By Andrew Bary
Costco Wholesale stock has become the Palantir Technologies of retailing, with a rich valuation and a cult investor following to match. Investors should start heading for the exit.
There's nothing wrong with Costco's business. The leading warehouse club chain continues to deliver value for its 77 million members worldwide, while putting up consistently strong financial results and steadily expanding its footprint both in the U.S. and overseas.
Members put up with crowds and long checkout lines for some of the best deals in retailing, including $4.99 rotisserie chickens and a $1.50 hot dog and soda combination whose price hasn't changed in 40 years. That's helped Costco generate consistent sales and earnings growth, and massive returns: The stock is up nearly 600-fold since its 1985 initial public offering at a split-adjusted price of $1.67, and the company pays a small regular dividend of 0.5% supplemented with periodic special dividends, most recently a $15 payment at the end of 2023.
It's the kind of stock investors are willing to pay dearly for -- perhaps too dearly. Costco's shares, which have gained 45% this year to $962, now trade for 53 times projected earnings of $18.12 a share in its fiscal year ending in August. No other company among the top 20 in the S&P 500 index -- Costco ranks 18th with a $430 billion market value -- comes close based on 2025 earnings forecasts except for Tesla, which has a price/earnings ratio of over 100.
Costco looks expensive next to growth-stock favorites Apple, Microsoft, Nvidia, and Mastercard, which trade for around 30 times forward earnings, while the P/E of Walmart and Amazon.com are around 35. But Costco doesn't have the growth to back it up. Its projected growth in earnings per share over the next few years -- about 10% annually -- is less than some of these stocks, and its P/E-to-growth rate is steep at about five, against two to three for most growth stocks.
That's also pricey relative to its own history. Brian Yarbrough, a retailing analyst at Edward Jones, points out that Costco traded at 40 times forward earnings at the start of 2024 and 30 times before the Covid-19 pandemic. That means the stock could stall out as earnings catch up with its price -- or drop 15% to 20% if there is a market selloff or an unexpected profit or revenue miss.
"Costco is one of the highest-quality retailers in the industry, but it's extremely difficult to justify the valuation of the stock," he says. "It's going to be hard for the stock to outperform over the next three to four years."
Analysts at Trivariate Research agree. Their research shows that companies that breach a 50 P/E for the first time often fall back below 40 times a year later and tend to underperform the market over the ensuing three years. Barron's wrote favorably on Costco two years ago when the stock traded at less than half the current level. If Costco were to trade at 40 times projected fiscal 2025 earnings, the stock would fall over 20% to $725.
"While we can certainly appreciate many merits of Costco's unique business model, it strikes us as a lofty increase in valuation for a business whose top-line growth isn't materially different than it has been historically," the Trivariate analysts wrote.
There's nothing wrong with that. Costco's revenue is seen rising 7% in the current fiscal year after gaining a similar amount in the year ended in August 2024. Earnings per share were up 10% in the recently reported quarter ending in November, adjusting for one-time tax factors, and are expected to rise 9% for the current fiscal year, according to FactSet. Same-store sales, a key financial measure, have risen between 5% and 6% in the past two years. Costco is also increasing the number of stores it has open -- now nearly 900, with 616 in the U.S. -- by 25 to 30 a year.
What's the bull case? J.P. Morgan analyst Christopher Horvers wrote recently that "no other retailer has succeeded in every country it entered," and he views the club model as one of the best in retailing. Costco has nearly a third of its store overseas, and huge lines often form when it opens new ones outside the U.S.
Morgan Stanley analyst Simeon Gutman sees the company "getting bigger, faster" with profit growth accelerating. He has an Overweight rating and a $1,150 price target.
Costco's fans focus on its distinctive business model, particularly the membership fee income that accounts for about half of operating profits. The company is benefiting from a $5 increase in its annual membership fee to $65 in September, its first in seven years. Another plus is that nearly half of Costco members choose an Executive Membership at $130 a year.
Those membership fees, which give Costco a Netflix-like quality, especially given 90%-plus renewal rates, make the company deserving of an outsize P/E multiple, the bulls say. Yarbrough, however, says valuing the membership fees separately from the retailing profits is a stretch since the company pursues a holistic strategy that makes them inseparable.
Costco's model is driven by delivering value to its members. It's one reason the company's net margins are low at 3%. Costco could drive those margins higher by being more aggressive with membership-fee increases, which would also help reduce crowds. Costco could also raise prices slightly and still maintain rock-bottom levels. But it prides itself on keeping prices low and generally not marking up any product more than 15%, which makes it unlikely to be undersold. That's just how the company operates.
Costco's attitude on pricing was underscored by longtime CEO James Sinegal, who told his successor Craig Jelinek nearly a decade ago: 'If you raise the f -- ing hot dog, I will kill you."
The membership model also yields other benefits, including high purchase volume and low shoplifting rates at just 0.1% of sales -- probably the best among large retailers. Longtime Costco board member Charlie Munger, who died a year ago at 99, said the membership model weeded out the wrong type of shoppers, including those who would steal.
And there is no better management team in retail -- and few more skilled anywhere. The executive ranks are filled with corporate lifers who have worked their way up through the ranks, including CEO Ron Vachris, 59, who began as a forklift operator at 17.
But while Costco has expanded its offerings, it's similar in many respects to the company it was two decades ago, offering food and staples at low prices to members. Food is about half of sales and online sales are less than 10% of total revenue. "We'd rather you come in to shop, you'll buy more," Richard Galanti, Costco's chief financial officer for nearly 40 years before stepping down in March, told Barron's earlier this year.
The company has a huge private-label business, including the Kirkland brand, that generates about a third of sales. It also has had success with wine, clothing, travel, eyewear, gold bars, and a rapidly growing pharmacy business. It also sells discounted gift cards, including a price of $38.99 for two $25 cards for See's Candies, the Berkshire Hathaway company and Warren Buffett favorite, which rarely discounts.
But there may be a limit to how much Costco can grow its U.S. store count. The company continues to find success with new stores in areas where they already exist, like Pleasanton in the East Bay near San Francisco, and in new markets, such as Scarborough, a small city near Portland, Maine.
"We see some runway for a few years ahead of us yet where we have a combination of new markets," Vachris said on the recent earnings conference call.
But Costco's size could make it harder to match its historical growth rates, says Bill Smead of the Smead Value fund. With over $250 billion in sales, "it's almost mathematically impossible for it to grow as fast in the future as it has in the past," he says. Though Costco is a "wonderful business," Smead says, it is representative of "large-cap, wide-moat" companies with sky-high valuations that recall the Nifty Fifty of the early 1970s. They went on to underperform over the next decade.
There is a lot to like about Costco -- just not the stock.
Write to Andrew Bary at andrew.bary@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
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December 20, 2024 01:00 ET (06:00 GMT)
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