until it falls to more fundamentally supported levels in the mid-$70’s.

As of this writing, Luke Lango was long COST. 

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