The basics of Costco
Costco is a very different company than most other retail stores. While supermarkets typically charge a considerable premium over wholesale prices Costco keeps that premium to about 15%, ensuring lower prices for its customers. While big-box stores like Wal-Mart Stores, Inc. (NYSE:WMT) and Target Corporation (NYSE:TGT) pay their workers as little as legally possible the typical Costco worker makes about $45,000 per year as of 2011.
This all leads to lower margins for Costco Wholesale Corporation (NASDAQ:COST) compared to Wal-Mart Stores, Inc. (NYSE:WMT) and Target Corporation (NYSE:TGT), but the business model is superior in many ways. Wal-Mart Stores, Inc. (NYSE:WMT) has been facing criticism regarding its extremely low wages, with some workers recently going on strike demanding higher wages and better working conditions. They say that any publicity is good publicity, but I don’t think that holds in this case.
Costco charges a membership fee, the standard rate being $55 per year, which allows customers to buy products at its stores. Most of the company’s operating profits come from these fees, and with renewal rates around 90% in the United States earnings should be fairly consistent and predictable. Costco Wholesale Corporation (NASDAQ:COST) only accepts cash, debit cards, and American Express cards, meaning that the typical customer is likely more financially stable than the average consumer and thus better equipped to withstand economic weakness.
Another strong quarter
Costco recently reported strong third quarter earnings. Comparable store sales rose 6% in the U.S. year-over-year and 5% overall, and revenue jumped by 7.8%. Diluted EPS rose 18% to $1.04 on net income of $459 million.
Like I said above, membership fees account for most of the operating profit. Of the $722 million in operating profit reported for the quarter $531 million of this was from membership fees, about 74% of the total. These fees grew by 11.8% year-over-year, outpacing revenue growth considerably. Since this is where most of the profits come from, this is great news for the company.
The balance sheet remains strong even with the addition of some debt. Total cash and investments total $6.5 billion compared to debt of $4.9 billion. At the end of last year Costco Wholesale Corporation (NASDAQ:COST) paid a special dividend of $7 per share which was financed by a $3.5 billion debt offering. Although the interest rates were low on the debt this seems like a strange action to take. I’m generally not in favor of taking out debt to finance dividends or buybacks for that matter – I wrote about a particularly bad case of this a while back. Why not instead pay a higher regular dividend, making the stock more attractive to dividend investors?
Trading at a premium
In fiscal 2012 Costco Wholesale Corporation (NASDAQ:COST) recorded EPS of $3.89 per share, and the average analyst estimates for fiscal 2013 and 2014 are $4.55 and $5.05 respectively. The stock trades at about $112, putting the current P/E ratio at 28.8, the 2013 P/E ratio at 24.6, and the 2014 P/E ratio at 22.2.
It’s hard to buy Costco at these prices. I don’t doubt that earnings growth will be strong, but compared to other retailers there’s quite a premium here. Wal-mart trades at just 15 times last years earnings, while Target trades at a slightly higher 15.4 ratio.
Of course, there’s good reason why Costco should trade at a higher ratio than its competitors. Wal-mart recently missed analyst estimates for its most recent quarter, showing revenue growth of 1% and net income growth of 1.1% year-over-year. Target Corporation (NYSE:TGT) did even worse, with revenue dropping by 1% and a small drop in adjusted EPS. Costco, on the other hand, grew revenue, members, and profits considerably.
Is Costco’s price reasonable? I like PEG ratios to be around 1 for fast-growing companies, and Costco is not quite there. Analysts are assuming 17% EPS growth in 2013 and 11% EPS growth in 2014, and using the highest of these numbers and the 2013 P/E ratio the PEG ratio is somewhere around 1.45. It’s not outrageous, but it’s higher then I’d like.
The bottom line
I won’t be buying Costco Wholesale Corporation (NASDAQ:COST) at the current price. It’s a great company which will likely see strong growth for the foreseeable future, but I think that the stock has gotten a bit ahead of itself. How big can Costco get? How many people are willing to pay for a membership? Costco currently has around 67 million card holders. It seems like there should be a hard limit somewhere, and the question is at what point will Costco saturate the domestic market? This may be a long ways off, but it’s something to think about.
The article This Retailer Is a Bit Too Expensive originally appeared on Fool.com and is written by Timothy Green.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale (NASDAQ:COST). The Motley Fool owns shares of Costco Wholesale. Timothy is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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