Costco - Shares Of This Well-Led Company Trade At A Too Rich Premium

| About: Costco Wholesale (COST)

Shares of Costco (COST) lost some 1.7% over the past trading week. The wholesaler of predominantly food products reported its first quarter results on Wednesday, which triggered little enthusiasm among investors.

First Quarter Results

Costco reported first quarter revenues of $23.71 billion for the first quarter of its fiscal 2013, up 9.6% on the year before. Sales growth was driven by a strong same store sales growth of 7%, driven by a 9% increase in international same store sales. Excluding the impact of gasoline inflation, same store sales rose by 6%.

Gross margins rose 6 basis points to 10.68% during the quarter. Selling, general & administrative expenses fell by 7 basis points to 10.05%. Higher gross margins and lower operating expenses resulted in an 18% increase in operating income, coming in at $639 million.

Net income rose 30% compared to last year coming in at $416 million. Earnings per share rose a similar percentage to $0.95 per diluted share. Growth was driven as last year's earnings were impacted by several one-time charges. The company took a $12 million charge related to the tax audit of its Mexican operations, and a $17 million charge related to a possible reform of its alcoholic beverage laws. Excluding these items, earnings rose some 19% on the year.

The company ended the quarter with 621 warehouses, of which 448 were located in the U.S.


Costco ended its first quarter with $5.6 billion in cash, equivalents and short-term investments. The company operates with $1.4 billion in long-term debt for a net cash position of $4.2 billion.

For the full year of its fiscal 2012, Costco generated revenues of $99.1 billion. The company net earned $1.7 billion, or $3.89 per diluted share.

The market currently values Costco at $41.9 billion. This values operating assets of the firm at the firm at 0.38 times 2012s annual revenues and 22-23 times annual earnings.

Costco pays a regular quarterly dividend of $0.275 per share, for an annual dividend yield of 1.1%.

Some Historical Perspective

Year to date, shares of Costco have risen some 16%. Shares rose from $83 in January to highs of $106 earlier this month. After paying a special dividend of $7 per share, shares are currently exchanging hands at $97 per share.

Shares of Costco have risen from lows of $40 at the start of 2009 to fresh all time highs earlier in the month. Between 2009 and 2012, revenues increased almost 39% to $99.1 billion. Net income rose from $1.1 billion to $1.7 billion over the same time period.

Investment Thesis

Costco is a well-led company with a very strong balance sheet. The net cash position of the firm rose to $4.2 billion, enough to finance the special $7 dividend. The special dividend will cost the firm roughly $3.0 billion, but will still leave the company with a net cash position of $1.2 billion, giving the company a lot of financial flexibility.

Part of the cash will be used for the openings of new locations, which will be accelerated from last year. Costco plans for 30 new openings in 2013, of which 14 will be located in the U.S. As such, the international division of the firm will see an increased focus in the company's growth plans, especially in Asia.

Earnings have been driven by a $5 membership fee increase in the U.S., with membership rates costing roughly $55 per annum. The renewal rate during the first quarter came in at a solid 89.7%. Costco sees little to no impact on renewal rates as a result of the 10% hike in membership fees.

Despite the high annual fees, many customers keep going to Costco as the firm offers razor sharp deals. A selective inventory of products, high turnover rates and great bargain power allows the company to provide very competitive food and fuel prices.

Costco is a great company and has an excellent tradition in long-term value creation. The strong balance sheet allowed the firm to pay a high special dividend and finance its expansion plans. The firm will boost sales by 4 to 5% per annum by new store openings, while same store sales growth could jack up the total sales growth rate of 2013 to 10% or higher.

Despite the decent same store sales growth, expansion plans and a well-received increase in membership rates, the valuation at 22-23 times annual earnings is a little too rich. To justify the current valuation, Costco should boost its current net margins. Costco reported a net income margin of roughly 1.8% for the first quarter, roughly half the net margin of 3.7% reported by Wal-Mart (WMT).

Shares are only attractive at these levels if the company structurally manages to boost net margins over 2% a year. As I don't see this happening anytime soon, I remain on the sidelines on valuation concerns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.