One of Charlie Munger (Trades, Portfolio)’s favorite stocks, Costco (COST, Financial) will continue to grow its business and brand, but the stock is more than likely dead money at this valuation.
- $80 billion market cap.
- 31x earnings.
- 1.04% dividend yield.
Key stats
- $118 billion sales (2016).
- $2.35 billion net income (2016).
- 732 stores (510 in the U.S.).
- 214,000 employees.
- 85 million members (88% renewal rate).
- 143,000 square feet per store.
Revenue
- $550,000 per employee.
- $1,388 per member.
Income
- $11,000 per employee.
- $28 per member.
It’s no secret that Costco’s efficient distribution and merchandise strategy allows it to generate over $1,000 in sales per square foot versus competitors at $600 or less. Nothing is worth overpaying because even the right company bought at the right price is a mistake. The 2% net profit margins are extremely low, even by retail standards, yet the key is to keep driving more members. That will always equate to higher sales, profit and market value. Better yet is the company's ability to raise prices while remaining a low cost leader. The company has done an incredible job doubling sales and profit in the last decade while improving gross margins.
While retailers have been hit hard, Costco has survived and thrived, producing 111% and 217% in per share gains (dividends not included) over the last five and 10 years.
Costco has increased its member count by 26% in just five short years. Given that rate over the next five and 10, membership could grow to more than 125 million. That would equate to $174 billion in sales and tack on another $1 billion in net income annually. That will likely equate to $8 to $9 per share.
All this growth does not matter at this price. Costco is headed for a decade of flat market prices. Its multiple will likely drop to 20x or lower as it grows. The business itself will get a lot stronger, but the price will probably not rise as fast as the overall market.
Thinking that a 9% to 11% growth rate will equal a similar outcome for the stock price is faulty logic and doesn't take into account overall market pricing and what people are willing to pay for larger companies. The one potential saving grace is Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Warren Buffett owns a sizable amount of stock, and it could possibly be a takeover target. I cannot imagine Buffett would be happy paying 22x pretax earnings no matter how strong or lasting the business model may be at Costco.
I can’t see Costco as a takeover target. The stock makes up less than 0.50% of the Berkshire stock portfolio, Buffett isn’t keen on retail as a margin of safety, and if he continues to buy at this price point Buffett could be headed for a disappointment similar to the likes of Walmart (WMT, Financial).
If Costco can get its earnings up to $15 a share, it could be worth owning now, and there is potential in the Citi (C, Financial) Visa (V, Financial) Costco credit card that helped boost earnings by 16 cents last quarter alone. Since the average customer earns an upper middle class income or better, Costco could successfully convert more members into co-branded credit card users. The other possible way Costco can keep earnings pushing higher is through its online shop, which doesn’t require a membership and carries higher prices to nonmembers.
That all seems like a much steeper uphill climb to achieve the growth rates seen over the last decade. With that in mind, Costco could be a flight to safety for investors liquidating other stocks; this could keep the stock price level through the next market downturn.
All in all, Costco is a great company. I’m a member. However, for now, it’s definitely not a buy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
