Is Costco Still A Solid Buy?

| About: Costco Wholesale (COST)

Shares of Costco Wholesale Corporation (NASDAQ:COST) have posted a solid return of 29.13% over the past 12 months. The rise has helped lift the stock price close to the 52-week high of $97.76. There remain a lot of investors on Seeking Alpha who are bullish on the stock at the current price level (here, here and here). Although I largely agree with their analysis, I also performed my own research check and have come out with the following points to draw a buy/sell decision:

Positive Factors

1. Even after the solid upward price action and a 1-year diluted EPS growth of 11.9% (on LTM basis as of May 6, 2012) , COST stock valuations remain flat over the past 12 months. The chart below shows that both the forward P/E and EV/EBITDA measures are almost unchanged from a year ago at 22.3x and 9.6x, respectively.

Click to enlarge

2. COST's growth potential is substantially superior to that of its peers. Analysts in average estimate COST's revenue, EBITDA, and EPS to rise by solid 2-year CAGRs of 8.4%, 10.7%, and 15.4% over the current and next fiscal years. Such estimates almost double the averages for Target Corporation (NYSE:TGT), Wal-Mart Stores, Inc. (NYSE:WMT), and Kroger Co. (NYSE:KR) (see comparable analysis table below).

3. COST also has a strong liquidity position (see comparable analysis table above). The company's debt to capitalization ratio of 9.4% is substantially lower than the peer average of 53.8%. As such, it is able to maintain a very healthy interest coverage ratio. Both COST's current and quick ratios are significantly better the peer averages, suggesting a relatively liquid balance sheet. Moreover, COST's net cash position of $4.6B represents approximately 11.1% of the current market capitalization.

4. Management has a strong commitment to maintain a sound dividend policy. Annual dividend per share has grown steadily from $0.43 in FY2005 to $0.89 in FY2011 by a 7-year CAGR of 11% (see below).

4. COST has ample cash resource to sustain or improve the current dividend payout and stock buybacks. The chart below shows that FCF has experienced significant improvement since 2010. Over the past few years, the total cash spent on annual dividend payout and share repurchase only represents about 50% of the annual FCF generated, indicating an ample room for greater capital return to shareholders in the future.

Negative Factors

1. COST's profitability is almost the worst compared to that of TGT, WMT, and KR. Both COST's gross and EBITDA margins are the lowest in the group, and its EBIT and net profit margins are only marginally better than KR's. The company's ROE and ROIC are also the lowest in the group (see comparable analysis table above).

2. COST stock is currently trading at a large premium over its peers (TGT, WMT, and KR). The current stock price of $96.02 implies a large valuation premium of 33% over the 3 most relevant peer average multiples (see below). This valuation gap is somewhat difficult to be justified due to the company's below-average profitability.

3. Accounting for the earnings growth, the stock trades at 1.7x PEG, the highest level in the group. I coincidently found that COST's PEG is comparable to that of Whole Foods Market, Inc.'s (NASDAQ:WFM) (WFM is less comparable to COST, thus it was not included in the above comparable analysis). However, WFM has superior growth and financial performance in almost every aspects (see below), suggesting that COST is likely overvalued to its growth prospects.

Based on the aforementioned factors, I would put a hold rating on COST, given that the stock's current risk/reward profile is not quite attractive. However, I would consider selling out-of-money put options to potentially acquire the shares at a cheaper valuation.

Comparable analysis and valuation tables are created by author, all other charts are sourced from Capital IQ, and all financial data is sourced from Morningstar and Capital IQ.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in COST over the next 72 hours.

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