Costco (Nasdaq:COST) is one of the largest discount retailers, and it continues to grow at a nice pace. In the latest quarter, sales increased 16% to $20.6 billion, which is quite impressive in light of the company’s size.
No doubt, Costco has been a solid investment. The shares are up nearly 40% over the past 12 months, and they’re close to a 52-week high.
However, as seen with the recent drop in Dollar General (NYSE:DG), the discount retail space is certainly not risk-free. Might Costco be a stock to avoid for now, or can investors expect more gains?
Let’s take a look at the pros and cons:
Pros
Great business model. Costco charges a membership fee, which is a juicy source of high-margin revenue. But the company also quickly pushes huge volumes of product through its warehouse stores. Because of this, Costco has high returns on its asset base.
The company also has a solid recurring business, such as from gasoline sales and groceries.
Global growth. So far, Costco has 580 locations. Roughly about 420 of them are in the U.S.
In other words, there is much room for growth in foreign markets, and Costco has already demonstrated that its warehouse concept has appeal abroad. Consider that comparable-store sales in international markets were up 18% in the latest quarter.
Private-label products. This is definitely a big opportunity for Costco. How important is a brand for cost-conscious shoppers? Perhaps not much, but if so, margins should improve as the company rolls out more private-label products.
Cons
Competition. The discount industry is fiercely competitive. Costco must contend with rivals like BJ’s Wholesale Club (NYSE:BJ),
Big Lots (NYSE:BIG), PriceSmart (Nasdaq:PSMT) and Wal-Mart (NYSE:WMT).
Commodities prices. While Costco has a strong sourcing platform — as well as economies of scale — it is still tough to deal with increasing raw materials costs. The fact is that it can be extremely difficult to pass along higher prices to its customers.
Valuation. Costco’s stock is not cheap, with a price-to-earnings ratio of 25. That’s a bit frothy as the company has relatively thin margins. The dividend yield is also a paltry 1.2%.
Verdict
As the largest U.S. warehouse retailer in terms of revenue, Costco certainly has good prospects. Of course, it looks like the global expansion opportunities can help propel the growth for the long haul.
Yet the valuation is a concern. And, as seen in the current volatile environment, investors can get jittery and quickly sell off a stock. Because of this, it’s probably best to hold off on the shares for now as the cons outweigh the pros.
Tom Taulli’s latest book is “All About Short Selling” and he has an upcoming book called “All About Commodities.” You can find him at Twitter account @ttaulli. He does not own a position in any of the stocks named here.
