Saturday, January 5, 2013

Is Costco Worth Buying?

In a recent article, I suggested that Costco (NASDAQ: COST) was going to see decent results but the stock was hardly looking cheap. Judging by the market’s initial muted reaction to the recent Q1 results, it seems that it agrees with me. The numbers were pretty good, and the read across for the US economy and retail in general is good. It is part of a slowly evolving, but positive, trend and investors should not downplay its significance.

Costco’s Q1 Results

 A brief summary of the results

  • Q1 Revenues of $23.72 billion vs. estimates of $23.67 billion
  • Q1 Diluted EPS of 95c vs. estimates of 93c

It’s an earnings ‘beat’ but it seems this was well anticipated by the market. No matter, serious investors focus on reading into the long term trends rather than knee jerk trading over results. With this in mind, I think there are some interesting things here which this chart helps to demonstrate.

The key point here is that this is the first quarter in a while where gross margins (yearly comparison) have improved at the same time comparable sales growth has accelerated. Whereas previously it was possible to argue that there was a trade-off between margins and sales growth, this is no longer the case. I think there is a good case for the argument that the big box retailers are going to move into a ‘sweet spot’ where a marginally stronger consumer increases their top lines while slower growth in emerging markets reduces input costs as commodity prices fall and demand from China etc slows.

Broad Based Strength

Costco saw broad based sales strength across its categories with particular good results within ‘hard lines’ sales. Interestingly management declared that gross margins were flat in hard line sales, with any significant inflationary effects mainly restricted to fresh food categories. The latter hasn’t had much effect on sales, but the former is somewhat surprising. My suspicion is that margins in hard goods and electronics will start to improve in future quarters.

However, the strength in hard lines was a bit unexpected given that Target (NYSE: TGT) had cited hard line comparable sales as being slightly down, with particular weakness in electronics. It is easy to put these things together with flat gross margins (in hard lines) and conclude that Costco must have been extra competitive on pricing. If so, it wasn’t apparent from the conference call.

This is all somewhat distinct from what Wal-Mart (NYSE: WMT) said in its recent results, in which it announced that comparable same store sales growth came in lower than it had expected. Wal-Mart cited movements from inflation (causing more trading down), and deflation in some categories (that came late in the quarter) reduced sales growth.  Moreover, Wal-Mart had cited macro weakness and a level of uncertainty amongst its customers that Costco did not.

Turning back to Costco specifically, membership fees increased by over 14% but were expected to be somewhat higher in some quarters. Frankly I don’t think this is a particular issue because Costco increased fees by 10% last year, and although this implies new member growth has slowed, the key issue is to keep renewal rates up. Longer term customers tend to spend more in retail so the first priority should be to keep existing customers.

Where Next for Costco and the Big Box Retailers?

As ever, investing is about trying to find the right price to pay for the risk/reward profile of a stock. For the reasons articulated above I think the big box retailers will see an improvement in performance; however, they also face the same macro risks as the rest of the market. Therefore, any investment in the sector is de facto a position on the direction of the economy, especially as Wal-Mart's, Target's and Costco’s customers and their spending decisions will be governed by how they feel about their incomes and job security.

Costco is undoubtedly the strongest performing of the three, but its PE of 25 and EV/EBITDA multiple of nearly 11x means it is hardly cheap, despite the double digit growth forecasts. Putting these things together means Costco is going to have to stay on my monitor list for now.

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