Is Costco Too Costly?

Oct.11.12 | About: Costco Wholesale (COST)

Costco (NASDAQ:COST) is fully valued and now is an excellent time for shareholders to cash in on the investment. Before dismissing this claim, please take the time to understand the reasoning below.

What is the outlook for Costco? We can get a feel for the strength of this position by looking at its potential results in the future.

Assuming exceptional performance

Even if COST significantly beats estimates in the coming quarters, there will likely be only small changes to its market price. This is evidenced both from a market sentiment perspective and a value perspective.

· Costco reported its 4th quarter results on Wednesday, October 10th, and they surpassed the already optimistic expectations. Specifically, EPS of $1.39/share beat consensus estimates of $1.31 driven mainly by a revenue stream 11.9% higher on a year over year basis. Despite crushing estimates, the stock closed up only 1.92%. This happened because expectation of nearly perfect performance is already priced in. It seems reasonable to assume the market response to future good news would be similarly subdued.

· On a current basis, Costco trades at a P/E around 26. Even once we factor in projected earnings growth this ratio remains somewhat lofty around 22. Additionally, it trades at a price/book of 3.43. The current heavy valuation of the stock serves as a deterrent to any significant price increases.

Between value logic and the recent market behavior it seems strong performance, even that surpassing expectations, will lead to only small returns. The downside, however, is far more significant.

Assuming mediocre performance

Given the strong openings of its new stores and increased membership, it seems unlikely that Costco could experience losses in the near-term. However, a number of emerging factors make mediocre results, at or slightly below expectations, very plausible.

· Both Wal-Mart (NYSE:WMT) and (NASDAQ:AMZN) have announced same-day delivery. These companies can already compete with Costco on a value to the consumer basis, but now they have a level of convenience which cannot be matched by a big-box store. While many of Costco's customers appreciate the thrill of the treasure-hunt style of shopping, some of the more efficiency oriented consumers will undoubtedly be lost.

· As a service to its members, COST provides discounted gasoline. Pending oil price fluctuations, this can create significant loss to Costco.

· The retail industry has a notoriously low barrier to entry. We must not forget the possibility of another company operating under a similar model entering the field. Costco already has a direct competitor in Sam's Club (part of Wal-Mart) which has used the membership and buy in bulk philosophy for decades.

Regardless of the cause, a mediocre performance could cause investors to rethink their valuation of COST and drop its price to a more stable earnings multiple maybe in the 18-20 range.

Costco is a great company and hats-off to them for the stellar performance. The stock seems fully valued and the relatively small upside potential does not, in my opinion, justify the relatively larger downside risk. It is too strong to short, but now is a great time for current investors to cash in on returns.

Disclosure: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.

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.