Costco Shares Are No Bargain for Now

Dec.23.10 | About: Costco Wholesale (COST)

Costco Wholesale (NASDAQ:COST), a big favorite with consumers hunting for bargains on brand-name merchandise, might seem a great investment, too. After all, it leads the “membership warehouse” retail segment, has an upscale and loyal clientele, and by most accounts the company is as well-managed as are its stores.

Over the past decade, Costco shares handily outperformed mature rival Wal-Mart (NYSE:WMT); the volatile and smaller BJ’s Wholesale Club (NYSE:BJ); and the S&P 500.

If that’s not enough, there’s this:

About nine years ago, Warren Buffett threw 5.6 million Costco shares into his shopping cart, and even after selling more than 900,000 shares early this year, his Berkshire Hathaway (NYSE:BRK.A) still holds 4.33 million Costco shares, a 1% stake. Buffett’s investing buddy, Charlie Munger, is a longtime Costco director, and isn’t shy about talking up the retailer.

But today isn’t nine years ago, and Costco’s stellar performance has made its shares pricey. Just a tad too pricey in today’s market, YCharts Pro concludes. One potential justification for the shares’ rich valuation: an interesting play on the nascent rebound that California’s giant, troubled economy appears to be mounting. But let’s come back to that.

Costco battles rivals like Wal-Mart’s Sam’s Club unit, and BJ’S, and squares off as well against mass merchants Target (NYSE:TGT), Home Depot (NYSE:HD), and Lowe’s (NYSE:LOW). It’s a tough game, with slim profit margins, even for companies – like Costco – that are large enough to achieve economies of scale, and to wring low prices from suppliers.

For Costco, growth has trended consistently higher over the years.

So have per-share earnings, despite occasional pressure from economic downturns.

But would Buffett buy the stock today? Sure, it’s a well-run company, with margins which tend to hold up through recessions.

And yes, since its 1983 founding, Costco has been a pioneer in the warehouse format that continues to grow by drawing market share away from mainstream grocery and retail channels.

Costco’s unusually loyal customers pay $50 a year for a standard membership ($1.69 billion in fees in the year ended Aug. 31), to gain access to rock-bottom prices for jeans, jewelry, TV sets, and bulk groceries. And in contrast to the relatively down-market shoppers who patronize Wal-Mart’s Sam’s Club stores, Costco’s clientele tends to have more disposable income. That helps stabilize quarterly revenues.

The problem? A well-known story, too often, results in a fully-priced stock. Especially after the recent run-up.

And the 1.09 percent dividend yield seems an afterthought:

Absent some unexpected earnings catalyst, why buy Costco?

Here’s one potential reason: Costco, despite its national stature, derives fully 26% of its sales from the state of California. That outsized exposure, born of the company’s bi-coastal expansion strategy, was a good thing when the state was growing. And then, after the housing bust and high-tech job losses, it became a major drag on growth.

These days, with California showing signs of recovery, the retailer’s fortunes are likely to get a boost. The question is when.

“Yes, it’s getting better,” in California, CFO Richard Galanti acknowledged cautiously during a fiscal first quarter earnings call this month. “I don’t want to suggest that life’s great out there. We all know what the underlying unemployment statistics and the economy concerns are.”

When California comes back, Costco will benefit. If that happens faster than Wall Street thinks, there’s likely some upside in the company’s shares.

Disclosure: none