Costco (NASDAQ:COST) is on a winning streak. Costco stock recently hit new all-time highs, and now shares are up 15% year-to-date and 24% over the past 12 months.
That makes sense, as Costco has delivered stellar earnings. Customers have turned to the retailer to stock up in the face of the novel coronavirus.
In a year where so much of the economy has shut down, retailers that provide essential services have been indispensable. However, even in a great year for grocery, Costco has stood out.
Here’s what you need to know.
Earnings Its Membership Dues
Costco has strengthened its competitive position this year. Its membership model tends to create a very sticky client base. Globally, nearly 90% of Costco shoppers choose to renew their paid memberships every year. One of Amazon’s (NASDAQ:AMZN) competitive strengths is the Prime program. Once people pay for access, they tend to order more through the site than they would have otherwise.
Similarly, Costco has created fantastic customer lock-in with its pay-to-shop system. The membership creates the feeling of exclusivity.
In 2020, this has been more important than ever. Folks want a simple in-and-out reliable shopping experience in these trying times. Costco’s large format stores with a limited number of different products means that there’s plenty of the basic essentials for shoppers. Costco doesn’t offer the widest selection, but what it has is cheap, reliable, and high in quality.
Costco’s huge scale in warehouse and infrastructure logistics also paid off this year. The company’s recent quarterly results positively dazzled: Its reported earnings per share of $2.36 came in 49 cents per share ahead of expectations, truly a blowout number.
Costco has proven itself as a trustworthy institution for nervous consumers this year. That should be good for the company’s membership rolls going forward. And it’s not resting either; Costco added a $1 billion logistics acquisition this year to further its competitive advantage.
Costco’s Stiff Valuation
Alas, as great as the business is going right now, it’s hard to get excited about Costco’s stock here. That’s because, at this time, Costco is selling for 39x trailing earnings. For the year ahead, analysts see earnings jumping around 10% to $9.41 per share. That would put the stock at 35x forward earnings.
You might be wondering why Costco stock’s earnings can’t increase more given the highly favorable economic environment. Costco is firing on all cylinders with the current stay-at-home trend. Even despite that, however, Costco is already so big that it’s hard to grow quickly. Over the past year, Costco pulled in $161 billion in revenues.
It’s hard to move the needle when you’re already that size.
Additionally, with the huge run-up in the stock price, Costco’s dividend yield has fallen substantially. Last year, COST stock yielded around 1.1%. From that already low level, the yield has slumped to just 0.8% annually now. In other words, don’t buy Costco as an immediate income play.
Much More Expensive Than Peers
Let’s turn back to the price-earnings ratio for a second. I wouldn’t dispute the idea that Costco should be the most expensive of the major brick-and-mortar retail companies. Still, just how much of a premium is justified?
Walmart is selling at 26x forward earnings. Walmart remains the king of physical retail, and its e-commerce presence is sharply improved in recent years as well. Target also goes for 26x earnings. Kroger is a lower-quality business than the rest of those peers, but you can’t deny that it’s having a fantastic 2020. Yet Kroger only sells for 14x earnings.
Against that backdrop, it’s really hard to justify paying 39x earnings for Costco stock. Yes, it could work out for the best out of those four if you hold on long enough. But you have to imagine that the valuation gap will close at least a little in the interim as the pandemic tailwind wears off.
Costco Stock Verdict
An investment in Costco today comes down to your time horizon. If you’re looking to make a trade, Costco is probably not going to work that well over the next few months or year. The stock is simply too expensive on an earnings basis for it to offer a favorable risk/reward profile here. With the coronavirus-induced buying surge wearing off, Costco’s momentum will slow in coming quarters.
That’s nothing against the company or its management. Costco is making all the right decisions now in terms of running the business. However, Costco’s share price is now so high that flawless execution will be needed to justify further short-term gains.
On the other hand, if you’re looking to buy and hold a high-quality company for the next five or 10 years, Costco stock is a fine choice. As our Dana Blankenhorn recently wrote, Costco could be an an ideal buy and hold forever position. The pandemic has given the company another chance to demonstrate its excellence. Just know that you’re paying full price for your investment.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he held no positions in any of the aforementioned securities.