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Short-Term Profit Taking May Take a Bite out of the Costco Stock Price

Costco Wholesale (NASDAQ:COST), the second-largest global retailer by revenue, has been making news headlines amid coronavirus panic-buying, and Costco stock has rewarded its shareholders well so far in 2020 as the share price is up about 4%. In comparison, the S&P 500 index is down around 10%.

Short-Term Profit Taking May Take a Bite out of the Costco Stock Price

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In recent weeks, the volatility in broader markets has been breathtaking. Many analysts debate what the economic effects of the viral outbreak may be in the U.S. and globally. And Costco shareholders are wondering whether the stock may continue its price gains.

Although I believe COST stock is likely to go up higher in the long-run, there will be profit-taking around the corner. Therefore those investors who may want to recession-proof their portfolio could regard any dip in the stock price as a viable opportunity to buy into the shares.

Costco’s Recent Earnings Were Robust

On Mar. 5, the group released strong Q2 and year-to-date (YTD) operating results for FY2020 as well as February sales results.

Reported net income for the quarter was $931 million, or $2.10 per diluted share, compared to $889 million, or $2.01 per diluted share, last year.

Net sales for the quarter also increased 10.5%, to $38.26 billion from $34.63 billion last year. Similarly, same-store sales saw a quarterly increase of 7.9%, beating expectations. These numbers were solid.

Its February sales benefited from an uptick in consumer demand in the fourth week of the reporting period. Management attributed this “to concerns over the Coronavirus.”

Anecdotal evidence and social media reports over the past several days also point to a general surge in demand for daily household items, cleaning and disinfecting materials, as well as canned food and dry grocery items. And retailers like Costco, BJ’s Wholesale (NYSE:BJ), Kroger (NYSE:KR), Target (NYSE:TGT), and Walmart (NYSE:WMT) have seen a considerable increase in customer numbers.

During the conference call, investors were rather relieved to hear that Chinese suppliers were operating at about 80% of capacity and many Chinese ports had been reopened. 

Over the past quarters, the Street has also been applauding Costco’s cost structure, one of the lowest in the retail industry.

Costco’s Business Model Makes It Resilient

Costco operates in the warehouse club (or wholesale club) space within the retail industry. Due to the low-cost and high-value products offered by warehouse clubs, this sector usually performs well regardless of macroeconomic conditions. In this segment, Costco’s main competitor is Walmart and both companies have been thriving in recent years.

The group runs on a “subscription business model,” whereby customers pay an annual membership fee to have access to its bargain-priced bulk goods. In 2019, Costco collected around $3.35 billion in membership fee revenue, which is almost entirely profit. The membership service has a renewal rate of over 90% in the U.S. as the group scores high on customer satisfaction surveys.

By using a membership-only system, Costco is able to book nearly all of its profits one year in advance. Thus the annual membership model contributes to its operating income and gives Costco stock immense earnings stability.

Coupled with strong customer loyalty, the retail giant has pricing power, too. And as a result both the top and the bottom lines register YoY increases.

International Expansion

Costco has 785 warehouses worldwide, including 546 in the U.S.  The number of international stores are 100 in Canada, 39 in Mexico, 29 in the U.K., 26 in Japan, 16 in Korea, 13 in Taiwan, 11 in Australia, two in Spain, and one each in Iceland, France, and China. 

Asia, including Japan, Korea and Taiwan, is a key market for Costco. The first Japanese store was opened in 1999.

According to recent academic research:

“Costco been able to win the Japanese consumers with a business model unfamiliar to them, whose shopping behaviors were said to be difficult, if not possible, to be changed… Many Japanese customers bring their friends and relatives to Costco, who do not have a membership card and share the bulk purchases with them… To many Japanese consumers, shopping at Costco is an exciting event.”

The company sees increasing membership signups on the opening day of Asian stores. In August 2019, it also opened its first physical outlet in China. That day that saw huge crowds visit the flagship store. The opening of new warehouses in Asia could easily accelerate the company’s current growth rate.

Finally, the company has a burgeoning e-commerce operation both in the U.S. and overseas. Its online and same-day delivery show strong growth and is likely to add to Costco’s bottom line for years to come.

What Could Derail Costco Stock Soon?

Over the past year, COST stock is up about 4%. On Feb. 21, the price hit a 52-week high of $325.26. And currently, it is hovering around $305.

So in the next few days to weeks, there might be profit-taking in the stock. As a result of the recent impressive run-up in the price, short-term technical indicators have become over-extended.

Investors who pay attention to short-term oscillators should note that Costco’s technical message has also become “overbought.” 

In the rest of this month COST stock could easily go below $300, possibly even to low-$270’s level, where the stock is likely to find important initial support. 

I regard the forward P/E ratio of about 36 a bit richly valued. In comparison, the metric for BJ, KR,  TGT, and WMT are 15.4, 13.6 15.3 and 22.6 respectively.

COST stock’s beta is 0.95, which means its volatility on average mimics that of the broader market. Therefore, if the industry or the broader market declines, Costco may also be adversely affected.

As Costco reports monthly sales regularly, you may want to keep an eye on March figures that would be reported in early April.

In other words, investors should watch for short-term market corrections in the stock as we get more updates on the COVID-19 outbreak. Were U.S. consumer confidence to get hurt, so could the share price, at least in the short run.

If you already own Costco stock, you might want to hold your position. That said, if you are worried about short-term profit taking, then within the parameters of your portfolio allocation and risk/return profile, you may consider placing a stop loss at about 3-5% below the current price point, to protect your profits to-date.

The Bottom Line on COST Stock

The rest of March is likely to bring further volatility to the stock market. We may all need time to digest the continuous news flow regarding virus developments on the health and economy front. So I’d not advocate bottom picking. However, I’d regard any price dip in COST stock as a buying opportunity for long-term shareholders.

Due to its membership-only subscription system, Costco is a unique warehouse stock with attractive high margins and downside earnings risk. I believe Costco will continue its long track record of strong performance. Finally, investors who buy into the COST stock price can enjoy a dividend yield of about 0.9%.

Tezcan Gecgil has worked in investment management for over two decades in the U.S. and U.K. In addition to formal higher education in the field, she has also completed all 3 levels of the Chartered Market Technician (CMT) examination. Her passion is for options trading based on technical analysis of fundamentally strong companies. She especially enjoys setting up weekly covered calls for income generation. As of this writing, Tezcan Gecgil did not hold a position in any of the aforementioned securities.

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