Costco: SOLID Company BUT Expensive Stock. Why? Because Nothing Is Really ‘New’

What Costco Does Right:

Costco can take a 34% reduction in merchandise revenue before they move negative.

Their weighted average cost of debt is 1.7-1.8%

Their Interest income on their $16Bil cash reserves exceeds their interest expense on leases and senior notes

Membership fee revenues (>90% retention annually) pay for 23% of their fixed costs

Proven pricing realization as merchandise costs increase

Growing new RMN revenue stream with high profit margins

Costco has very good cost control in a bad economy. I say this because of the subtle recession fears that are cropping up in few but notable places. Areas of concern like: job market pessimism, creeping unemployment rates, drop in consumer sentiment and sustained inflation due, in part, to tariffs, although, mostly attributable to monetary expansion.

Through it all, Costco has great pricing authority, very few competitors and a deep focus in a sector that they uniquely have a pulse on. I would argue that they have a unique product mix that captures sales volume shift from grocers like "Whole foods" and traditional retailer outfits particularly in the apparel space.

Costco also has an incredibly diverse consumer base. They can capture sales from small businesses like restauranteurs, convenience stores, high-income and middle-income households.

Looking at their revenue performance between 2007 to 2012, you'll see they vaguely experienced any adverse economic consequences in our peak recession years 2008-2010.

So what could cause Costco to hurt?

If they fail to respond to merchandise costs in a timely manner and their pricing doesn't track in times of higher inflation or deflation (less likely), their already thin gross margins can compress further or their revenue (less sensitive) could decline due to slow tracking.

Demographic shifts can also cause harm. As it is, Costco's growth is unitary and very linear. Adding square footage and store openings are essential for their growth. Growth is directly tied to their stock's performance. This is a small fear as Costco rarely develops into areas where the future is unknown. They look to real estate values, property mix, consumer behaviors tied to those demographics; etc. Any area could experience a population decline, but their growth model hinges tightly to areas with slow drift.

As for their share price, you can make an argument for them being extremely expensive compared to their historical P/E ratios. No new developments or clues left by their executives hint at anything vastly innovative to warrant belief that their revenue growth will suddenly break beyond their average of 9-10%.

you can argue their added revenue streams, ecommerce, RMN and so forth, but these have not materially increased the projected future revenue growth above the 9-10% expectation nor are they expected to grow margins to a degree that support the higher share price. So, they are expensive based on what we can reasonably price in and the impact on free cash flow to investors.

So from a Free cash flow perspective, accounting for new growth assumptions, we can say that their valuation is almost twice as expensive as what it was.