Costco: Premium Valuation Under Pressure With Earnings Growth Stalling

May.30.14 | About: Costco Wholesale (COST)

Summary

Costco reported steady topline revenue growth again.

Margins are under pressure, thereby limiting earnings growth.

Premium valuation is too high despite a great track record and excellent management.

I will only buy on significant dips.

Investors in Costco Wholesale (NASDAQ:COST) hardly reacted to the company's third quarter results released on Thursday before the market open.

Costco is facing some headwinds in its cost basis which does limit earnings growth despite nice topline growth. Very thin operating margins and a premium valuation make me hesitant to invest at the moment despite the great long-term track record of the business.

Third Quarter Headlines

Costco reported third quarter revenues of $25.79 billion, up 7.1% compared to the year before.

Topline growth was partially offset by margin pressure with earnings improving by just 3.1% to $473 million. Diluted earnings per share were up three cents to $1.07 per share.

Looking At The Operational Performance

Costco reported 7.1% revenue growth in its net sales which came in at $25.23 billion. Membership fees were up by 5.6% to $561 million. Total sales growth was driven by 4% comparable sales growth with sales increasing by 5% on a comparable basis within the US, and increasing by 3% in international markets.

Excluding the impact from volatile gas prices and in constant currencies, Costco reported 6% comparable sales growth overall. The company's international division posted an 8% jump in comparable sales.

Costco faced 6 basis points of pressure on gross margins which fell to 10.62%. At the same time, selling, general and administrative expenses were up by 4 basis points to 9.86% of sales putting pressure on already very thin operating margins which came in at 2.87%.

Net earnings were still up thanks to the topline growth and a very modest fall in effective tax rates.

Valuing Costco

Costco operates with a rock-solid balance sheet which contains $7.3 billion in cash, equivalents and short-term investments. Total debt stands at $5.0 billion, resulting in a comfortable net cash position.

At $114 per share the company's equity is valued around $50 billion which values operating assets around $48 billion. The company posted trailing revenues of $107.9 billion over the past year on which it earned a little less than $2 billion.

As such, operating assets are valued at roughly 0.45 times annual revenues and 24 times earnings.

Costco's quarterly dividend of $0.355 per share provides its investors with a 1.2% dividend yield.

Steady Growth

Over the past decade shares of Costco have tripled, seeing a steady rise from levels around $40 in 2009 to highs of $125 at the end of last year. Shares have seen a roughly 10% correction ever since, but still trade at premium valuations.

Over the past decade the company has grown to become the 4th largest US and global retailer while it operates just 649 warehouses. This implies annual revenues per warehouse of an incredible $165 million.

With employment approaching the 200,000 mark and the company processing 2.3 million transactions per day, you can see the sheer size of the operations of a single store. Each store employs on average some 300 workers which process some 3,500 transactions per day.

Between 2004 and 2013, Costco grew its annual revenues from $48 billion to little over $105 billion, implying an annual growth rate of around 9%. Earnings grew even quicker, with growth approaching 10% per annum after the company posted earnings of little above $2 billion last year. In the meantime the company retired nearly a tenth of its shares outstanding, boosting the performance on a per share basis.

Takeaway For Investors

Price pressure is being felt by Costco which operates with razor thin operating margins coming in at just 2.87% over this past quarter.

Earnings are entirely driven by membership fees which came in at $561 million, making up more than 75% of total operating income. Some 40.3 million households hold a total of 73.4 million cards and renew their cards at a greater than 90% renewal rate per annum. On average the membership card costs about $30 per annum.

Costco is widely admired for very competitive pricing, good stores but even more so for its strong culture. The company is often cited as an employer which is taking care of its employees, paying them above-market average salaries. Yet this might come at a price, with operating margins facing some pressure recently.

While the company is showing great and consistent growth, margins are very thin which is actually a concern for me combined with the high valuation at 24 times earnings.

I continue to like the long-term growth prospects and management team, yet I would have to see a significant correction toward $90 per share before getting excited again about Costco.

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.