Costco Wholesale Corporation (COST, Financial), a leading global bulk retailer that has warehouse club operations in 11 countries, has just reported its third-quarter fiscal 2023 earnings, and it was a mixed bag. However, the company itself is not what has investors worried following the earnings report. The company’s executives have dropped a dire forecast, warning that they have noticed a change in consumer spending that may lead to economic recession.
Customers switch to less expensive products, an omen of a possible recession
Costco's latest earnings report noted that shoppers have made a significant switch to buying cheaper product alternatives, trying to save money in a difficult macroeconomic environment. For example, they are buying more pork and chicken rather than beef.
Costco mentioned that this trend of changing consumer spending habits and turning to cheaper products in the same category was in the past evident during economic recessions. Nothing is certain, and statistics do not always reveal the whole truth, but this warning causes a lot of uncertainty both for the shares of Costco and for the broader economy.
Third-quarter earnings breakdown
Costco's net sales for the quarter increased 1.9%, to $52.60 billion compared to $51.61 billion in the prior-year quarter. The net sales for the first 36 weeks increased 5.5% year-over-year to $160.28 billion.
However, the e-commerce sales for the quarter were lower by 10%, and for the past 36 weeks, they were down 7.8%.
The company also reported revenue that was less than the analysts’ expectations of $54.57 billion.
Furthermore, Costco reported a quarterly profit of just $2.93 per share, which was lower than the expectations of $3.29, according to Refinitiv data.
A strong economic moat with a mixed valuation
Costco is known for offering a wide range of products at competitive prices to its members. While Costco may not have a traditional economic moat like some technology companies or pharmaceutical companies that rely on patents and intellectual property, it does have several key elements that contribute to its competitive advantage and strong market position. These elements include low-cost products, a solid membership model, customer experience and loyalty and brand strength.
Costco follows a low-cost strategy by leveraging its bargaining power with suppliers, maintaining a limited selection of products and focusing on high sales volumes. This allows ir to offer products to members at significantly lower prices compared to traditional retailers. By offering attractive prices, Costco creates a strong value proposition for its customers, which helps to retain existing members and attract new ones. Costco operates on a membership-based business model, where customers pay an annual fee to become members. This fee provides a significant portion of Costco's profits and creates a loyal customer base. The membership model acts as a barrier to entry for potential competitors, as it requires customers to commit to a long-term relationship with the company.
Costco focuses on providing an excellent shopping experience to its members. The company is known for its efficient store layout, friendly customer service and high-quality products. Additionally, Costco offers additional services like gas stations, pharmacies and optical departments, which further enhance the overall customer experience. By consistently delivering a positive shopping experience, Costco builds customer loyalty, making it less likely for members to switch to competitors. Costco has established strong relationships with suppliers and follows a streamlined supply chain management approach. By purchasing products directly from manufacturers and eliminating intermediaries, Costco reduces costs and ensures a reliable supply of merchandise.
Over the years, Costco has built a strong brand that is associated with value, quality and customer satisfaction. The Costco brand has become synonymous with bulk purchasing, and many customers trust the company.
The economic moat Costco has built should be taken into consideration with the valuation of its shares. Currently, the forward enterprise-value-to-dales ratio of 0.91 and the forward price-sales ratio of 0.94 for Costco indicates the stock seems to be rather cheap (forward estimates are based on my compilation of average analysts' estimates). When you compare other key financial metrics of the stock to the Consumer Staples sector median values, you get a positive difference, meaning the stock is more expensive on a relative basis. Out of the 10 key valuation metrics I monitor, Costco stock is more expensive on a relative basis in eight of them. For example, the stock has a PEG ratio of 3.89, much higher than the sector median value of 0.64.
Should investors place a lot of weight on the Costco executives’ warnings? I argue that they should, as the shares do not look attractive now from a valuation standpoint, so economic indicators flashing red is a worrying sign.
