Is Costco still a Value Investment?

Costco Wholesale (NASDAQ: COST) might be a better value investment than before because its’ stock price is dropping despite having a great quarter.

Costco’s stock price dropped from a high of $181.67 a share on June 14 to a low of $154.11 a share on July 7 and fell again to $151.57 a share on July 10, 2017. It dropped another $2.98 between June 6 and June 7, falling from $157.09 to $154.11 in just a day despite a wonderful earnings report.

During the quarter that wrapped up on May 31, 2017, Costco’s revenues grew by $2.09 billion and its net income grew by $155 million. Revenues grew from $121.19 billion in February to $123.38 billion just three months later. The club store operator reported a net income of $2.384 billion in February that grew to $2.34 billion at the end of May.

This sure looks like a value investment to me, the data indicates Costco’s business and income are growing yet its’ stock price is dropping. What’s going on here? My guess is that all the hysteria about Amazon (NADAQ: AMZN) totally conquering retail is driving investors away from Costco.

Costco Stock is overpriced

A related development is that Mr. Market has realized that Costco stock is way overpriced. My take is that it should be trading at around $100 a share, but it’s been fetching a far higher price for as long as I can remember.

Despite that Costco is still a really good stock its owners were rewarded with a 21.93% return on equity on May 31, 2017. They also took home a 50¢ a share dividend on May 10, 2017. That makes Costco a really good stock but not yet a value investment because it is overpriced.

Costco is not a stock to buy right now; it’s a stock to watch because the price is falling. The value characteristics are certainly there; including an unsexy company in an unfashionable business, that’s out of favor with Mr. Market. Yet the price still high to be a classic Graham-type value investment.

Costco is generating a Lot of Cash and Value

Costco also has a lot of cash for a retailer. It reported a free cash flow of $1.066 billion, $5.725 billion in cash and short-term investments and $4.723 billion in cash from operations on May 31, 2017.

Although there was one worrying sign; cash from operations dropped by $253 million during the quarter that ended on May 31. Costco reported $4.976 billion in cash from operations in February and $4.723 billion in May. The most likely cause of this was falling gasoline and food prices.

Despite Costco’s revenues are up which is a sure sign of increased sales. That indicates Costco might be immune to some trends in the modern retail environment including growing ecommerce, wage stagnation, growing income inequality and changing lifestyles.

Is Costco Profiting from the Retail Apocalypse?

Some skeptics will point to Costco’s success as evidence there is no retail apocalypse. My response to that is the mass closing of stores in the retail apocalypse is driving at least part of Costco’s growth.

One reason why Costco’s sales are increasing is that competitors like Sears, Kmart, JC Penney and some supermarkets are closing stores. The demise of Sears Holdings (NASDAQ: SHLD) in particular is a godsend for Costco because it competes for many of the same middle and upper-middle class customers.

The closing of eight Sears and 35 Kmart stores was announced on July 7, CNN Money reported. That brings the number of Sears Holdings shuttered in 2017 to 279. This means Sears has closed more stores in the first months of 2017 than in all of 2016 when it closed 240 locations.

One reason why Sears’ demise helps Costco is that customers figure Costco will be there next month; or next year, but Sears and Kmart will not. Nobody’s going to purchase anything with a warranty; or that they might need to return, from a store that might close.

This means that the working and middle class people who were shopping at Sears and Kmart have more reason to head to Costco. Costco also offers far better customer service; and a lot of things Sears and Kmart do not carry such as groceries, clothes and precooked meals.

Is Costco Amazon Proof?

The billion dollar question must be; is Costco Amazon proof? My take is that Costco is fairly invulnerable to today’s Amazon – but not tomorrow’s Amazon.

Amazon’s recent moves such as trying to purchase Whole Foods Market (NASDAQ: AMZN), considering a purchase of BJ’s Wholesale Club and greatly expanding its fulfillment center network should worry Costco.

Owning Whole Foods will give Amazon access to more of the higher priced high quality foods Costco offers. It also gives Amazon a network of 400 brick and mortar locations for Prime members to pick up orders and drop off returns and pay for items in cash. Whole Foods stores can also be used as local or regional hubs for same-delivery services including Amazon Fresh.

A major menace to Costco would be Amazon adding hot food from Whole Foods to Prime. These meals can be delivered to customers via UberEATS, Deliv, GrubHub (NYSE: GRUB) or a new app-based solution from Amazon.

Other threats include similar services from Kroger (NYSE: KR) and Walmart (NYSE: WMT) both of which are experimenting with same-day delivery. Kroger is also making aggressive moves into the realms of hot food and natural items.

Costco is trying to counter this with lower prices online; delivery via Google Express and higher quality food. Costco locations in the Los Angeles and Sacramento areas are offering a higher cost “Shake Shack Style burger,” The Sacramento Bee reported. Such efforts can be problematic because they will increase operating expenses.

Despite the Amazon threat I think Costco will remain a value investment for some time to come. I’d recommend that investors watch Costco and buy the stock, if it drops below $120 a share. Charley Munger is right; Costco is a value investment at the right price.