Costco’s Weak Earnings Will Send Shares Lower

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Costco (NASDAQ:COST) on Thursday reported its second-quarter 2014 earnings, and it wasn’t a pretty picture. While the company’s sales rose from $24.3 billion to $25.8 billion, profits fell from $547 million to $463 million due to lower margins.  What’s worse is the fact that the company’s growth is slowing considerably. Year-over-year sales growth has slowed from 14 percent (2011 versus 2010) to 11 percent (2012 versus 2011) to 6 percent (2013 versus 2012). While it seems to have stabilized at 6 percent for now, shrinking margins really highlight the longer-term trend.

The fact of the matter is that Costco is getting larger and it is becoming harder for the company to grow. The company does a really good job as a retailer in that it fulfills a particular market niche and it does so better than any other company. Namely, it provides everyday consumers with the opportunity to buy bulk goods inexpensively. But clearly it is having trouble attracting new customers. While it grew its same-store sales in the United States by 4 percent year over year, same-store sales were flat internationally. A lot of this international weakness was due to a strong dollar, and Costco’s news release emphasizes this point.  Still, the company reported a bad quarter, and the stock fell 3 percent to reflect this fact.

There is no doubt that the company is struggling to grow its top-line figures, and its bottom line is shrinking. I think this says a lot about not just Costco but the retail environment in general. We are seeing weakness out of several retailers, from Wal-Mart (NYSE:WMT) to the struggling J.C. Penney (NYSE:JCP). Consumers have less disposable income, and companies like Costco are suffering the consequences.

Despite this fact, Costco trades at a rich valuation — 25 times earnings and 4.5 times book value. This is more or less in line with the S&P 500, but when we think of a company trading at 25-times earnings, we expect to see growth on both the top and bottom lines, and we aren’t seeing this. I think other investors are seeing this too, and they are selling off the shares.

Costco stock peaked at an all-time high of $126 per share in November, and while it rebounded from the $110-per-share level, the sharp decline on Friday on volume of nearly 9 million shares tells me that we are seeing the beginning phases of a daunting technical pattern of lower highs and lower lows. Furthermore, there is no long-term technical support until we get to about $70 per share, which means we can see a nearly 40 percent decline.

That would take us to a price-to-earnings ratio of about 15, which seems much more reasonable assuming management can reverse the decline in margins. A 15 P/E ratio is appropriate for a large company with slow to moderate growth, which is the sort of investment Costco will likely be going forward.

Therefore, I think investors should consider selling their Costco shares. The rapid growth period we saw from the lows hit during the financial crisis through 2012 is clearly over, and the stock is extremely vulnerable to the downside. Value investors will likely not want to get involved until we see a price point of around $70 per share. Growth and momentum traders, who drove the shares up to mid- to high-20s P/E ratio, have no reason to continue buying the stock and several reasons to sell it. This means that in all likelihood the shares are headed lower.

To end on a positive note, I want to point out that Costco is one of the better retailer investments out there even, if investors should wait before entering. I don’t buy retail stocks given how competitive the retail space is, but if I chose to break that rule (which is by no means set in stone), Costco would be near the top of my list of retailers to own. As I have already mentioned, it is the one company that consumers go to in order to buy bulk goods inexpensively, and this gives Costco an intrinsic advantage and a necessary role in the marketplace for the foreseeable future.

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