Oct. 6, 2017 10:44 p.m. ET
Have you ever had one of those days where nothing you do goes right? That’s been
Volume (Delayed 15m)
Rev. per Employee
(COST) for most of the past five months.
What do I mean? Ever since Amazon announced its purchase of Whole Foods Market in mid-June, Costco has been on the ropes. Its shares have dropped 12% since then, even as the members-only retailer has delivered the goods with earnings beats and same-store sales increases every step of the way. It makes you wonder: Just what does Costco have to do to lift the cloud?
Case in point: Last week’s fourth-quarter earnings. Costco delivered nearly everything you could ask for. A better-than-expected profit? Costco’s earnings beat analyst forecasts by six cents a share. Consensus-topping revenue? Total sales rose 16% to $42.3 billion, ahead of estimates of $41.6 billion. Ridiculously good sales at stores opened at least 13 months? Same-store sales rose 5.7%, if we exclude volatile gasoline prices and currency fluctuations. In this retail environment, those are surely results worth celebrating.
Or maybe not. Costco’s shares fell 6% last Friday, as investors saw flaws where they once saw perfection. They point to Costco’s gross-profit margins, which slipped to 13.2% from 13.4% a year ago, and lower membership renewal rates—retail renewals dropped to 89.3% from 89.5%. But there’s another reason Costco can’t seem to catch a break: It’s just too expensive.
After Friday’s earnings report, Costco trades at 24.5 times 12-month forward earnings. While that is well off its June peak of 31.2, it’s still 1.5 times other food and staples retailers, and well above the S&P 500’s price/earnings ratio of 19.3. Normally, that wouldn’t be a problem—Costco almost always trades at a premium—but these aren’t normal times.
With Amazon at the controls, Whole Foods started cutting prices. That means everybody in the business will be feeling pressure to do the same. Costco’s chief financial officer, Richard A. Galanti, in fact cited “investing in price” as one reason for the weaker margins.
But does anyone want to pay 25 times for a company facing that kind of pressure, especially when it could result in an earnings miss at any time? Writing after Costco’s results, Wells Fargo analyst Zachary Fadem argued that with competition increasing, beating earnings forecasts will get more difficult, while same-store sales are likely to slow.
The result: Risk/reward that skews toward risk, he says. “Another strong quarter—it’s what they do—but skepticism remains,” Fadem adds.
And most likely will continue to, as Costco is forced to change its business model on the fly. The company, which has long relied on customers schlepping out to its stores, announced two delivery options for its customers: one, a same-day delivery service from its wholesale clubs, and the other, a two-day service for nonperishable goods to be known as Costco Grocery.
On the surface, that all seems well and good. Guggenheim analyst John Heinbockel notes that prices will be slightly higher for Costco Grocery versus those bought in stores, but roughly in line with those of Amazon Prime.
So what’s the problem? No one knows how Costco Grocery will affect in-store traffic and membership, especially with memberships growing at a sluggish pace, Heinbockel says. “Will Costco Grocery adversely impact club traffic or free up consumers’ time and cart space to buy value-added items, such as fresh foods?” he asks. “It’s too early to tell.”
That isn’t the kind of answer investors want to hear when paying for a stock with an ultrapremium valuation. That means Costco either has to get cheaper or answer those questions. We’ll know the company has gotten there when its stock stops selling off on good news.
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