Why Is Costco Stock Dropping? Despite early hints suggesting that rising inflation might be about to cool off, a recent report by Morgan Stanley predicts that the U.S. economy is still likely to take a nosedive in 2023.
Indeed, although there are some signs that consumer spending has remained strong – wage growth was solid this year, personal consumption is up, and the unemployment rate has rarely been this low in half a century – other indications suggest that an imminent slowdown is on the cards.
For example, the personal savings rate of 2.3% is the worst it’s been since 2005, while credit debt is also at an all-time high.
In fact, analysts at Morgan Stanley are now advising investors to take a loss on their equity positions and rotate into income-producing assets instead.
This situation is terrible news for big-box retail outfit Costco. The company’s been curtailed by a series of problems over the last twelve months, including rising commodity prices, higher wages, and increased transportation costs.
While these headwinds have led to supply chain disruptions and slower growth, the firm’s share price has also suffered. The stock is down almost 19% since January, and, although that’s in line with the S&P 500 Index, the enterprise is especially susceptible to falling consumer demand.
However, in the face of these challenges, Costco is still a stellar brand. But macroeconomic trends aren’t helping the business, and the stock might not be the attractive proposition it once was.
So, let’s examine where Costco’s difficulties lie – and, more importantly, what the firm can do to solve them.
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Inflation Is Taking Its Toll
There are several reasons why Costco’s stock might be dropping right now. Still, one of the most important is the high-inflationary milieu in which the business currently operates.
In fact, inflation is known to erode the value of a company’s profits. This makes the stock less attractive to investors, who may be reluctant to pay as much for its shares.
Rising interest rates can also affect a firm’s stock price by making it more expensive for the company to borrow money. If a company borrows money to fund its operations or make investments, it may have to pay higher interest rates, which will cut into its profits.
To that end, Costco carried total liabilities of $44.6 billion in the first quarter of fiscal 2023 – up $1.1 billion sequentially – demonstrating that the business would be particularly exposed if it needed to raise further funds for any reason.
Moreover, rising inflation and interest rates can disproportionately impact retail businesses like Costco’s.
Fortunately, there are a number of ways the company can insulate itself against the threat of cost expansion. For example, rather than increasing prices all at once, it can do so gradually, helping to avoid alienating customers and affecting sales volumes too dramatically.
However, while retailers may find some relief by passing on the costs of inflation to customers, it’s definitely not a long-term solution. Inflationary pressures will eventually force companies to change their business models in order to stay profitable. This could include moving to online sales, or selling more affordable goods and services. And retailers that don’t adapt will likely struggle to survive in this increasingly onerous environment.
That said, there’s another problem for Costco too: the brand is already known for its extremely competitive pricing policy, and it’s questionable whether the company could discount its products any more than it already does.
And yet, the firm may well have an ace up its sleeve through its relatively unique membership model. In fact, during its latest quarterly earnings call, Costco CFO, Richard Galanti, said it was “a question of when, not if” the company would hike its membership fee. This would deliver the business a cash bonanza without having to shoulder any additional costs itself.
Is Costco Still A Value Play?
Businesses involved in the retailing of necessity goods are usually thought to be reliable defensive stocks. They typically perform well during economic uncertainty and often provide an income stream through the distribution of a company dividend.
That said, even a dividend-paying venture like Costco can lose its luster when market conditions are so volatile. For instance, although COST’s distribution has increased at a 5-year compound annual growth rate of 12.4%, it still only yields a paltry 0.78%.
Moreover, many investors would once have been attracted to the firm’s safe dividend, given its cash flow payout ratio is excellent at just 21.0%. However, with interest rates at the levels they are today, the risk profile of investing money in a stock market asset might not be worth it.
This is because government bonds also tend to yield higher returns when interest rates are up. And since sovereign bonds or treasuries are generally considered less unpredictable than other securities, this makes them a more stable investment choice – especially for investors who are somewhat risk-averse.
But factoring in the reality that Costco hasn’t beaten the market in terms of price action – and given that its dividend isn’t necessarily the most enticing – there doesn’t appear to be much to lure undecided investors to the business at the moment.
Indeed, the company’s valuation remains sky-high even with its stock value falling. Its P/E ratio of 34.4x is 75% greater than the Consumer Staples sector median, while its gross profit margin is equally woeful at just 12.1%.
Costco: Every Cloud Has A Silver Lining
While some observers might take a pessimistic view of Costco’s future fortunes, the firm’s position as the world’s third-largest global retailer seems pretty much unimpeachable.
Furthermore, the key metric for investors might actually be its return on common equity, which stands at 29.5% on a trailing twelve-month basis. Perhaps this measure of operational health is enough to justify a steep premium for a company that has, after all, done no worse than the market as a whole.
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