Markets

Stock Sale: Is Costco Buying?

Worrying about the potential impact of a recession weighs heavily Costco (COST 0.57%)as historically high inflation and rising interest rates could affect the future growth of the storage club.

Costco’s shares are down 19% for the year, roughly in line with the S&P 500. But with a business model that relies on low-margin, high-volume sales, rising costs — including those for goods and transportation — are putting pressure on profits.

A man walks down the aisle in the club's warehouse.

Image source: Getty Images.

While most of its earnings come from membership fees, which typically increase every few years, Costco will be hard-pressed to raise them again now that consumers are already feeling the pinch. While this would provide an immediate increase in revenue, it could also force customers to not renew or sign up.

There are a number of competing factors weighing on Costco’s stock, so let’s see if the warehouse club leader can continue to grow over the next few years, and if that makes its stock a buy.

Consumers descend on the market

Inflation is a double-edged sword for Costco. On the one hand, its business model is vulnerable to the ravages that inflation wreaks on consumers’ purchasing power and the effect that rising costs have on its margins. But on the other hand, those same consumers are also looking for ways to save money and stretch their wallets, and they might turn to Costco for its bargains.

But the retailer faces more competition — and not just from other storage clubs Walmart‘s (VMT 0.13%) Sam’s Club or BJ’s Wholesale Club, but also from non-traditional stores such as dollar store chains. They may not offer bulk-buying options (not always an advantage), but deep discounters have expanded their range of goods to include fresh and frozen foods, making them surprisingly effective rivals.

During the Great Recession of the last decade, Dollar General and Dollar Tree saw more luxury shoppers visit their stores, but not all left when times turned good again. The improved selection and higher perceived value of their goods kept them coming back.

Indeed, financial advice guru Dave Ramsey says consumers often find themselves overspending at Costco to make their membership fees feel worthwhile.

Walmart itself has said it’s seeing higher-income shoppers increasingly move down the market to its stores. Once upon a time, the retail king mainly catered to the low- and middle-income segments, while Costco attracted middle- and upper-income shoppers. But Walmart said those making $100,000 or more are more likely to be in its ranks.

That could be why Costco’s net sales rose 8% in its fiscal first quarter, which ended Nov. 20, while Walmart posted nearly 10% growth.

The high price of free money

Another factor affecting Costco’s inventory is the growth of its physical store footprint. The company operates around 847 warehouses worldwide and has been expanding rapidly in recent years. This expansion helped drive the company’s growth, as it allowed the warehouse club to reach new customers and increase its market share. However, the expansion of Costco’s brick-and-mortar stores also came at a cost, as the company had to invest heavily in new locations and infrastructure.

What’s more, Costco’s stores aren’t just about food, they also carry large amounts of discretionary spending items that consumers can easily set aside when push comes to shove. As CFO Richard Galanti told analysts on the retailer’s earnings conference call, “we’re all getting rained on during these tough times, especially with higher ticket discretionary items.” However, he also argues that the softness Costco is experiencing is relative to the strength he saw a year ago.

But it was a period marked by consumers splurging on goods after receiving extra stimulus checks, something many economists now see as the match that lit the fuse for inflation. Unfortunately, that free money is no longer available.

Crossing the digital divide

Costco has also struggled to keep up with other retailers in the e-commerce space. This has been of particular concern in recent years, as the pandemic has led to a surge in online shopping. In response to this trend, Costco is investing in its online capabilities and expanding its e-commerce offerings, but it remains to be seen whether these efforts will be enough to allow the company to compete effectively with other online retailers.

E-commerce sales fell 3.7% last quarter, or 2% on a currency-adjusted basis, while Walmart posted 16% growth.

This was largely due to the decline of those discretionary goods. Consumer electronics and appliances represent about 40% of Costco’s online volume, and were hit hard this quarter, falling by high single-digit percentages.

Worried friends look at laptop.

Image source: Getty Images.

Taking the good with the bad

All this may sound grim, but it’s not as bad as all that. First, Costco has a loyal customer base that appreciates the company’s low prices and wide selection of merchandise. This should help the company maintain its market share and attract new customers over time.

Second, Costco has a strong balance sheet, with healthy debt levels and strong cash flow. This should give the company the financial flexibility it needs to continue to invest in its business and pursue growth opportunities.

However, it is not the cheapest action. Even with its stock in decline, Costco is trading at elevated valuation ratios compared to earnings, sales and free cash flow. I wouldn’t buy large tranches of Costco stock at this time, but taking small bites until better prices emerge will ensure your portfolio can benefit from this fundamentally high quality business.

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