2023-07-09 05:50:02 ET
Summary
- Costco is sitting near a record overvaluation, with slowing company growth and an economic recession on deck.
- Most every other major retailing name makes better sense to own, based on lower valuations and similar growth prospects.
- A price decline in the -40% to -50% range cannot be ruled out over the next 12-18 months.
I have written several bearish articles on Costco Wholesale Corp. ( COST ) focused on its excessively expensive valuation over the last couple of years. My latest effort from February 2022 here forecasted weak returns for investors. Over the last 16 months, investors have eked out a total return of +4%, slightly better than a flat S&P 500 index performance, and about the same as received from holding cash at short-term saving rates.
My current suggestion for readers is to continue avoiding the stock, with an extreme overvaluation setup that does not match slowing company growth. For more aggressive investors, selling the company in favor of cheaper retail alternatives, or thousands of other names that have a valuation matching operating results may be rewarded with higher investment returns.
I continue to rate shares as an Avoid and Sell . If you believe in unbiased reasoning exercises, buying COST shares today has very little concrete logic backing up your decision.
Highest Valuation in Costco History
Retailing is a tough business. New competitors, changing supply chains and consumer tastes, low margins and returns, and company specific labor and debt issues have been hard to navigate successfully for more than several decades. Sears was the most successful mass merchandiser in U.S. history, but went out of business from excessive debt and a slow to the internet transition. Walmart ( WMT ) took the mantle as largest store owner in the country during the 1990s. Yet, Target ( TGT ) is catching up with higher growth rates, and Amazon ( AMZN ) will likely surpass Walmart for retail sales in another 5-10 years with its internet-only business model.
Costco competes with each on price and customer convenience, with no guarantees sustainable growth in its business will continue unabated. However, COST's stock price valuation vs. underlying results has become incredibly expensive over the last decade as shareholder fans have come to believe little can go wrong.
Expensive vs. Inflation
The 2022-23 valuation for shares on a trailing basis is historically the highest ever, especially if you are comparing earnings and cash flow returns on investment vs. the prevailing inflation rate. I have explained this problem for the stock market since 2021. When inflation rates are rising faster than corporate profitability, stock prices should decline to generate "acceptable" returns on investment.
For Costco, price has not declined over the past few years. So, investors buying shares are really sticking their necks out, hoping for high growth rates from operations. Below is a graph comparing the trailing earnings yield (after-tax cash flow owners can theoretically put in their pocket) vs. the U.S. CPI inflation rate YoY. Since the 1990s, Costco has almost always traded at a positive spread on this data point, until 2021.
To reach the same earnings yield as today's 4% to 4.5% inflation rate, COST would have to decline in price by -30% to -40%, all other variables remaining unchanged. If inflation does not slide back to 2% or 3% annual increases soon, it's impossible to say Costco is fairly valued or undervalued currently. What if inflation rates turn around and rise again on weakness in the dollar or a spike in crude oil soon?
Expensive vs. Retail Competitors
In addition to this stretched valuation idea vs. inflation, the company is trading at the high end of the major retailer industry spectrum on underlying business results. You can buy just about any other retailer at far lower and more reasonable valuation levels. Below I have graphed COST against brick-and-mortar leaders Walmart ( WMT ), Target ( TGT ), Dollar General ( DG ), Dollar Tree ( DLTR ), Kohl's ( KSS ), Dillard's ( DDS ), Kroger ( KR ), Dick's Sporting Goods ( DKS ), Best Buy ( BBY ), Casey's General Stores ( CASY ), and Ulta Beauty ( ULTA ) on price to forward estimated earnings in 2024. You can see how Costco is trading at a valuation more than DOUBLE the median average of this group, when taking into account projected growth over the next 12-18 months at each business.
Again, when we include debt and cash holdings for each, the enterprise valuation on core EBITDA is extremely rich for Costco. The same picture of an expensive stock appears. If anything, the premium valuation for COST has expanded vs. our peer group over the last 12 months.
To reach a premium valuation vs. the general stock market and industry in which you operate, usually a super-high profit margin and well above average growth rates are present. Not for Costco. For starters, Wall Street analyst projected growth is very near the peer group average going into 2025.
Plus, COST's net profit margin of 2.55% is running on the lower end of industry averages, not expanding much over the decades.
Expensive vs. Company's Past
When we look at historical trading back several decades, today's valuation setup for COST is borderline indefensible because of its large size and fading growth prospects. You would guess, Wall Street's valuation of the business today would be sitting at long-term averages or slightly underneath them because of its slowing-growth size, especially headed into a likely recession. Nope. Costco is essentially trading at its highest valuation ever in 2022-23.
On price to basic fundamental ratios, analyst and investor sentiment appears to be incredibly complacent moving toward blind greed. Price to trailing earnings, sales, cash flow, and book value are a good 30% to 50% premium vs. 10-year averages, and roughly double the underlying business results of 2013. After a multi-decade bullish run higher for price, it's difficult to imagine COST falling sharply and appreciably soon.
Reviewing total enterprise value vs. EBITDA and sales, we get a similar picture of extreme overvaluation today. Far from bargain territory, any hiccup in business sales and profitability could prove catastrophic to the share quote.
Expensive vs. Shareholder Return of Capital
Lastly, Costco's dividend yield of 0.7% is below average for the industry and pales in comparison to 4%+ CPI changes. With no serious stock buyback plan, share counts are not shrinking, and the company is not engaged in directly supporting ownership worth. In terms of an investment keeping up with inflation changes, shares are way overpriced on actual cash returns to shareholders in the real world. When you can get a cash distribution of 1.5% from the typical U.S. equity investment, plus significant share buybacks from many blue chips, what's the point owning Costco?
Final Thoughts
Why are investor and Wall Street created valuations so optimistic about Costco prospects? One common belief, somewhat supported by past circumstances, is COST's share price has survived recessions far better than other retailers. The thinking goes, when money is tight, households tend to make extra stops at their local Costco store. Yet, while this has been born out in the data during 2001-02, 2007-09, and 2020 recession experiences, the stock price still does have problems in the middle of an economic downturn in U.S. GDP.
Seeking Alpha's Factor Grades are listed below. The valuation score is clearly an "F" failing grade, and now analyst revisions are turning in a bearish direction on weaker-than-expected sales. Revenue results have started to disappoint over the last few months, with better than 5% growth rates a year ago sliding to flat to negative numbers currently. With overall company sales failing to keep pace with general inflation, serious trouble could be on the way.
Over the latest 12 months of trading, the total return outlined by Costco of +9.9% is beginning to lag the overall U.S. equity market, with a +16.6% equivalent return achieved by an index investment in the S&P 500.
My view is no room for error exists when buying Costco today. A saturated market for bulk-discount stores, potential management missteps, and a prolonged recession may individually or in combination halt the growth story for the company. If that is our future, the sub-10% annual growth rate now projected by analysts could be overly optimistic. Consequently, price could tumble into 2024, as price is rerated for a sagging growth outlook, with a valuation closer to retail-industry averages as the final destination.
I am modeling upside total return potential, in an expanding economy (if such happens), of less than +10% over the next 12 months, just like the past year. The valuation setup is too rich and has likely discounted years of slow-growth results from here.
The downside in a worst-case scenario is quite large. A -50% decline in price is very likely in a deep recession, as the double whammy of a valuation decline on sliding earnings and cash flow could easily be Costco's future. For example, a long-term average P/E ratio of 25x (closer to an earnings yield of 4% matching prevailing CPI rates) on $10 in EPS during a recession gets you to $250 a share. Don't say it cannot happen. I explained in story after story during late 2021, the Big Tech stocks would see a tumble for similar reasons in 2022. That's exactly what played out.
Without substantial dividend payouts and share buybacks lacking to prop up the share quote, rougher operating results could create a dramatic price implosion. If sales do not pick up into Christmas, unusual pain could be coming for Costco shareowners. That's my investment opinion, reviewing the cold, hard facts. Retailing is a difficult business, with competition on all sides. Ignoring the extreme overvaluation setup, heading into a recession, is a risk investors should not take lightly.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.
For further details see:
Costco: Too Dang Expensive, No Margin For Error