Costco: Steep Valuation With A Bright Future

Summary

• Costco continues to pump out incredible revenue growth and the future continues to look bright.
• Costco's e-commerce service will be a big-time contributor to revenues down the line, something to keep an eye on as the company focuses on the sector.
• Costco has a very rich valuation at current levels. I would be patient if looking for an entry point.

Mario Tama/Getty Images News

Costco Wholesale (NASDAQ:COST) stock has had an outstanding year, moving up about 50% in 2021. This is on the back of some pretty incredible growth considering how well-established and boring their business is. The good news is that this growth is scheduled to continue moving forward thanks to an extremely loyal, and growing membership base and a solid start to e-commerce which I think has a lot of potential down the road. The big question is around the valuation, which is why I am currently on the sidelines waiting for a better entry point.

What's Driving Costco?

In short, it's momentum. Behind that momentum is slow, and steady growth. The revenue growth that the company saw in the fiscal year 2021 was very impressive and helps shape why we saw the stock go up about 50% throughout 2021. The stock has been a good one to hold, but I don't think anyone saw this coming given the supply chain issues the world has faced over the last couple of years. The company closed the year with ~$196 billion in revenue for 2021. This is about a 17.5% increase year-over-year and the highest growth rate the company has seen in decades. Will we see a growth rate of 17.5% again this year? I don't think so, but I do think we will see 10%+.

The company reported Q1 2022 earnings on December 9th and posted $50.36 billion in revenues. This alone was a 16.5% increase year-over-year on 2021 Q1 revenue. This is all made possible by the membership program that Costco runs (and the hot dogs, I mean who doesn't love a good Costco hot dog?!). But all joking aside, it is brilliant what they have been able to accomplish. They currently have 62.5 million households, with 113.1 million (and growing) cardholders. For Q1, this totaled $946 million which is about a 10% increase year-over-year. The renewal rate is also staggering at 91.6% for the US and Canada and 89.0% worldwide. You're looking at ~$4 billion in just membership fees annually. It is also expected that Costco gives its members a fee increase over the next year or two. Typically, this happens every 5-6 years, and we are coming up on exactly 5 years since the last increase.

One of the pieces of their business that I think offers the most potential is the e-commerce side of things. The company saw big numbers here in 2020, which was likely pandemic driven. In 2021, the company saw gas/travel pick up the slack and e-commerce took a bit of a hit, which was expected. But if this stock is going to be worth $1,000 down the road, I think the future big growth with regards to sectors within the machine that is Costco, will come from membership, and e-commerce. All in all, we still saw e-commerce sales up 13.3% year-over-year for Q1 which is a good start to the year. The company is also rolling out e-commerce kiosks in the warehouses with video signage and easy touch-screen ordering as well. They are also rolling out e-commerce lockers. Currently, in the US, there are 112 locations with kiosks, and the plan is to more than double that number over the next 12 months.

As for the supply chain, a similar theme has erupted that we have heard from multiple companies across multiple sectors:

...overall, the factors pressuring supply chains and inflation include port delays, container challenges, COVID disruptions, shortages of various components, raw materials, ingredients, and even packaging supplies, labor cost pressures and truck driver challenges.

- CEO, Richard Galanti

All in all, the company is doing a fairly good job of maintaining inventory. There are cases where some items' typical seasonality is changing due to delays, but generally, things are going smoothly. ~79% of their import containers are late by ~51 days (month and a half). However, because of the pressures on supply, they do not have to hold inventory very long. Once it comes in, it's selling, which is good news. This is impacting everyone, not just Costco, and it will eventually improve again. If this was an isolated Costco issue, it would be worth spending more time on, but it's a global bottleneck at this point that only time can solve.

At the end of the day, there is a lot to look forward to here as Costco continues to scale even larger and grow memberships and revenues.

How's The Dividend?

Well, it is small. It doesn't seem small when you consider it's almost $3 per share... but the share price is at $566, which works out to a ~0.60% yield, which isn't great. Now, something is better than nothing, but I do think shareholders would like a bit bigger piece of the pie. A large part of the dividend being what it is right now is how much the share price has run in the last year. It essentially cut the yield in half, and I do think the company will do right by that.

What I mean by that is I do expect to see another special dividend in 2022 at some point. I have no idea when, but if I was a betting man, I would expect it to be in the second half of 2022. Let's look at free cash flow and CapEx, which are pictured below. We can see that it is fully expected that we see free cash flow explode over the next few years. Essentially doubling over the next 5 years. At the same time, CapEx is going to increase, but not near as much. What this means for shareholders is that they could see some potentially larger dividend increases over the next few years, but it really is hard to say. As mentioned, I do fully expect them to keep the yield somewhere between 1-1.5% as it has been historically.

What Does The Price Say?

This one is tricky. Because based on what you've just read above, you would think that there is lots of room. How could you not buy a company with a solid balance sheet that is going to continue to grow revenue every single year? It comes at a steep price. I'll start with fair value, which is based on forward levered cash flows, which as I've mentioned are growing, so, therefore, the share price should as well right? Well yes. I will say I have no doubt that Costco will be a $1,000 stock over the next few years, but I do have concerns in the very short term from a valuation/technical point of view.

(Source: Simplywall.st)

Starting with the numbers, you're looking at a company with a PE of 48.7x, more than double the industry average. Follow that up with a PEG ratio of 5.5x and a PB ratio of 13.6x compared to the industry average of 2.2x and it's easy to see why the seed of doubt comes in. It's not quite a "tech level" valuation, but it's close. If you look at one of their biggest competitors, Walmart (WMT), you'll notice a PE of 50x, PEG ratio of 4.1x, and PB ratio of 4.9x. The run over the last year in Costco's share price is why there's such a difference in the PB ratio, but if all else is essentially equal, I do think Costco is the clear winner in the long run.

As for some of the technicals, I will start with a chart showing the share price, and the RSI. RSI is an oversold/overbought indicator. Based on price action over the last two+ years, we can see that an RSI of 18 is a buy signal, and 85 is a sell signal. Currently, the stock is trading around 55, which is relatively neutral. This is a good thing, meaning that there is still room to run in the short term. The stock is not currently overbought by any means.

(Source: TC2000.com)

So here is where I get a little iffy on if it's time to buy or not... Looking below, we can see a daily chart first, and then a weekly chart second. The big red flag for me is how much distance there is between the current price and the 200-day moving average (orange line). While it may only be 20%, it is $100 per share that needs to come off for a touch at this point. It's not uncommon for there to be large gaps between touches, but what I can assure you is that the 200-day moving average will one day touch the stock again.

(Source: TC2000.com)

What this means is that either the stock needs to trade sideways for a while and allow the moving average to play catchup, or the stock needs to go meet the moving average. I am leaning towards the latter happening at this point and part of that is based on the weekly chart below. It's gone parabolic, and what goes up that fast, usually falls just as hard.

(Source: TC2000.com)

I would like to see the stock come back to the $469 range (nice) and meet the moving average around that level. That is the most obvious level of support on a drop from current levels. As for the upside, we need to see the current ascending pattern that is forming to break to signal another leg higher. Look for $572. This pattern will break one way or another, and that should help you pick a side to trade if you are on the sidelines like I am right now.

(Source: TC2000.com)

Wrap-Up

I am going to stress patience on Costco right now. There is a lot to like about the fundamental side of the business but at the current valuation, it's hard to press the buy button, even if I think it will be a $1,000 stock one day. I would prefer to protect capital and wait for a better buying opportunity. The dividend is not attractive enough for me to sit and wait either; at less than 1%, my money is better off elsewhere. The real growth here down the road will come from the e-commerce side in my opinion. The memberships will always be there, and they will always have the large warehouses, but e-commerce is the next level for Costco and that's what I'm betting on to be a real revenue contributor from 2025 and beyond. Happy New Year! All the best in 2022.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.