The debate over Costco Wholesale (NASDAQ:COST) isn’t about the quality of the business. The argument is over the price of COST stock.
After all, this is one of the world’s great businesses. It pioneered an entire retail business model, yet no other competitor has been able to execute that model nearly as well. As a result, Costco stock has generated exceptional long-term returns for investors.
Yet of late those same investors seem rather skeptical toward that same business. COST stock has declined over 9% so far in 2021. It’s down 12% from late November highs.
Those declines don’t sound all that notable in a market that’s seen some exceptional volatility over the past few weeks. But for a name like Costco, a 12% move is rather significant. It’s not just significant – it’s a buying opportunity.
Why COST Stock Has Fallen
To be honest, it’s difficult to precisely pin down why COST has slid over the past three months. But there are two possible explanations.
Investors may be worried that Costco’s growth is about to slow tremendously. That’s not necessarily because there’s anything wrong with the business, but rather because of the operating environment. During the height of the novel coronavirus pandemic, we all saw pictures of the lines at Costco locations as consumers stocked up.
Those sales likely pulled forward some revenue. More importantly for calendar 2021 results, they might create difficult year-prior comparisons. The combination could mean Costco shows significantly slower headline growth.
The other explanation is that investors are worried about competition. That’s not necessarily true in terms of warehouse clubs. Costco remains dominant. In fact, just three years ago, its biggest rival suddenly closed a large number of stores.
Rather, we saw e-commerce growth accelerate during the pandemic. And there’s perhaps a fear that some of that growth is going to come out of Costco sales.
Look at the Numbers
Those worries tend to fall flat when looking at Costco results over the past year. This remains a company firing on all cylinders.
Costco did take a modest hit during the pandemic, in part due to store closures. For instance, in April same-store sales excluding gasoline and foreign currency effects were flat. That’s a huge disappointment by Costco’s high standards.
But as stores reopened, Costco immediately got back on track. In June, for instance, same-store sales rose 14% on the same basis. For the third quarter (ending May 10), Costco drove 4.8% same-store growth. In Q4, the figure accelerated to better than 11%. Growth in December and January averaged better than 8%.
There’s not much in the numbers to suggest anything has changed. The pandemic caused a bit of volatility, yes, but Costco still grew adjusted same-store sales 9% in FY2020 and 6% the year before.
In FY2021 and FY2022, growth might “seem” a tough lighter due to the comparisons, but it’s not as if sales and earnings are going to fall a cliff. Costco’s results remain not just solid, but impressive.
As far as e-commerce goes, the pandemic has given Costco a chance to build out its own business. E-commerce revenue grew 50% in FY2020 and climbed another 18% through the first 22 weeks of FY2021.
That aside, it’s hard to see how competition really chips away at Costco’s business. For bulkier items that are better bought in-store, no one can match Costco’s prices. For online sales, Costco’s scale allows it to compete on price, while its service remains unmatched.
Simply put, there’s basically no evidence that Costco’s business is under threat.
Is Costco Stock Too Expensive?
There’s a third potential cause of the selling: the rally in the first half of last year, combined with a seemingly pricy headline price-to-earnings multiple.
COST stock avoided much (though not all) of the selling pressure that roiled the market in February and March of last year. It then rallied nicely with the rest of the market to an all-time high.
And even with the recent sell-off, the stock doesn’t look cheap. It trades at 31x consensus earnings per share estimate for next year (fiscal 2022).
But let’s consider both of those factors. COST stock should have rallied with the market – because Costco is benefiting from the pandemic. That benefit goes beyond a spike in sales in the spring.
Remember that Costco’s profit comes largely from membership fees. In FY2020, for instance, membership fees were about 65% of operating profit. which was actually down from 71% the year before. Essentially, Costco turns about 1% of its sales into operating profit, then tacks on membership revenue.
That membership revenue is benefiting from customers acquired last year. Most are going to stick around for the long haul. The boost here isn’t like that of, say, a grocery store, whose sales will return to pre-pandemic levels as normalcy returns.
Remember also that membership revenue is part of why COST stock is expensive – and has been for years. Yes, this is a fantastically well-run company. But the model’s reliance on membership fees creates faster growth as well.
An extra dollar in membership fees drops to the operating profit line at huge margins. And so Costco can grow earnings faster than most any other brick-and-mortar retailer.
Investors in the past have been happy to pay up for that faster growth. In fact, they’ve often paid a higher multiple than they are now.
All told, Costco is a wonderful company, and COST stock is trading at a discount. The former isn’t going to change. I expect the latter will – soon.
On the date of publication, neither Matt McCall nor the InvestorPlace Research Staff member primarily responsible for this article held (either directly or indirectly) any positions in the securities mentioned in the article.
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