Costco Isn't A Good Buy Despite The Upcoming Dividend Raise

Summary

• Costco has been growing dividends for 16 years, and the 17th year is coming this month.
• The company's valuation seems out of touch.
• In my opinion, at the current valuation the risks are too high.

Photo by Thomas De Wever/iStock Editorial via Getty Images

Introduction

I am always looking for more candidates for my dividend growth portfolio. Right now in my dividend growth portfolio, I lack some exposure to REITs and consumer staples. In previous articles, I analyzed two REITs, and I also analyzed a retailer, Kroger (KR), and found it to be an interesting investment due to its attractive valuation.

I will analyze another retailer in this article. This time I will analyze Costco (NASDAQ:COST), a retailer with a different business model. Investment in retailers like Walmart (WMT) and Target (TGT) has been very stable and offered stable returns with both price appreciation and growing dividend payment, and I expect Costco to be the same.

I will analyze Costco using the graph below which represent my methodology for analyzing dividend growth companies. I use the same methodology in my analysis since I want to be able to compare possible investments under consideration. I will analyze the company's fundamentals, valuation, opportunities, and risks, and try to determine whether Costco is a good company and a good investment.

(Graph made by author)

According to Seeking Alpha company overview, Costco engages in the operation of membership warehouses in the United States, Puerto Rico, Canada, the United Kingdom, Mexico, Japan, Korea, Australia, Spain, France, Iceland, China, and Taiwan. It offers branded and private-label products in a range of merchandise categories.

(Source: wikipedia.org)

Fundamentals

In the last decade, the company has more than doubled its revenues. This happened due to its organic growth inside the United States and internationally as well as growth in same-store sales. The company expects a double digits growth rate in sales in 2021, and analysts covering it expect a mid to high single digits growth rate, which is a very healthy growth rate for a retailer.

Data by YCharts

The bottom line has been growing at an even faster pace, and EPS has more than tripled in the last decade. The growth in EPS was fueled by top-line growth as can be seen above, and by margins expansion as profit margins have increased significantly in the last decade. Analysts covering the company expect that the company will keep achieving impressive bottom-line growth in the high single-digits area.

Data by YCharts

The company is focused on its dividend, and since initiating it in 2014 it has grown by 13% annually on average. Besides, as the graph shows, the company is paying any excess cash it has in the form of special dividends. The company is about to declare another dividend increase in the coming weeks, and I expect it to be in line with its historical growth rate as the current yield of 0.77% is adequately covered with a payout ratio below 30% when not taking into account the special dividends.

Data by YCharts

While the company doesn't have a prominent buyback plan and prefers special dividends when there is excess capital, it is important to note that shareholders are not being diluted, and in the last decade the number of shares outstanding has grown by only 1%, and in my opinion this is negligible. Besides, at the current valuation, buybacks would have little effect and I agree with the management's capital allocation plan.

Data by YCharts

Valuation

The company's P/E is alarmingly high. We are talking about a retailer, a supermarket chain in effect, and it is trading for more than 36 times its forward earnings. A valuation which I cannot explain. While this valuation seems in line with the valuation in the past year, I still find it hard to pay such a premium for a business that grows at roughly 10% annually in the medium term.

Data by YCharts

The graph below from Fastgraphs.com shows the entire story. The company always traded for a premium with an average valuation of 25 times earnings. However, in 2019 the company's stock price started growing much faster than the company's earnings. While the company's forecasted growth rate is in line with its historical growth rate, its valuation is extremely higher.

(Source: Fastgraphs.com)

The company has great fundamentals. Topline growth fuels an even faster bottom-line growth, which in turn fuels impressive dividend growth. However, these great fundamentals are coming with an unfortunate valuation which I cannot justify at the moment. The company will have to offer investors a unique growth opportunity to justify such a premium.

Opportunities

The graph below shows a key growth factor for Costco in the past and the future. The margins expansion allowed the company to show such impressive bottom-line growth, and it is fueled and will be fueled by an increasing number of members and increased online sales. Both are a priority for Costco, and both will keep driving margins higher, and allow the company to offer higher than average margins in the sector.

Data by YCharts

The balance sheet is another important aspect for future growth. As you can see in the graph below, the company has a growing cash position that is by now bigger than its long-term debt. The leverage is extremely low, and it allows Costco to keep growing fast, invest in the business, compete with its peers, and if needed make larger acquisitions that will be supporting EPS growth long-term.

Data by YCharts

Another opportunity is the company's business model of paid membership. This stream of revenues allows the company to gain stable revenues due to the over 90% retention rate. Also, as the company's availability is growing due to e-commerce and delivery options, there is more room for additional members. The current business model is a medium-term growth opportunity as the availability of deliveries across the U.S will allow for more potential clients to sign-up.

Risks

Competition is a major risk for Costco. At the end of the day, Costco is a retailer, and even with its private label, it essentially sells commodities and works in a low margin environment fighting to offer the most attractive value proposition which focuses on price in this business. The company is competing with other giants like Walmart, Target, and Amazon (AMZN) with its Whole Foods subsidiary. If the competition intensifies, it will pressure the margins and will hurt EPS growth.

The margin of safety is the biggest risk in my opinion. The company is expected to grow at around 9%-10% annually in the medium term. This is an impressive growth rate, but it cannot justify paying 36 times earnings. In my opinion, the company is priced for more than perfection, and the chart below shows how this retailer without any significant moat, is trading for a higher valuation than four of the big five tech companies. Therefore, I believe that the margin of safety is an alarming risk.

Data by YCharts

The company's business model will have to adapt to the new consumers' tastes. It might require to adapt the way they acquire clients as gradually e-commerce has been a growing segment which more than doubled for Costco in the last decade. Also, the company is expanding into other businesses such as travel in which it is less experienced. Costco will have to keep growing while adapting to new trends in different markets, and it will have to do it to keep growing at the same pace and enjoy the current premium.

Conclusions

There is no doubt in my mind that Costco is a great company. The company has strong fundamentals growth with growth on both top and bottom line. Also, it pays a growing reliable dividend and offers several growth opportunities which will maintain a high single-digit growth rate, and therefore, the quality is here.

However, while the company has manageable business risks, it has an investor risk deep inside it. There is no margin of safety to the point where the valuation is detached from the fundamentals. The current valuation is higher than the valuation of major technology companies, and therefore, I believe it is better to wait for a better entry point.

Analyst’s Disclosure: I am/we are long WMT, TGT, AMZN. 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.

Comments

[LookingAtStocks]

From the 5/10/21 Investor's Business Daily...
"When it comes to technical analysis, Costco stock shows overall weakness but an improvement in recent weeks. In the past few weeks, shares have reclaimed both the 50-day and 200-day lines. Costco is nearing the 393.25 buy point of a cup base. Shares remain roughly 3% away from the entry."

[jasaggie]

Any company willing to run off good customers in order to force mask-wearing, couldn’t be in my portfolio. And it’s expensive to boot. Makes it seem like they don’t really believe in the vaccine, requiring vaccinated associates and customers to wear a mask, even in states that are “open”. 🤔

[MoreBacon]

@jasaggie At most, mask wearing is a minor inconvenience, but "entitled" people apparently don't give a s**t about anyone but themselves. Long COST

[Valuestocks007]

@MoreBacon i am always shocked when people get on a stock forum and talk about masks... am i the only one?

[jasaggie]

@MoreBacon if you mean by not wearing a mask, I'm thinking about myself, so be it. if you mean, by taking the vaccine, I'm thinking about myself, so be it. but, if you mean, you like your COST management team running off business, we don't agree. there is a cost to acquire customers as you know.

I am curious, do you believe in the vaccine? even Dr Fauci, who admittedly has been all over the board when it comes to masks, yesterday said the indoor wearing of masks needs to be reviewed in light of the number of vaccinated.

and @Gina1996 the article premise is about COST being overpriced. management plays a role in that. and this is an example of a business policy that makes no common sense.

[KC_Alpha]

Costco has a very sticky subscriber business model, with most of their revenue coming from repeating membership fees, so their margins don’t need to be high. They had an Amazon Prime model before Amazon. I’ve owned it close to 15 years and it’s been a great run. No plans to sell.

[Valuestocks007]

@KC_Alpha dividend reinvestment!! i am close to 15 .. for sure more than 10. keep it rolling COSTCO!

[navigatoris]

Don't understand why anyone would trade COST. Bought in 2004 at 38, then again in 2005 at 53. Never traded it, always re-invested distributions. Remember some analysts considered it overpriced because their margins were too thin. Maybe they should raise the price of their great hot dogs.

[cptstupendous]

@navigatoris "Maybe they should raise the price of their great hot dogs."

Silence your heresy this instant.

[ocvegasproperty]

@navigatoris As My uncle Kevin O’Leary would say, “That is their soul along with the 5.99 chicken” which the price hasn’t changed in about a decade. First time I remember buying costco was at 40 and may have been before that...

[Valuestocks007]

@navigatoris how many years have we heard.. "costco is expensive" glad i never listened and just kept buying!

[Pey Shadzi]

Not sure how you can write an article about Costco without speaking extensively about their current international expansion plans. They just opened their first store in China in 2019. Membership sign ups are through the roof. Costco’s run as a business is just beginning.

The multiple is high, yes, it’s always been but no one has ever been right yet betting against Costco. Buy the stock now and on dips, reinvest the dividend and hold on for life.

I wrote an article on SA in 2012 saying COST was expensive at $80 a share. How naive I was. Don’t make the same mistake.

[sutterhome1971]

@Pey Shadzi why did they stop expansion internationally after opening only one store in China? what about expansion in ohter countries. I know they have in UK

[Friendorfoe]

@Pey Shadzi Good job of explaining COST to Khen, especially your comment: "I wrote an article on SA in 2012 saying COST was expensive at $80 a share. How naive I was. Don’t make the same mistake." Although I have not gone thru the exercise, I believe if you looked at this stock in 5-year spans over its entire public period, you would find reason to make that same comment at every single 5-year segment. I have tenaciously been holding shares since 1989.

[mnk1969]

Costco has always been overpriced. But it doesn't go down much, go figure

[Money 29]

Great company COST, but overvalued at this time.

[southbuckeye]

Costco and Target are the two overpriced stocks in the sector.

[ocbearclaw]

@southbuckeye I agree but at least Costco has membership revenue and loyalty PLUS the Special Dividend.

[MoreBacon]

@southbuckeye
I agree, but they are the cream of the crop in the retail sector. I own both and will continue to add on dips.

[VR_VR]

Only thing I don't like about Costco, that we are spending more and more money there as time goes buy.
Yesterday stopped by just for a few things , walked out with around $250 less in my pocket :)

[Cheever]

Never underestimate the value of good service. When combined with their low prices (where else can I buy gas that's $0.30 cheaper), I think they are best in class for the retail sector and deserve the premium that is reflected in the stock price. Additionally, the employees seem happier there which makes the whole shopping experience that much more enjoyable. And I haven't even touched on the treasure hunt aspect of their model.

[Buyandhold 2012]

Costco is a buy at $340 or lower and a hold over $340.

[spooker35]

....and they turn inventory at a phenomenal rate.

[formercaddie]

COST, HD, TGT, AMZN. Buy on dips, DRIP, and hold forever. You won’t be sorry.

[Valuestocks007]

@formercaddie amzn no drip... but i agree!!! buy and hold these market leaders!

[ggerry]

There’s a bunch that’s incorrect or omitted here. You mention Costco’s competition risk: all of those companies have been competing against Costco for the entire duration of its existence. Even more so during the pandemic. Nothing has changed there. Hasn’t slowed it down, and if you’ve ever shopped at a Costco, you wouldn’t be comparing it to Whole Foods whatsoever. It’s not a supermarket chain, it’s a one-stop shop. That’s a completely false equivalency. They sell many items where the markup is quite large (laptops, alcohol, tech products, toiletries, disposables, list goes on and on). They’re selling more and more of these as time goes on, in addition to higher margin private label versions of the day’s hottest products (like kombucha).

You don’t mention the size of the revenue driven by memberships. Huge advantage to Costco that really only Amazon has, among the comps you made.

Multiples are high across the market. That’s a macro issue, not micro specific to this company. You fail to explain why Costco’s is any worse than any other comps. In fact, it isn’t, except for Walmart, which it generally doesn’t compete with geographically (Walmart seeks out lower income areas, Costco prefers higher income areas).

You also don’t mention the idea that consumer behavior may have significantly changed long-term due to the pandemic, favoring stores like Costco and Walmart where you can get everything you need at a low price in bulk in one trip. Costco has a significant moat actually, it’s generally the cheapest AND the highest quality retailer wherever it operates, across multiple categories as mentioned above. As you mention, digital sales will likely continue to grow and add more value: they have only recently started going after that market with any energy, and if they can offer the same deals at the same quality as in-store there’s no reason they cannot gain market share in that sphere as well.

Don’t necessarily disagree with your point that the multiple is high and the stock is expensive though, I just don’t know that that’s a Costco thing as opposed to a market thing

[goblue16]

@ggerry you mention that Costco does sell some high margin items like Laptops, Alcohol etc. I watched an interview with the CEO about 5 years ago and. heard him say NOTHING is marked up over 15%. I love Costco and own the stock, but I believe the thinking that Costco sells some high margin items is not correct because they are not taking advantage of these typical high margin items.

[Friendorfoe]

@goblue16 Pardon my redundancy but you are exactly correct! This and the issue of the company's insistence on not fiddling around with that discipline is, perhaps, the key point when analyzing either the company or it stock performance.

[ocvegasproperty]

@goblue16 I know for a fact that any items marked up over 10% need executive approval.

[div2keep]

Memberships not margin.

[Current$ea]

Article nicely done.

Couple of things to consider.

First, you neglected to mention China. COST hasn’t even started there but they do have agreements and plans, so it isn’t just speculation.

More importantly,
While a PE 30 for a retailer is unprecedented, same can be said of many other stocks - railroads, automakers etc.

Fiat money is inflating asset prices.
And no, I am not a goldbug.
What do about it? Market can stay irrational longer than you can afford to fight it.

Stay invested.

At best (or worst) sell some minor portions of some positions and raise cash - although in the long run that’s probably a bad idea.

[John Troup]

"The company is competing with other giants like Walmart, Target, and Amazon (AMZN) with its Whole Foods subsidiary. If the competition intensifies, it will pressure the margins and will hurt EPS growth."

Not true. Costco profit is about what membership income is. Combining everything else and Costco sells at cost. None of the above mentioned companies can compete with that. Reading this article you would think Costco is going to fade away in a few years.

[Current$ea]

@John Troup
Author is conflating COST business model with those of competitors.

[skymole]

@John Troup Yes, Costco has no real competition. Still, it is pricey just now. I bought around 315-320 during recent dip; now holding. Under 300 would be a cherry entry, about the best we may see barring a market collapse.

[goblue16]

@John Troup You are CORRECT. They make almost all of their profit from member ships and they cap markup at 15%. As a result of this cap, they are not making that much money from product they sell and that is especially true for their wonderful $1.50 hot dogs and fantastic $4.99 chickens.

[Stewcrew14]

*Doubled revenue in the last decade
*Organic growth
*Expects double digit sales growth this year
*Tripled EPS in the last decade
*Significant margin expansion
*13% average annual dividend growth rate
*Special dividends
*30% payout ratio
*Not diluting shareholders

And you still can't understand it's high PE ratio?

[Current$ea]

@Stewcrew14
Add China to list - huge market in future, real not speculative, and not to be underestimated.

[rmyurick]

@Current$ea How can a thing be both "future" and "real, not speculative"?

[MoreBacon]

Much better shopping experience than most others. Their prices are always competitive. The quality and prices of their Kirkland branded products are excellent. For example, their 25 year old single malt whisky costs less than half of what you would normally pay for a comparable product. I’ve owned their stock for a couple of years as part of my core holdings, with no plans to sell. An unexpected bonus was a $10 per share special dividend last December.

[fliboy]

I think you are a young guy trying hard to apply what the professors just taught you. I'm sure you will do very well as you learn to apply what you learned when it is combined with some experience. This is a really great company.

Is it GameStop or bitcoin? No. However, if you buy and hold, at least as it looks now, you will do quite well. Probably much better than the S&P 500, which is very hard to beat.