Costco Stock: Valuation Likely Peaked

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Costco Wholesale Corporation (COST) specializes in operating member warehouses to provide its member base with competitive pricing fueled by high sales volumes and rapid inventory turnover.

Costco currently operates 828 warehouses worldwide, including 572 locations in the United States, Washington, DC, and Puerto Rico, 105 in Canada, 40 in Mexico, 30 in Japan, 29 in the United Kingdom, and a few more in seven of other counties. Costco also uses e-commerce channels, although the company is primarily valued for its physical retail sales.

Costco’s investment case is truly unique. Its business model appears straightforward, although phenomenal management execution has massively differentiated the company in the space.

What sets Costco apart from the rest of traditional retailers is its membership plan, which leads to a steady stream of membership revenue for the company.

As a result, Costco can offer products at a noticeable discount, which maximizes customer loyalty, resulting in unique economies of scale.

Costco’s growing presence and growing finances have produced extraordinary returns for shareholders over the years. Investors really love this stock, with stocks continually hitting new all-time highs. However, this has resulted in a steady increase in Costco’s stock valuation multiple, which I believe is hardly sustainable.

While the company exhibits some of the finest qualities in the space, I think there will come a time when investors realize the stock is simply too expensive. As a result, I find it difficult to jump on the Costco bull bandwagon, and so I’m neutral on the stock.

Eternal Expansion

Costco’s continued expansion was once again demonstrated in its Q2 2022 results, which were quite strong. Revenue rose 16.1% year over year to $50.94 billion from $43.89 billion last year.

Adjusted same-store sales (which exclude the impacts of gas price changes) in the United States, Canada and internationally increased by 11.3%, 12.4% and 9% respectively year-on-year on the other, in a context of strong consumer spending.

Same-store sales were boosted by increased in-store traffic, which grew 9.3% globally, or 8.3% in the United States, year-over-year in the second quarter. Average transaction or ticket growth of 4.6% globally and 6.9% in the US also boosted results for the period. Costco also increased its online sales by 12.6%.

Of the total revenue, $967 million was attributed to membership fee revenue, which includes Costco’s high-margin cash flow.

All catalysts boosted net income to $1.29 billion ($2.92 EPS), from $951 million ($2.14 EPS) in Q2 2021.

That said, note that last year’s results included $246 million or $0.41 per diluted share in costs resulting primarily from COVID-19-related salary premiums.

Although Costco’s business model is known for extremely thin margins in actual merchandise sales, the company has managed to maintain double-digit gross margins.

Yet amid rising costs across the board, they stood at 12.31%, down from 12.73% last quarter. Net profit margins approached their usual levels at 2.5%.

Solid performance after the second quarter

Costco’s performance after the end of the quarter remained robust, with February total comparable sales increasing 10.6%. In fact, growth seems to be accelerating lately. Costco recently shared its March sales, with total comparable revenue growing a remarkable 17.2% year-over-year.

Following its continued growth trajectory, Wall Street now expects the company to generate EPS near $13.04 for fiscal 2022, implying 17.73% year-on-year growth. other.

Rating peak?

The stock has been on an endless rally, with no signs of recovery.

However, one thing has changed during this time: how much investors have paid for the underlying value/growth. Following the stock’s prolonged rally over the past decade, the forward price-to-earnings ratio has steadily increased from 20x to 42.6x.

Could Costco’s perpetual expansion justify this multiple? Perhaps. After all, growth remains in the double digits, while earnings should expand if costs fall in the medium term.

However, Costco is ultimately a discount retailer. Of course, the qualities of its economic model deserve a premium. For perspective, if Costco’s leading P/E were 30x, that would still imply a premium of over 50% over its industry peers that would reflect those qualities.

A premium north of 100% compared to the industry and net margins at 2.5%? It’s a tough proposition for me as an investor.

The Taking of Wall Street

As far as Wall Street is concerned, Costco has a strong buy consensus rating based on 15 buys and four takes awarded over the past three months. At $606.58, the average COST price target implies 2.7% upside potential.

Take away

Wall Street, apparently, likes Costco stock. Even today, analysts continue to assign buy ratings with the stock’s valuation at ultra-premium levels. Don’t get me wrong, Costco is probably (one of) the biggest companies in the industry, without a doubt.

However, I think the upside might be rather limited to its current price levels. On the contrary, the case for compressing valuations should be quite strong, in my view. Therefore, I will remain on the sidelines for now.

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