Costco: Price May Have Outdone Itself (Valuation Downgrade) (NASDAQ:COST)

Introduction

Costco (NASDAQ: COST) is a company that has proven to be a monster of dividend growth as well as resilient in the face of higher interest rates for longer. This is likely attributed to their strong brands, customer loyalty and one-stop shop experience.

I often joke to my girlfriend that she will be able to buy a baby from the retail giant in a few years. I mean now they sell gold bars, so who knows what else they can sell in the future.

It’s a joke, but of course that’s just a testament to Costco’s financial savvy and growth among peers. This is evident by the stock’s stunning 62.45% appreciation over the past year, well above its 5-year average P/E.

Because of this, I think the stock could have, and might, get ahead due for a price correction. In this article, I discuss the company’s latest earnings, fundamentals, and why it could see a lower share price in the short to medium term.

The previous thesis

We last covered Costco earlier in the year, upgrading stock to a buy in an article titled: Costco Q1: A stock to buy and keep no matter what. My reasoning for this is that I thought the stock could go up a lot from the price at the time. It turns out I was right, as Costco’s stock price has continued to rise over the past 8 months. Since then, the stock has appreciated more than 31%, doubling the S&P’s return.

We discussed the company’s earnings since then, which saw them post a strong EPS beat of $0.16. That was $3.58 for the first quarter, while revenue was in line with analysts’ estimates of $57.8 billion. We also hit the $15 announced special dividend payment that they paid in January.

Resilient finances

Since my last article, Costco has had two additional quarterly earnings reports, both of which show how resilient the company has been in the high-interest environment.

In the second quarter, the retailer beat EPS estimates by $0.07 and missed the top line by $690 million. During Q3 earnings reported at the end of May, COST managed to post a double beat.

Net income rose from $1.466 billion to $1.68 billion, or $3.78 per share. This was $3.30 in the previous quarter. This was a similar beat to the first quarter on their bottom line, beating estimates by $0.16.

Net sales were in line at $57.39 billion. This was up 5.8% from the previous quarter’s $54.24 billion and up 9.1% from Q3’23. Costco’s solid financial growth was driven by steady growth in membership, which also grew 9.4% from 68.1 million members in Q3’23 to 74.5 million in their latest T3. Membership was 72 million at the start of the fiscal year.

Although membership grew, gross margins retreated slightly from 11.04% in Q1 to 10.84% ​​during the third quarter, likely due to the slowing economy and financially constrained consumers.

However, margins expanded year-on-year by 0.52%, a testament to their brand and customer loyalty, despite the greater downward pressure on longer interest rates that they have exerted consumers.

For comparison purposes, Target Corporation’s ( TGT ) gross margins rose nearly 2% from 27% to 28.9% from 27% to 28.9%, while Walmart’s ( WMT ) rose slightly from to 24% to 24.4% in the same period.

The average ticket was up 0.5% globally and slightly higher in the US at 0.7%. Traffic increased by 6.1%. That was compared to the previous year, when the average ticket fell slightly to 3.5% in the US and 4.2% globally. So even though interest rates have remained at current levels for more than a year, consumers have remained loyal to Costco and the company’s brands.

Increase in dividends

In addition to rewarding shareholders with a special dividend at the start of the year, the retail giant also increased its dividend by double digits from $1.02 to $1.16 in April, showing that they are a cash flow machine.

In 2023, Costco’s free cash flow was approximately $6.8 billion, with cash from operations of $11.068 billion and CAPEX of $4.3 billion.

For fiscal 2024, management expects CAPEX to be in the range of $4.3 billion to $4.5 billion for the full year. This year, free cash flow is expected to fall slightly to $6.528 billion, according to SimplyWallSt, likely due to higher capital spending as well as constrained consumers. Despite this, their dividend remains well covered.

However, strong double-digit dividend growth is likely to continue for the foreseeable future due to their low payout ratio of just 26.5%. In addition, the company has been doing share buybacks, although that has slowed this year, likely due to the rapid increase in the share price.

In the first 36 weeks, management bought back 749 million shares, compared to 908 million in the first 36 weeks of 2023. And they have $3 billion left in the current program, which expires in January 2027.

Balance sheet

The company’s balance sheet also supports dividend growth, with just $5.8 billion in long-term debt. That was compared to Walmart’s $35.3 billion and Target’s $13.157 billion.

Their cash and cash equivalents of $10.4 billion was enough to wipe out almost twice their entire debt load. Additionally, they have no debt maturing until May 2027 and have an A credit rating from all three major credit agencies.

Limited upside/downside risk

Costco is currently trading well above its 5-year average of 38 times earnings. Quant also assigns them a rating grade of F, signaling that the stock may be significantly overvalued, with a forward P/E of 54.7x currently. Using their 5-year average, this means that the stock could see significant downside, especially if the market sees a major correction or crash in the near future.

At $890 at the time of writing, Costco’s stock price has appreciated more than $200 in the first 9 months of the year. And while they’re a great company with strong customer loyalty, COST’s share price is unlikely to see much upside from here, which makes me downgrade them to a hold.

A recession could also cause the stock price to pull back. During the Great Financial Crisis, Costco’s net income fell double-digit 15% despite growing membership, I noted during my previous thesis.

Investor Takeaway

Despite their strong and resilient earnings through the first 9 months of the year, Costco appears to be significantly overvalued using their 5-year historical average of 38 times earnings.

As a result, the stock could be at risk of a price correction in the coming months. The company is one of my favorite stocks to not currently own because of its valuation.

However, I would consider owning them if their share price saw a major correction nearby or if the stock split. As the stock is up more than 31% since my last thesis in January, I’m downgrading the stock to a hold.