Time To Sell Charlie Munger’s Top Retailer?

A few years ago it would have been hard to imagine a competitor of Costco (NASDAQ:COST) falling outside the usual grocery store suspects, whether that’s Kroger, Walmart, Target or even Amazon.

But today a new rival has appeared from a very unlikely sector, healthcare. Over the past few months, a chorus of skeptics have been increasingly vociferous as they exclaimed Ozempic, a weight-loss drug, had the potential to upend the consumption of beverages and food, including sodas and even grocery store necessities.

If they are right, there is a real concern that Costco stock may be overpriced, but are they right?

Is Costco Stock Overvalued?  

Whether price-to-earnings ratios or a standard discounted cash flow forecast analysis is applied, Costco does appear overvalued at this time.

On a P/E basis, Costco trades at a 39x premium, above its long-term average, and well-above the sector average of 11.9x.

Comparing Costco to other grocery firms, though, is a bit of a misnomer because it falls into a rather unique bucket thanks to its membership model that now encompasses 71 million households.

The predictability of Costco’s revenues add a premium to the regular grocery store model. Another factor in favor of Costco is its product mix, which largely features staples as opposed to discretionary items.

Costco members are willing to pay the annual fee because they know they will derive value from buying day-to-day necessities in bulk over the course of the year at low prices.

Even if we acknowledge that Costco is only marginally inflated on a P/E basis relative to its own historic norms, it is fully valued, and then some, on a discounted cash flow basis. 

When we ran the calculations, Costco had a fair value of $550 per share, which sits below the current COST share price.

It must be said, though, that analysts are a little more optimistic and have a consensus target of $590 per share on the company. The upside is fairly minimal if realized so, at the very least, it’s time to give pause to the merits of an investment.

Will Ozempic Hurt Costco?

We have seen relative underperformance of Costco share price versus the S&P 500 recently. For example, on October 6, the S&P 500 was up by 1.18% while Costco fell by 2.11%.

The primary cause of the selloff emanated from concerns that Ozempic would torpedo grocery stocks like Costco just as it had spread fear among shareholders of companies like Coca Cola.

KO shareholders may have more to worry about here than Costco, however. That’s because Coca Cola very much plays in the sugary beverage industry that could indeed see demand reduction if consumers find success with Ozempic in quashing their appetites.

Costco, by contrast, primarily sells goods that consumers need every day, and sells them in bulk, whether that’s paper towels or toothpaste.

Ordinarily, a selloff in Costco shares on such news is an opportunity to buy versus offload stock. Given the present valuation, more caution is warranted now.

Costco Forecasts Are Bright

Even if it does seem as if Costco shares are priced to perfection now, the future is still bright, and the company is most definitely worth adding to a watchlist.

One key metric to pay attention to is its return on invested capital that sits at 18.8%, an astonishing figure for a grocery store.

Remember that, over the long-term, ROIC is the return an investor should theoretically earn by holding a stock. The reality of markets is such that fundamental factors, competition, sentiment and other exogenous variables can derail the actual amount earned but it remains a very good guidepost for what to expect.

It’s also worth highlighting that revenue forecasts for Costco imply that the grocery titan will continue chugging on to ever greater successes. FY 2024 is expected to produce a top line of $253 billion while FY 2025 sales should hit $271 billion and FY 2026 sales are forecast to reach $289 billion according to analysts.

Those revenues are expected to yield earnings-per-share figures in the respective years of $15.70, $17.12 and $18.58.

There is simply no sign of a slowdown and history would suggest the estimates are spot on. After all, when we went back ten years, we couldn’t find a single instance when sales didn’t grow on a year-over-year basis.

It’s astonishing, in fact, quite how predictably the top line grows at Costco. Take 2019 and 2020, for example, which were two entirely different years for the world. Costco reported revenues up 7.9% in 2019 and up 9.2% in 2020. It’s as if the health scares of 2020 didn’t budge consumer behavior much at all, up or down, for Costco.

Stability Is The Name of the Costco Game

That kind of predictability leads to a comfort among investors that the future will be stable. Revenues will grow, earnings will grow, and no matter what happens in the world, the odds are high that households will still pay for their Costco subscriptions. It’s easy to see why Charlie Munger is such a fan of Costco and has been for so long. 

The gravy on top for Costco investors it the dividend yield. It’s a modest payout admittedly of just $4.08 per share, which translates to a dividend yield of 0.72% but investors can be confident that they will receive it for the foreseeable future thanks to a low payout ratio of just 19.88%.

A final factor to woo prospective investors can be found on the balance sheet. Last quarter, Costco reported $13.7 billion of cash on hand, in addition to $1.5 billion in short-term investments. 

Now a savvy investor might immediately wonder whether much of that is offset by debt. After all, Costco relies largely on a brick-and-mortar presence so perhaps it’s very heavily indebted. But that’s not the case at all. In fact, Costco has just $8.8 billion of debt on the books.

Wrap-Up

All in all, Costco is an extraordinary revenue generator and is expected to be for the foreseeable future. It also has a very robust balance sheet that should withstand threats from macro factors as well as competitors. 

The company may well be selling off on the news that Ozempic could hurt consumer sales but we think that’s overblown.

Of greater concern in our eyes is the present valuation which suggests Costco is fully valued at this time without much room for execution mis-steps.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.