Costco: Wholesale Profits with an Option Combination

Costco (COST) closed on January 6, 2008 at $51.45/share.

• 52-week range: $43.58 (Nov. 20, 2008) - $75.23 (May, 14, 2008)
• Dividend = $0.16 quarterly = 1.25% current yield

Costco Wholesale is probably familiar to most of us who like bargains on our consumer purchases as much as we enjoy picking up stocks at discount valuations. Since merging with Price Company in October 1993, Costco has become the dominant player in the warehouse membership segment of discount retailing.

Like Wal-Mart (WMT), Costco may be a beneficiary of the weak economy with many consumers ‘trading down’ to save money. Previous periods of poor general market conditions have resulted in temporary dips in Costco’s earnings that were followed by renewed EPS growth the very next year.

This happened in FY 1994 and FY 2001 (the last official recession prior to now) when EPS dipped from $0.50 to $0.44 and from $1.35 to $1.29 respectively. These 12% and 4.5% earnings drops were followed up with 18.2% and 14.7% gains in FY 1995 and FY 2002.

Even in today’s horrendous period, Costco posted a good year-over-year quarter in November with EPS of $0.65 versus $0.59. FY 2008 (ended August 2008) was the seventh straight record earnings year for COST with EPS of $2.89 and all-time high sales of $72.483 billion.

Here are Costco’s per share numbers for the past six years as reported by Value Line:

Consensus estimates for FY 2009 ending this August are now centered on $2.93 with FY 2010 now expected to be around $3.18/share.

Costco’s balance sheet looks fine with long-term debt at just 20% of capital and over $3 billion in treasury cash. Value Line gives COST an ‘A’ rating for financial strength, a 90^th percentile ranking for ‘stock price stability’, and a 100^th percentile ranking for ‘earnings predictability’ (100^th being best). Value Line also notes that Costco shares have outperformed 85% of the 1700 stocks in their research universe over the long haul.

This is a high quality, relatively low risk (Beta = 0.85) issue that appears well suited to present day conditions. Yet the shares now trade at valuation metrics near 11 year lows. COST’s 10-year median P/E has been 24x.

Using an even lower 20 multiple on calendar year 2009 estimates of $3.00 brings me to a year-end target of around $60. This seems quite reasonable as COST shares hit highs of $72.70 and $75.20 in 2007 and 2008 when fundamentals were lower than they are today.

Here’s the play I put on yesterday (at 10:15 AM when the stock was trading at $51.40/share):

At expiration date (January 15, 2010), if Costco shares are $55 or higher, (just 7% above our starting price and well under my $60 target):

Your $55 calls will be exercised.

Your shares will be ‘called’ (sold) for $55,000.

Your $50 puts will expire worthless (a good thing for you as a seller).

You will have no further option obligations.

You will have received (at current rate) $640 in dividends.

You now will have $55,640 for your original $35,600 net cash outlay.

That’s a $20,040 profit or + 56% cash-on-cash return in this best case.

What’s your risk?

If Costco shares are below $50 on expiration date, you would be forced to buy an additional 1000 shares for $50,000.

Your $55 calls would expire worthless.

You would still own the original 1000 shares bought at $51.40/share.

Thus you would now be long 2000 shares of COST.

What’s your break even on the whole trade?

On the original shares bought at $51.40 it’s that price minus the $7.40 /share call premium = $44.00 /share.

On the shares that were ‘put’ at $50 it’s the strike price minus the put premium of $8.40 = $41.60 /share.

Your break even on the whole trade is thus $42.80 /share. That’s $8.60 below our starting price of $51.40 / share. You would not lose money on this trade if COST share drop less than 16.7% by expiration date.

While nobody can assure you that Costco shares will not go below that $42.80 break even level, it should be noted that the dead lows touched in 2006, 2007 and 2008 were $46.00, $51.50 and $43.88 respectively (and that includes the panic sell-off of 2008).

Disclosure: Author is long COST shares and short COST options.

Comments

[Paul Price:]

Please note that the write up was done with COSTCO shares at 5 cents lower than the Jan. 6th closing price [due to the time lag for submission here on Seeking ALPHA].

Jan 07 07:29 AM

[casey00001:]

Paul:
I don't know but your 35K is tied up for a year at 1.25% return rate on the dividend. You are not factoring opportunity cost at all.

Jan 07 08:33 AM

[Paul Price:]

Casey,

I think there's an excellent probability of that 56% cash-on-cash return in under 12.5 months.

What's wrong with that as my best case opportunity?

Jan 07 08:47 AM

[claudio.lan...:]

If one continues to make trades based upon Paul Price's analysis it is hard to believe at the end of the year the investor will not come out ahead even if several of the trades go below the estimated parameters.

Jan 07 10:15 AM

[Tom Armistead:]

To answer casey00001, the static return (if the stock stays where it is) is 31%. Costco is a low beta stock and the return is excellent compare to the risk.

Jan 07 10:44 AM

[Glenn McSpa...:]

I like this covered call idea alot. It's a very good case you make about the low risk inherit because of the low-beta association and the practical situation that more and more people are going to do their shopping for the next year at low-cost retailers like costco. You've got way more guts than I do though to sell 10 puts with an expiration a whole year away. I would not do that part and I would caution your readers to strongly consider the downside inherit there.....

Jan 07 12:13 PM

[Paul Price:]

Glenn,

I would take the contrary view and think that one or two years from now is much more likely to be back to normal than just a few months from today.

You can do this trade as small as 100 shares with 1 put and 1 call contract if 1000 shares is higher than your typical dollar trade.

I have no trouble with writing the 2011 options with this although the premium per unit of time is lower than the 12.4 month time frame. Using 2011 options lowers the cash outlay and break-even point even further than in the listed example.

Jan 07 12:32 PM

[Cousin Calvin:]

I'm ok with these moves. However if I were to do this exactly as you have laid it out, Fidelity would place $50,000 in a Put Reserve to cover the potential of being Put on the 1,000 shares at $50.
So now I would have $85,600 set aside for a year for this trade. That is a return of 23% on committed cash under the best case.
Using your same stock investigation logic I would just sell the $50 Puts with a closer expiration date than Jan 2010. You could sell puts at least 3 times before 1/2010 and still clear the $20,000, with only $50,000 committed.
Thanks

Jan 07 04:18 PM

[Paul Price:]

Calvin... you can meet the Reg-T margin requirement on the puts simply by having adequate paid-up equity in your account. It does NOT have to tie up cash unless the puts are actually exercised.

Jan 07 04:48 PM

[Cousin Calvin:]

Paul, I did not make it clear that the trade would be in my IRA account, no margin allowed.
Take a look at GG, sells below $30 with good sell premiums.
I am bullish on gold and with their cost structure they should enjoy a good bump. Your January covered call and selling put strategy would appear to be a winner.
Thanks

Jan 08 10:36 AM

[Kevin_S:]

Costco is one of the companies that will benefit the most with Obama's stimulus package - Schools and goverment agencies will spend it shares of the money at Costco. I would sell walmart or other thief stores (dollar stores) to buy costco and target.

Jan 09 09:37 AM