Costco Shares: Wait for More Weakness

Source: Thinkstock

Source: Thinkstock

On Thursday morning retail giant Costco (NASDAQ:COST) reported its third quarter earnings results. The company saw its sales increase by about 7 percent for the quarter to $25.23 billion from $23.55 billion. Net income was weaker with a gain of just 3 percent — this figure rose to $473 million from $459 million, or $1.07/share from $1.03/share.

If we look at comparable sales figures we find that the company saw far more gains from its U. S. operations — comparable sales up 5 percent — than from its international operations — comparable sales up 3 percent. The reason for the disparity was largely due to a strong dollar, and in fact international comparable sales grew at a faster rate — 8 percent vs. 6 percent.

In response to the news shares of Costco were basically unchanged during pre-market trading. They currently trade at just over 25-times earnings. This is a premium to the S&P 500, which trades at roughly 22-times earnings according to the iShares S&P 500 Index Fund (NYSEARCA:IVV) website.

Although the company grew both its sales and its earnings, Costco is having a problem that has hit many retailers over the past few quarters — declining profit margins resulting from higher input costs. With rising commodity prices, particularly rising oil and gas prices, retailers are facing higher distribution and power costs, and this goes directly to the bottom line.

Investors are clearly assuming, for the most part, that this is a temporary problem, as is evidenced by the premium price to earnings multiple that investors are willing to pay for Costco shares. While it is true that the company has a very strong business model that has enabled it to carve out a market niche that drives sales growth it is not immune from macro-economic issues such as a tepid economy, a weak retail landscape, and rising commodity prices.

Thus Costco shares are currently a mixed bag. On the one hand, the company has a solid business model with a loyal customer base, and, on the other hand, the company faces macro-economic headwinds.

So for the time being, I think that Costco shares are going to have a difficult time moving higher. Investors may not sell the shares to a lower price point, as they are willing to hold the stock at the current valuation, but at the same time the company clearly lacks the earnings growth needed in order to drive the share price higher.

With that being the case, there doesn’t seem to be any reason to hold the stock, at least not at the $114/share level. While the company has a long history of consistently raising its dividend, the current yield, which is 1.25 percent, is too low to consider the shares for income, or even income growth.

Considering that the company has both positive and negative drivers in the current market place it deserves to trade with a market multiple, which is 22-times earnings — not 25-times earnings. This would put the valuation at just under $100/share. Of course prudent investors know that the best time to buy a stock isn’t when it is fairly valued, but when it is undervalued. With this being the case, interested investors should wait for additional weakness.

Disclosure: Ben Kramer-Miller has no position in Costco.

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