Costco now sells for $47.50 or 19x the already recession-reduced $2.50 estimate for FY 2009 [ends August 31].
That compares with a 10-year median P/E of 24x and a most recent five year average multiple of 21.7x. If you believe we’re near the bottom of the economic cycle this looks like a good time to play COST for a rebound over the next couple of years.
Costco has proven to be a great operator during both good and bad times. If this FY’s earnings do come in lower than last year’s, it will be only the third down year-over-year comparison in the past seventeen. The others came in 1994 and 2001 during similarly depressed conditions.
Many shoppers have been ‘trading down’ to save money keeping sales close to all-time highs. Value Line gives Costco its highest safety rating and an ‘A’ for financial strength. They also note that COST was in the 95th, 85th and 100th percentiles in their ‘stock price stability’, ‘price growth persistence’ and ‘earnings predictability’ categories respectively [with 100th being best].
As the economy starts to improve sales and earnings should pick up nicely.
Even without a turnaround the shares don’t look overpriced.
Here’s a nice less than 21 month play that can make good total return even if the shares do very little between now and January 2011:
>>>>>>>>>>>>>>>>>>>>>>>>>>>> Cash Outlay >>>>>Cash Inflow
Buy 1000 Shares @$47.50 >>>>>>>>>>>>>$47,500
Sell 10 Jan. 2011 $50 Calls @$7.20 >>>>>>>>>>>>>>>>>>>>$7,200
Sell 10 Jan. 2011 $50 Puts @$10.00 >>>>>>>>>>>>>>>>>>>$10,000
Net Cash Out-of-Pocket >>>>>>>>>>>>>> $30,300
If Costco shares climb to at least $50 [up 5.3% or better] by expiration date in 2011:
Your $50 calls will be exercised.
You will sell your shares for $50,000.
Your $50 puts will expire worthless (a good thing for you as a seller).
You will have collected $1,120 in dividends.
You will have no further option obligations.
You will hold no shares and $51,120 in cash for your original
outlay of $30,300.
That’s a cash-on-cash profit of $20,820 / $30,300 = 68.7% over the 20.5 months of this trade.
This best-case scenario return would occur if COST shares move up by 5.3% from today’s price.
What’s the Risk?
If COST were to remain under $50 through expiration date:
Your $50 calls will expire worthless.
Your $50 puts will be exercised.
You will be forced to buy an additional 1000 shares and to
lay out another $50,000 cash.
You will have collected $1,120 in dividends.
You will have no further option obligations.
[u][/u]
You will end up with 2000 shares of COST.
What’s the break-even point for this whole trade?
On the first 1000 shares it’s the $47.50 cost basis less the $7.20 /share
call premium = $40.30 /share.
On the ‘put’ shares it’s the $50 strike price less the $10.00 /share
put premium = $40.00 /share.
Thus your net break-even on the 2000 shares is the average of
$40.30 + $40.00 / 2 = $40.15 /share.
Take away the $1120 from dividends and your net outlay for the 2000 shares is:
2000 X $40.15 = $80,300 less $1,120 = $79,180 = $39.59 /share.
At $39.59 /share the P/E on this year’s depressed earnings would be
In contrast, the annual highs in those same years:
Year ……. High Price ….. 52-Week P/E Range ……FY - EPS
2004 ……... $50.50 ……… 21.9x – 26.5x …………..$1.86
2005 ………..$51.20 ……… 19.5x – 25.2x …………..$2.03
2006 …………$57.90 ……… 19.9x – 25.1x …………..$2.31
2007 …………$72.70 ……… 19.6x – 27.6x …………..$2.63
2008 …………$75.20 ……… 15.2x – 26.0x …………..$2.89
Conclusion: You have a chance to play a high-quality, very profitable company near its lowest valuation ever. The upside is 68.7% over just 20.5 months = 40% annualized even if the shares only rally by 5.3% from today’s depressed price point.
You are protected against loss if the shares stay above $39.60 so anything less than
a 16.5% drop would not cause harm.
Disclosure: Author is long COST shares and short COST options.
That compares with a 10-year median P/E of 24x and a most recent five year average multiple of 21.7x. If you believe we’re near the bottom of the economic cycle this looks like a good time to play COST for a rebound over the next couple of years.
Costco has proven to be a great operator during both good and bad times. If this FY’s earnings do come in lower than last year’s, it will be only the third down year-over-year comparison in the past seventeen. The others came in 1994 and 2001 during similarly depressed conditions.
Many shoppers have been ‘trading down’ to save money keeping sales close to all-time highs. Value Line gives Costco its highest safety rating and an ‘A’ for financial strength. They also note that COST was in the 95th, 85th and 100th percentiles in their ‘stock price stability’, ‘price growth persistence’ and ‘earnings predictability’ categories respectively [with 100th being best].
As the economy starts to improve sales and earnings should pick up nicely.
Even without a turnaround the shares don’t look overpriced.
Here’s a nice less than 21 month play that can make good total return even if the shares do very little between now and January 2011:
>>>>>>>>>>>>>>>>>>>>>>>>>>>> Cash Outlay >>>>>Cash Inflow
Buy 1000 Shares @$47.50 >>>>>>>>>>>>>$47,500
Sell 10 Jan. 2011 $50 Calls @$7.20 >>>>>>>>>>>>>>>>>>>>$7,200
Sell 10 Jan. 2011 $50 Puts @$10.00 >>>>>>>>>>>>>>>>>>>$10,000
Net Cash Out-of-Pocket >>>>>>>>>>>>>> $30,300
If Costco shares climb to at least $50 [up 5.3% or better] by expiration date in 2011:
Your $50 calls will be exercised.
You will sell your shares for $50,000.
Your $50 puts will expire worthless (a good thing for you as a seller).
You will have collected $1,120 in dividends.
You will have no further option obligations.
You will hold no shares and $51,120 in cash for your original
outlay of $30,300.
That’s a cash-on-cash profit of $20,820 / $30,300 = 68.7% over the 20.5 months of this trade.
This best-case scenario return would occur if COST shares move up by 5.3% from today’s price.
What’s the Risk?
If COST were to remain under $50 through expiration date:
Your $50 calls will expire worthless.
Your $50 puts will be exercised.
You will be forced to buy an additional 1000 shares and to
lay out another $50,000 cash.
You will have collected $1,120 in dividends.
You will have no further option obligations.
[u][/u]
You will end up with 2000 shares of COST.
What’s the break-even point for this whole trade?
On the first 1000 shares it’s the $47.50 cost basis less the $7.20 /share
call premium = $40.30 /share.
On the ‘put’ shares it’s the $50 strike price less the $10.00 /share
put premium = $40.00 /share.
Thus your net break-even on the 2000 shares is the average of
$40.30 + $40.00 / 2 = $40.15 /share.
Take away the $1120 from dividends and your net outlay for the 2000 shares is:
2000 X $40.15 = $80,300 less $1,120 = $79,180 = $39.59 /share.
At $39.59 /share the P/E on this year’s depressed earnings would be
In contrast, the annual highs in those same years:
Year ……. High Price ….. 52-Week P/E Range ……FY - EPS
2004 ……... $50.50 ……… 21.9x – 26.5x …………..$1.86
2005 ………..$51.20 ……… 19.5x – 25.2x …………..$2.03
2006 …………$57.90 ……… 19.9x – 25.1x …………..$2.31
2007 …………$72.70 ……… 19.6x – 27.6x …………..$2.63
2008 …………$75.20 ……… 15.2x – 26.0x …………..$2.89
Conclusion: You have a chance to play a high-quality, very profitable company near its lowest valuation ever. The upside is 68.7% over just 20.5 months = 40% annualized even if the shares only rally by 5.3% from today’s depressed price point.
You are protected against loss if the shares stay above $39.60 so anything less than
a 16.5% drop would not cause harm.
Disclosure: Author is long COST shares and short COST options.
