Costco, At What COST?

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September 13, 2006 | Stocks | | Author Asif

Costco Wholesale Corp (COST) has been on my watch list for years now, but every time I look at the stock, I come away with the feeling that it may be a little overpriced and that I should wait for a pull-back before starting a position. The reason I felt the company may be overpriced had to do with the fact that Costco sports a higher Price/Earnings (P/E) and Price/Sales (P/S) ratios when compared to competitors like SINLetter pick Safeway (SWY), Walmart (WMT), Kroger (KR) and BJ’s Wholesale Club (BJ) as you can see from the following table.

Company P/E P/S Profit Margin Dividend Yield
Costco 21.71 0.41 1.94% 1.00%
Safeway 19.64 0.34 1.75% 0.80%
Walmart 18.8 0.61 3.23% 1.4%
Kroger 17.24 0.27 1.56% 1.1%
BJ’s Wholesale Club 15.69 0.23 1.48% NA

The dividend yield at 1.00% is also not impressive when compared to the average dividend yield of 1.6% for the S&P 500. I find it difficult to imagine how Costco could possibly expand its product line given that it sells everything from “institution size” packs of Oroweat bread and Odwalla orange juice to big ticket items like flat panel HDTVs and even cars.

However there is a lot to like about Costco. They treat their employees much better than Walmart by paying them higher wages and providing better health benefits (notice the difference in the profit margin in the table above?) and hence have low employee turnover. They have a loyal customer base that regularly renew their annual membership and these renewals are very important to Costco as they derive a shocking 72.7% of operating income from membership fees according to this SeekingAlpha article. Their customer loyalty is evident from the difficulty in finding a parking spot at my neighborhood Costco, a dearth of shopping carts outside the store and the long lines at checkout counters.

Costco also has room for store expansion both on the domestic front and internationally according to this excellent article about Costco by Travis Johnson. Once you consider the facts that the company generates over a billion dollars in annual free cash flow, has $3.3 billion in cash and short-term investments on its balance sheet (over $7 per share) when compared to just $599 million in debt and is still growing earnings at a slow but steady pace, the stock appears to look less expensive than it did by looking at just the P/E and P/S ratios. As the holiday shopping season approaches, sales of higher margin big ticket items could also pick up.

An opportunity to buy Costco did present itself two weeks ago when Costco warned that it expects lower fourth quarter earnings because it had to mark down the price of big ticket items and faced larger than expected amount of returns. The stock fell more than 4% in reaction to this news but has since made up most of those losses.

A quick glance at the income statement from the fourth quarter of 2005 will reveal that they had excellent revenues and earnings in that quarter, which have not been matched in the first three quarters of 2006. When Costco releases fourth quarter 2006 earnings, the year-over-year comparison is likely to look bad and the stock could drop in response, providing just the opportunity I am looking for to start a position in Costco.

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  1. Costco Employee
    September 16th, 2006

    Costco’s year over year #’s won’t be bad this fall due to the fact that FY 06 has 53 weeks in it instead of the normal 52. This occurs about every 6-7 years due to a FY calendar adjustment. The Q4 & FY 07 numbers will be low based against original earnings estimates though, but the pre-anounced figures already stated that a couple weeks back. Look for COST to actually beat the low end revisions, and a rise in the stock thereafter. The price of gas is dropping daily, and contrary to last year, Costco makes money when the price of fuel drops. So, don’t let those Comp Sales figures fool you. SSS are low because less revenue is coming thru the pumps, but profit is up!

  2. Asif
    September 17th, 2006

    Thanks for your insights Costco Employee. From what I have seen in the past, if a year has 53 weeks then companies mention that fact while reporting year over year comparisons. Q4 numbers will be low as stated in the pre-announcement, but the stock has made up most of the 4% drop since then.

    I wonder if anyone remembers why the Q4 2005 revenue number was that high ($16.7 billion). Costco raised the membership fee from $45 to $50 around that same time period if I am not mistaken. Would that have something to do with the Q4 2005 numbers coming in high?

    I guess we will just have to wait until October 12 to see what the final numbers are and how the market reacts to those numbers. The low gas prices are definitely a plus for Costco.

  3. Costco Employee
    September 17th, 2006

    Membership fees haven’t been raised in at least 5 yrs…. Don’t remember exactly when, but sometime near 2000. Last years Q4 was higher than normal due to a special one time gain due to tax breaks I believe. Of course all of this is in the Quarterly and Fiscal Year End reports.

    In addition, since this was originally a membership income topic, some notes to remeber in your calculations…. Any membership income received is spread out over the entire 12 months (by law), not all in the month paid. Since Costco’s membership was increased in May 06, there will still be members just beginning to pay the higher fee as late as April 07. And, those will not be fully recognized as income until March 08. Of course any new members pay the $50 rate right away.

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