Wednesday, March 20, 2013

Costco Performing Well but Where is the Value?

There have been a lot of mixed messages coming from the mass market US consumer recently. On the one hand employment is up and certain key areas like housing and auto related spending have seen some strength; on the other, retail sales ex-gasoline remain tepid, and a host of issues are ganging up to constrain the US consumer. Where does Costco (NASDAQ: COST) stand in all of this?

A Bifurcated Retail Sector

In the good old days the big box retailers like Wal-Mart (NYSE: WMT), Costco and Target (NYSE: TGT) might be seen as trading down plays and therefore strategic beneficiaries from a weak economic recovery. However, even that argument has fallen foul of the new economic reality as consumers are increasingly buying consumables from the dollar stores. Moreover, items like clothing and home goods are being increasingly bought from off-price retailers. They are the winners out of the recovery and everyone knows it.

Of course the key to investing is not necessarily to find the best companies, it is more about finding the best priced companies. Frankly, for large parts of last year the dollar stores looked like they were overvalued despite the ongoing same store sales. Indeed, all it took was for some slowing in their sales growth (an inevitable consequence of their significant expansion plans in my view) and they all corrected pretty significantly.

However, it isn’t just about trading down. I would argue that the high end consumer has seen an asymmetric improvement in his or her fortunes, and luxury and specialty retailers are doing fine. In common with the dollar stores--and this is all they have in common--the high end names have been doing well, but what of the mid market?

Costco Doing Okay, Relatively

The big box retailers are somewhat stuck in the middle of all of these trends. They are not reliant enough on the high end, and they can’t rely on trading down. But the reality is that Costco is doing pretty well, and this chart helps explain why.

Essentially, its prospects have gotten better over the last year largely as a consequence of moderating inflation and decent same store sales growth. There is also the sense that its wholesale membership club offering has enabled it to grow same store sales even while Wal-Mart continues to refer to a weak consumer. Costco’s business renewals rate is running at 93.9%, and it is this attention to service that has given it the chance to expand sales where others cannot.

Wal-Mart’s larger presence and mix of superstores and Sam’s Wholesale Club means that it is more reliant on mass spending. Throw in the potential for consumption to be constrained via payroll tax changes, the effects of the Sequester and higher gasoline prices and it is not going to be a great environment for the big box retailers.

Target’s story is more of a company that has been successfully remodeling its stores. Indeed, its strength has been in growing comparable same store sales growth within what it describes as its ‘less discretionary frequency businesses.’ In other words, the staples are doing well, but discretionary spending remains weak. I think it is fair to read into this that, with Target, it is a case of execution with core consumables rather than hitting the ball out of the park by sourcing and selling new discretionary spending items.

Where Next for Costco?

It looks like more of the same. Inflation is moderating, and this will continue to help gross margins while improvements in housing will help out some of COST’s lines. For example, I don’t think it is a coincidence that its strongest lines in the quarter were in hardware, patio, lawn & garden and tires. Consumers may well be resuming spending in housing and automobile related sectors (after a significant hiatus) but elsewhere things aren’t as good. In addition, the stock is looking like fair value on a historic basis.

COST Price / Sales Ratio TTM data by YCharts

Putting all these things together it is hard to see the stock appreciating significantly from here despite the strengthening economy.

Nevertheless a fairly valued stock can always ‘do its earnings’ in returns, and with analysts penciling in earnings growth in the teens for the next couple of years the stock looks attractive for those looking for some cyclical exposure.

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