Costco: Looking Overvalued, Maybe Time To Checkout? (NASDAQ:COST) (2024)

We last wrote about Costco (NASDAQ:COST) (NEOE:COST:CA) in late 2022. It was already trading at a premium, but given the quality and growth outlook, we rated it a buy. The long-term thesis is still intact, stable revenue growth, improving margins, and industry-leading efficiencies. A Sell rating on a high-quality company like Costco comes with significant risks. But given the current share price and better opportunities elsewhere, it is time to consider taking profits.

Financial Analysis

The second quarter revenue growth of 5.7% was less than expected. However, earnings beat expectations and came in at $3.92, up 19% compared to last year's $3.30. The slower revenue growth had investors rethinking the long-term outlook and questioning the valuation multiples that Costco commands. Share prices fell from a near all-time high of $785.6 closing 7.6% lower at $725.6.

The recent March sales results are more promising with revenues up 7.7%. This is significantly lower than the 5-year average of 11.3%. If growth is lower, the valuation multiples should be lower.

The long-term revenue has seen high single-digit growth and EPS has grown by 12.1% over the past 15 years. If we break down revenue further, the last five years saw revenue growth of 11.3%, and the 10 years before that, from 2008 to 2018 saw revenue growth at a more modest 7%. The average P/E ratio from 2008 to 2018 was approximately 24x. With higher growth, the average Non-GAAP (TTM) P/E ratio over the past 5 years has been 39.6x. If growth going forward will be as strong as the past 5 years, we believe the share prices have outpaced the fundamentals and expect some adjustments.

The consensus estimates for EPS are to grow in low double digits and revenues to be mid-single digits. This points to improving margins. This would be a good sign for other companies, but for Costco, it could point to a potentially different issue. The business model is a high turnover with low margins while providing value to its customers. As this may be considered contrary to its business model, we would ideally like to see the top and bottom lines grow in tandem. In our opinion, cost savings passed on to the customers would be compensated with higher revenues.

Looking deeper into the financials and comparing them to peers, we see how Costco operates.

Gross margins for Costco are significantly lower in comparison to Walmart (WMT) and Target (TGT); however, net income margins are similar to Walmart and about 1% less than Target. These financials point to two commonly known traits about Costco, per-unit prices are lower for customers and the company runs its operations significantly more efficiently with lower operating costs than its peers.

Costco operates membership warehouses offering members low prices on a limited selection of products in a wide range of categories, producing high sales volumes and rapid inventory turnover.

The company has a strong balance sheet with over $10bn in cash and about $9.4bn in total debt. Interest coverage is 58x and a dividend cover of 4.3x. The FY23 dividend yield was a modest 0.8% and given the rise in share price, the FY24 dividend is 0.64%.

The risk to our thesis is we see organic revenue growth reaching and maintaining double digits over the next few years.

SA Quant rating points to Costco as a Hold, failing miserably on valuation and being kept afloat on growth, profitability, momentum, and revisions. Still above the industry average, we think growth is going to be slower than its historic averages. We cannot fault profitability, but for Costco, higher profitability can be a double-edged sword, where customers will perceive it as cost savings not being passed down to customers. With an overall momentum rating of A, the short-term momentum has flattered to a B.

Valuation

Using EV, IC, ROIC & WACC to help identify potentially undervalued/overvalued companies

One way to look at companies is the ratio of return on invested capital to the weighted average cost of capital. This should directly correspond to the value of a company. The greater the spread, the higher the share price. This higher value should be visible in the higher spread between EV and invested capital. In other words, higher ROIC/WACC leads to higher EV/IC. This is a good starting point but we take that a little further and add inflation adjustments, asset life, and other adjustments to the mix. Instead of ROIC, we use ROCGA (Returns-on-cash-generating-assets) and gross assets instead of invested capital.

More information on calculating cash-flow-returns-on-investment, gross cash, and gross assets can be found in Bartley Madden's paper "The CFROI Life Cycle", p10. Bartley Madden is a significant contributor to the Cash Flow Returns on Investment methodology. Returns-on-cash-generating-assets or ROCGA uses the same methodology as cash-flow-returns-on-investment and measures economic returns.

We go a step further and divide EV/IC by ROIC/WACC. An increasing chart would show valuation getting more and more expensive, and the numbers getting lower would point to valuation getting more attractive.

Let's break this down a little further before we look at an example.

If the required returns are greater than the actual returns, the ratio is higher and the company is overvalued. If the ratios are trending downward, the company is getting cheaper. Let us have a look at an example.

Scenario 1:

The required return is $100.

Actual return is $80.

The ratio is 1.25x

Scenario 2:

The required return is $100.

Actual return is $120.

The ratio is 0.83x

This example shows that lower is better.

Improving margins and asset utilization resulted in higher economic returns, and in turn, higher ROCGA/WACC.

The EV/IC equivalent has risen over the years. They rose quicker than the ROCGA/WACC ratio and can be explained by higher growth.

In our opinion, growth is not going to be as robust as it has been during and post-pandemic, we believe the (EV / Gross Assets) / (ROCGA / WACC) ratio should revert to the pre-pandemic levels of 1x.

Share prices have increased 25% over the last six months with no particular economic catalyst driving this increase. The (EV / Gross Assets) / (ROCGA / WACC) ratio has increased and Costco looks more expensive. Our calculation shows if these ratios were to normalize, we could see a potential correction of 35%.

With FY24 P/E of 45x, if these revert to the long-term average of 30x, we could see a potential correction of 32%. Similarly, even if we compare the FY24 PS of 1.26x against the last 5-year average PS of 0.99x, Costco is trading a significant premium.

Conclusion

FY24 P/E is at a historical high of 45x and growth is slower than historic averages, it is hard to justify the current share price. Post-pandemic inflation-driven sales have moderated, but the company continues to be at unjustifiable valuation multiples. Our valuation methodologies all point to Costco being overvalued by over 30% and with better opportunities elsewhere, we would now advise on taking profits.

Nivesha Investors