Costco (NASDAQ: COST) offers branded and private-label products across a range of its merchandise categories. The company carries everything from seasonal and office products to dry foods and produce.
Costco has a cult-like following similar to that of the iPhone. Consumers recognize the brand for having fair prices and quality goods.
I am neutral on Costco Wholesale. The company has an excellent business model and has grown its revenues at a consistent rate of 8.35% since 2006.
The P/E multiple has grown consistently from 15x to 43.4x in the same time frame. The stock price appears over-extended. (See Analysts’ Top Stocks on TipRanks)
Future Outlook
Revenues grew consistently from 2006 to 2021 at a rate of 8.35%. Its net profit margins improved from 2% to 2.56% in the same period. The company saw a spike in revenue growth in 2021 at a 17.41% increase year-over-year. Revenue growth will likely taper gradually through 2023 and return to normal.
Costco has solid membership renewal rates of over 91% in the U.S. and Canada. During the pandemic, sales growth increased. Investors should expect this momentum to continue from strong membership renewal rates and 22 new warehouses planned for next year.
Due to inflation, the prices of products and freight have increased. As a result, margins will likely see pressure in the following years. To remain competitive, Costco needs to keep prices low despite transitory inflation. The company would see negative impacts in earnings due to the increased pressure on margins. Maintaining low prices will keep the membership base happy and create loyal customers which is beneficial for Costco in the long term.
With 22 new warehouses in the plans for next year, Costco is growing its geographic footprint, but the company is also improving its online presence. Online sales accounted for 6% of net sales in 2021. With the addition of new warehouses and improved online sales, the revenue growth will continue to bolster its cash flow statement over the next 12 months.
Company Financials
Costco’s forward P/E ratio is up to 43.4x, an increase from 33x in February. Investors are shifting focus to consumer defensive stocks as uncertainty rises from additional COVID-19 variants. This sharp increase points to an overextended stock price growing faster than its earnings.
Price-to-free cash flow shows a slightly different picture as the multiple has dropped from 38.7x in November 2019 to 35.9x as of December 10.
While the company is not showing an earnings growth rate to justify its price increase, the free cash flow growth tells a different story. Since 2016, free cash flow has grown from $2.93 per share to $15.57. This growth in cash flow will likely slow as margins decrease in the short term.
Valuation
Costco has improved margins consistently. Therefore price-to-cash flow has remained relatively flat while the stock price has risen, contrary to the P/E ratio increasing over the last year. With margin pressure on the horizon, P/E ratios will likely remain high but drop slightly due to overall revenue growth.
With margin pressure and the likely increase in revenues, I estimate earnings per share to fall around $13.50 next year. I support a price target of $553, or 41x earnings.
Risks
A slowdown in sales due to weakness in the economy presents a material risk to Costco. As government stimulus weans, consumers may limit spending and directly impact sales figures. The company also faces significant competition.
The increasing cost of goods and freight costs pressure Costco’s bottom line. As the company remains competitive with low prices, it will eat into its margins to meet consumer expectations. Finally, labor costs continue to rise further pressuring margins.
Analyst Consensus
Turning to Wall Street, Costco Wholesale has a Strong Buy consensus rating, based on 19 Buys, five Holds, and zero Sells assigned in the last three months. At $551.83, the average Costco price target implies 1.3% downside potential.
Final Thoughts
Costco is a giant company with an impressive track record. It continually improves earnings, and delivers consistent cash flows. Based on its track record of success, it deserves consideration from investors.
Disclosure: At the time of publication, Aaron Stine did not have a position in any of the securities mentioned in this article.
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