Topic: Growth Stocks

Growth stocks: Big box retailer feels the bite of Whole Foods, Amazon deal

COSTCO WHOLESALE CORP

Recently Pat McKeough replied to a Member of his Inner Circle about one of North America’s iconic big-box retailers. Like other large grocery sellers, Costco was hurt by the announcement of Amazon.com’s deal with Whole Foods. But the company continues to benefit from its loyal customer base: sales and revenue are up, cash is high and debt is low. Still, Amazon’s entry into an already very competitive field puts added pressure on Costco, which is trading at a high multiple to earnings.

Q: Hi Pat. I wanted to get your advice on Costco, which seems to be struggling lately. Thanks.

A: COSTCO WHOLESALE CORP. (symbol COST on Nasdaq; www.costco.com) owns and operates warehouse-sized stores that sell a wide variety of consumer goods and services.

The company charges its customers an annual membership fee to shop at its locations. That fee rose to $60 from $55 on June 1, 2017. It currently has 732 outlets, including 510 in the U.S., 95 in Canada, 37 in Mexico, 28 in the U.K., 25 in Japan, 13 in South Korea, 13 in Taiwan, eight in Australia and two in Spain. It also sells products online in the U.S., Canada, the U.K. Mexico, South Korea and Taiwan.

Costco opened more outlets in the latest quarter bringing the total store openings over the last year to 28. On June 22, 2017, the company opened its first store in France. It plans to open as many as 15 in that country.

Costco’s revenues have risen steadily over the last five years, as the company continued to open stores. Sales climbed from $99.1 billion in 2012 to $118.7 billion in 2016. Per-share earnings have moved up steadily as well, from $3.97 in 2012 to $5.33 in 2016.

In its fiscal 2017 fourth quarter, ended May 7, 2017, Costco’s revenue rose 7.9%, to $28.2 billion from $26.2 billion a year earlier. Same-store sales increased 5%. Costco operates discount gas stations at around 70% of its outlets, and nearly 30% its customers buy gas and shop on each visit.

Earnings in the quarter rose 28.4%, to $700 million, or $1.59 a share, from $545 million, or $1.24.


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Growth stocks: Shares drop after Amazon.com announces Whole Foods deal

The company plans to spend $2.5 billion to $2.7 billion on new stores and other improvements in fiscal 2017. It spent $2.6 billion in 2016. Costco can easily afford these outlays: as of May 7, 2017, its long-term debt was $2.8 billion, or just 4% of its market cap. It also held cash and investments of $5.7 billion, or $13.00 a share.

The company faces strong competition from discount stores, such as Wal-Mart and Target, as well as other warehouse-store chains, such as Sam’s Club (which is owned by Wal-Mart). That means Costco is unlikely to raise its prices as long as its purchasing costs stay low. This limits the growth of its profit margins, but helps it hang onto customers. The company’s member renewal rate is 90% in both the U.S. and Canada, and 88% worldwide.

Costco’s shares have dropped almost 16% since mid-June 2017. That’s after Amazon.com announced plans to buy Whole Foods for $13.7 billion U.S. That deal has hurt share prices for other grocery sellers such as Wal-Mart.

Profit margins in the grocery business are already low. But the willingness of new rival Amazon to absorb losses in order to win market share could send those margins even lower. As well, Amazon is expected to use its technological skills to upgrade Whole Foods with its customer analytics and “click and collect” grocery model.

Still, Costco’s loyal customer base is a huge advantage, and the company is already expanding its online ordering capabilities. Nonetheless, even with the share price drop, the stock trades at a high 26.3 times the $5.76 a share Costco is forecast to make in fiscal 2017. The $2.00 dividend yields 1.3%.

Inner Circle recommendation: Costco is okay to hold.

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