Costco: Not A Buy Yet But Follow It Closely

Summary

• Costco stock has outperformed the market in the previous 52 week period and YTD with great returns.
• The company has solid fundamentals, a great business model, effective management, and a legendary hot dog!
• The share price hike has resulted in high valuation multiples that exceed the industry average and Walmart, etc.
• This is a great stock to buy, but I currently rate it as a 'hold' because of its high valuation multiples and expect it to get cheaper and offer an entry point to potential investors in the coming months.

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Investment Thesis

Costco Wholesale Corporation (NASDAQ:COST) is currently trading around its all-time high of over $580 per share. 2022 has been a disappointing year for the stock market overall, but Costco has been an outlier and outperformed the S&P 500 and its peers in the previous 52 weeks and YTD with over 63% and 2.5% returns, respectively.

Data by YCharts

This steep gain has resulted in the stock trading at massive valuations, more expensive than its competitors, Walmart (WMT), BJ's Wholesale (BJ), and The Kroger Company (KR). The company's 3-year, 5-year, and 10-year return also far outpace its peer group with 150%, 284%, and 730%, respectively, but the current price premium is at one of the highest values in over 2 decades.

Data by YCharts

Potential investors may still benefit from buying the stock as the company is bolstered by strong fundamentals and a great business model. Still, the risks of buying such an expensive stock make the purchase akin to a gamble where you may win, but the chances of loss outweigh the chances of a reward.

The company has 17 consecutive years of dividend growth under its belt, but the yield is almost at an all-time low of 0.55%.

Data by YCharts

COST is a great stock that is likely to see great growth over the long term, but with current valuations, the returns for potential investors will be strained at best.

Potential investors who hold their positions and wait for the price to go down or the company's metrics to catch up with the price before investing in the company are likely to maximize their gains.

Sustainable Membership-based Business Model

Costco is one of the best-run companies in the United States with solid fundamentals, great prices for customers, exceptional employee care, substantial shareholder returns, and a mythical hot dog

The company operates nearly 820 stores, mostly in North America, and has almost 115 million members who can shop at its stores. Despite having a significantly higher merchandise-sale input in the top line, the company makes most of its profits from the membership dues with a smaller portion from its merchandise. This allows the company to undersell the competition by offering products in bulk at lower prices and ensures customer loyalty. Apart from repeat customers bringing in revenue, the membership program also aids the bottom line as the company sports a zero advertising budget.

The company's annual turnover for the first half of FY2022 included over $100 billion in merchandise sales and almost 2 billion in membership fees. With merchandise costs exceeding $89 billion, the company's gross margin is about half of Walmart's, over 24%, but the net margin of 2.62% leads WMT's 2.39% at a much more consistent pace.

Data by YCharts

Average Costco members' household income of nearly $93,000 leads to an extremely stable member base, with retention rates over 91.3%. Its $60 Gold Star standard membership or $120 executive membership ensures that the company retains most of its annual profits, as is apparent from the current period. Paid executive members totaled 26.5 million, including 836,000 new members in the MRQ, accounting for over 70% of total sales. Total revenues increased over 16% YoY, with the revenue from Membership fees increasing 9.7% YoY.

These consistently improving revenues and effective cost controls have resulted in a stable rise in the net margin by about 1% during the previous decade.

This consistency and sustainability add a layer of reliability to the company's ability to turn a profit year after year as it keeps increasing its core member base, even in times of inflationary pressures.

Reliable & Effective Management

We all probably know the story about the death threat over the hot dog; amusing as it may be, it is essentially the company's cost-saving-oriented philosophy in a nutshell. The company is deeply oriented toward optimal use of resources, as is apparent from its industry-leading resource utilization metrics. Not only does Costco outperform its biggest competitor, the consistency with which the company is improving screams reliability.

Data by YCharts

Another great way the management generates greater returns is by having a non-existent advertising budget. If Costco spent 0.5% of its revenue on marketing, its operating margin would be squeezed by almost 15% to under $3 billion. Unless the company can devise an advertisement campaign that can result in at least over 4.2 million new net executive members ($511 million cost/executive membership fee) per 0.5% of revenue spent, the company is well off with its current policy of a zero advertisement budget.

Further, as aforementioned, Costco's employee management tactics are a benchmark. While the company raised its minimum wage twice in 2021 to $17 an hour, its CEO has claimed earlier that the average wage for Costco employees is about $24 an hour. Costco employees also have a great benefits package, covering many medical treatments, including dental and optical, a 401(K) plan, an employee stock purchase program, etc.

These better-than-competitor metrics translate to the company attracting better talent and enjoying a much higher retention rate, resulting in an incredibly low employee turnover rate and an impressively high revenue per employee.

Data by YCharts

Valuation

The bull cases for the stock are extremely strong, and one may argue that the stock should be picked up in a heartbeat with such reliable, consistent, and effective management. However, COST stock sports a PE multiple of over 46x, outpacing WMT's 30.6x and the Retail Department and Discount stores' average of 31.26x.

The PS, PB, and P/CF ratios are also in line with 1.21, 13.15, and 25.70, compared to WMT's 0.79, 4.94, and 16.95, and the industry average of 0.86, 5.19, and 18.65, respectively. Costco has a dividend yield of 0.55%, but WMT is trading at around $150 with much better valuation multiples and a dividend yield of 1.48%.

Particulars	Costco	Walmart	Industry Average
PE	46.40	30.58	31.26
PS	1.21	0.73	0.86
PB	13.15	4.94	5.19
PCF	25.70	16.95	18.65

Click to enlarge

This means that the stock is traded at 52% higher PE, 66% higher PS, 2.7 times higher PB, and almost 52% higher PCF than Walmart. These numbers indicate that the premium being demanded by the market is too high despite the company's exemplary performance, and the market is bound to correct itself, offering potential investors a gateway in the coming months.

Conclusion

With high commodity prices and dominant inflation, the prospects for a cost-oriented company like Costco are great. I haven't even talked about the gas prices deal offered to the members, which is an amazing way for the company to drive traffic as gas prices climb up, especially due to the Russia-Ukraine conflict. Here's a great Seeking Alpha article for that.

COST stock is undoubtedly a great asset that has amassed great returns for its investors, and with a median target price of around $578, there is still minor upside potential. However, after the recent rally, the high valuation multiples are likely to sway investor sentiment and drive the price down to acceptable levels, offering a great entry point to potential investors.

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.

Business relationship disclosure: This article was researched and written by Waleed Tariq, reviewed, and submitted by myself.