Costco (COST) has incurred a 17% correction since it peaked, about three months ago. Every correction of the stock throughout its history has proved a great investing opportunity. Therefore, the big question is whether the stock has now become a bargain.
The Reasons Behind The Correction
A part of the correction of Costco can be attributed to the correction of the broad market. Since the stock peaked, S&P has lost 12% due to fears of an economic slowdown and the possibility of a recession in 2019 or 2020.
While the broad market correction has certainly affected the stock price of Costco, half of the losses of Costco have materialized after its recent earnings report. In the third quarter, the retailer grew its same-store sales by 7.5% and its earnings per share by 19% over last year. Nevertheless, the market punished the stock with an 8% plunge on the day of its earnings release. The adjusted earnings per share of $1.61 were marginally lower than the analysts’ consensus of $1.62. Moreover, the operating margin shrank from 3.0% to 2.7%, with management admitting that it is facing increasing competitive pressure, not only from supermarkets, but also from Sam’s. As Costco already operates at razor-thin margins, the market fears that the heating competition in the retail sector may soon begin to have a strong negative effect on the bottom line of the company.
Costco has an exceptional business model. It charges its customers an annual membership fee in order to offer them access to its bargain prices. The membership fees amount to $3.1 B per year so they seem negligible compared to the annual revenues of the retailer, which amount to $138.4 B.
Source: Investor Presentation
However, Costco sells almost all its products just above their cost price. As a result, the membership fees comprise the vast majority of its earnings.
When Amazon (AMZN) acquired Whole Foods, the stock of Costco plunged due to concerns that the online giant would disrupt its business model. Amazon has a similar business model, as the online giant charges an annual fee in exchange of free shipping, access to movies, shows and Kindle books. Consequently, the market was afraid that Amazon would take some market share of Costco and exert great pressure on its already-thin margins.
However, Costco offers a unique, “treasure-hunting” shopping experience to its customers so it enjoys a wide moat in its business. As a result, its business model is so strong that it is not threatened by Amazon. Indeed the market’s concerns have proved overblown, as Costco has continued to grow its same-store sales at an almost 10% annual rate every single month this year. Even small retailers cannot achieve such impressive growth rates.
A major factor behind the successful growth pattern of Costco is its exemplary management. Craig Jelinek joined the company in 1984 and spent 20 years in various store and regional management positions. He became the CEO of Costco in 2012 and has led the company to achieve great performance during his tenure. His multi-year experience in operations and merchandizing has been a major factor behind his successful leadership. As long as he remains at the helm, the company is likely to remain in its solid growth trajectory.
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Due to the razor-thin margins of Costco, investors should not expect meaningful margin expansion going forward. Moreover, the stock does not implement material share repurchases. Therefore, all the earnings-per-share growth will essentially come from the growth in its membership fees. This growth will in turn come from new customers, as well as the membership fee hikes that the company implements every few years.
Costco has grown its earnings per share at a 9.6% average annual rate in the last five years, mostly thanks to its membership fee growth. Given the strong momentum in its business performance and the absence of any signs of fatigue, it is reasonable to expect the company to continue to grow its bottom line by at least 9.0% per year on average in the upcoming years. Investors will be hard-pressed to find a large retailer growing at a higher rate than this, particularly in the current phase of the economic cycle. Costco is an exceptional growth stock.
Moreover, it has experienced business deceleration and intense competition in the past but has always returned to high-growth mode thanks to its wide moat and its solid execution. We thus consider the market’s concerns over margin pressure to be overblown.
The merits of the exceptional business model of Costco have not passed under the radar of most investors. As a result, the stock has almost always traded at a remarkably rich valuation. The stock is currently trading at a price-to-earnings ratio of 26.2. While it deserves to trade at a premium valuation, investors should realize that this premium results in significant downside risk in the event of an unforeseen downturn, such as a recession or a disappointing earnings report. The recent plunge of the stock after the release of an undoubtedly strong earnings report is only a testament to the downside risk of the stock that results from its premium valuation.
Even if the performance of the retailer proves resilient in the next recession, its price-to-earnings ratio will certainly contract. As a result, the premium valuation of the stock is likely to provide a headwind to its future returns. For instance, if the price-to-earnings ratio shrinks to 24.0 over the next five years, the stock will incur a 1.7% annualized drag due to the contraction of its valuation level over this period. This is a significant risk factor to consider, particularly given the absence of a recession for nine consecutive years and the growing concerns of the investing community over an economic slowdown in the upcoming quarters.
As the exemplary management of Costco is a major factor behind its success, investors should note that the current CEO is 65 years old. Consequently, it is possible that he retires at some point in the upcoming years. Given the intense competition in the retail sector, which has heated more than ever, the announcement of a change in the CEO position of Costco will probably cause shockwaves to its stock price. Investors should not underestimate the importance of the quality of management in the returns of the stock.
Costco has an impressive growth record and is likely to maintain its strong momentum for years thanks to its robust business model and its exemplary execution. The recent correction has rendered the stock more reasonably valued but its valuation is still rich. In the long run, high-growth stocks usually compensate investors for the high premium they pay when they purchase their shares. This is likely to prove the case for Costco. However, given the still-rich valuation of the stock and the ongoing steep correction of the broad market, which is likely to offer many great bargains elsewhere, we advise investors to wait for a more attractive entry point.