Costco, At What COST?

Costco Wholesale Corp (COST) has been on my watch list for years now, but every time I look at the stock, I come away with the feeling that it may be a little overpriced and that I should wait for a pull-back before starting a position. The reason I felt the company may be overpriced had to do with the fact that Costco sports a higher Price/Earnings (P/E) and Price/Sales (P/S) ratios when compared to competitors like InsideArbitrage pick Safeway (SWY), Walmart (WMT), Kroger (KR) and BJ’s Wholesale Club (BJ) as you can see from the following table.

The dividend yield at 1.00% is also not impressive when compared to the average dividend yield of 1.6% for the S&P 500. I find it difficult to imagine how Costco could possibly expand its product line given that it sells everything from “institution size” packs of Oroweat bread and Odwalla orange juice to big ticket items like flat panel HDTVs and even cars.

However there is a lot to like about Costco. They treat their employees much better than Walmart by paying them higher wages and providing better health benefits (notice the difference in the profit margin in the table above?) and hence have low employee turnover. They have a loyal customer base that regularly renew their annual membership and these renewals are very important to Costco as they derive a shocking 72.7% of operating income from membership fees according to this SeekingAlpha article. Their customer loyalty is evident from the difficulty in finding a parking spot at my neighborhood Costco, a dearth of shopping carts outside the store and the long lines at checkout counters.

Costco also has room for store expansion both on the domestic front and internationally according to this excellent article about Costco by Travis Johnson. Once you consider the facts that the company generates over a billion dollars in annual free cash flow, has $3.3 billion in cash and short-term investments on its balance sheet (over $7 per share) when compared to just $599 million in debt and is still growing earnings at a slow but steady pace, the stock appears to look less expensive than it did by looking at just the P/E and P/S ratios. As the holiday shopping season approaches, sales of higher margin big ticket items could also pick up.

An opportunity to buy Costco did present itself two weeks ago when Costco warned that it expects lower fourth quarter earnings because it had to mark down the price of big ticket items and faced larger than expected amount of returns. The stock fell more than 4% in reaction to this news but has since made up most of those losses.

A quick glance at the income statement from the fourth quarter of 2005 will reveal that they had excellent revenues and earnings in that quarter, which have not been matched in the first three quarters of 2006. When Costco releases fourth quarter 2006 earnings, the year-over-year comparison is likely to look bad and the stock could drop in response, providing just the opportunity I am looking for to start a position in Costco.