The Hidden Margin Expansion Opportunity At Costco: 40% Upside

Summary

• COST reported strong double-digit comparable sales during the pandemic.
• At first glance, the stock looks expensive at 32 times trailing earnings.
• The future may see margin expansion and a leveraged stock buyback.
• I rate shares a strong buy with 40% total return upside.
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Costco (NASDAQ:COST) was a huge beneficiary of the pandemic, as its stores were, for at least a brief period of time, one of the only places you could buy toilet paper. Yet the stock is relatively unchanged to where it traded just prior to the pandemic. I suspect that the poor stock performance may have to do with general misunderstanding regarding the long-term prospects of the company: while COST has been able to churn out solid double-digit bottom line growth over the past several years, the real money has yet to be made.

I view COST as having tremendous growth potential from eventual margin expansion. Wall Street also appears to be sleeping on the company’s ability to take on significantly more leverage. I rate shares a strong buy.

(2020 Annual Report)

Margin Expansion Story

Even nearly a year after the onset of the pandemic, COST has continued delivering strong results. The latest quarter ended this February saw comparable sales growth of 12.9% including 74.8% e-commerce growth. Yet consider that the stock has given up most of its 2020 gains and now trades just a hair above where it did 1 year prior:

(Yahoo Finance)

The problem appears to be twofold. First, COST is likely to see deceleration in growth following the pandemic, as consumers may increase their shopping elsewhere. Second, COST trades at 32 times trailing earnings, which appears to be a rich multiple in light of its historical low double-digit earnings growth rate. It’s difficult to predict to what extent its growth rate will be impacted beyond the pandemic, but it’s worth noting that COST reported 4.3% comparable sales growth in the quarter prior to the pandemic.

It’s the second point that is more interesting. COST is well known to offer lower prices than competitors (hence the company name). Consider that COST recently earned a gross margin of only 13% in its latest quarter - far lower than the 23.6% gross margin at Walmart (WMT). I don’t expect COST to be able to achieve gross margins like that of WMT, but I see room for growth. If COST can increase gross margins by 100 basis points, then net income would increase by approximately 47%.

If COST can increase gross margins by 200 basis points, then net income would increase by approximately 94%. The stock trades at only 16 times earnings assuming 200 basis points of gross margin expansion. 200 basis points of gross margin expansion isn’t a stretch from reality: COST can achieve the growth in a variety of ways, perhaps by passing on 100 basis points of costs to customers and vendors, as well as increasing private-label penetration.

Balance Sheet Catalyst

Margin expansion is in my opinion the most important long-term catalyst for the stock, but the conservatively leveraged balance sheet should not be underestimated. As of the latest quarter, COST had $9.2 billion in cash and equivalents versus $7.5 billion in long-term debt. Even including the $2.7 billion in operating lease liabilities, COST more or less carries a leverage-neutral balance sheet. Considering the resilience of COST’s revenue stream, I can see the company safely taking on 2 times debt to EBITDA worth of leverage. That equates to roughly $14 billion of additional debt that can be used, for among other things, share repurchases. At recent stock prices, that represents 10% of shares outstanding.

Risks

• COST may eventually succumb to the e-commerce headwinds. COST’s lower price point appears to have insulated it from the margin compression and deteriorating sales seen at typical retailers. However, COST may face material headwinds if, for example, its vendors were able to offer direct-to-consumer orders with bulk prices.

• COST may not be able to or may not choose to increase gross margins to the extent predicted in this report. COST is unlikely to aggressively increase gross margins until it has optimally taken market share of consumer spending. Management may have a longer-term time horizon than that of shareholders, who might instead prefer quicker profits. As a result, the stock’s valuation is likely to appear elevated for many years before any such margin expansion takes place.

Conclusion

At first glance, COST doesn’t appear to offer much value. However, the prospect for multiple expansion makes the valuation easier to digest. Further, COST will be able to fund aggressive share repurchases with leverage in the future. Both of these catalysts are likely to drive substantial upside in the stock price. My 12-month fair value estimate is $430, representing 40 times forward earnings. Shares have nearly 40% total return upside to that target.

Analyst’s Disclosure: I am/we are long COST. 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.