I am interested in Costco Wholesale Corp. (COST-Q) as a potential investment. We shop there regularly and the place is always buzzing. The people working there seem happy, and the products we buy are of good quality. Over the years the stock has done well, and in 2023 it did extremely well. However, the dividend yield is not impressive. What are your thoughts?
Investing in companies whose products and services you are familiar with can be a profitable strategy. The legendary fund manager Peter Lynch endorsed this philosophy in his book, One Up on Wall Street, in which he popularized the phrase “invest in what you know.”
Being a customer gives you insights that you might not otherwise have. There’s also something satisfying about participating in the profits of a business that you use regularly. It’s one reason I own stocks such as Telus Corp. (T-T), Enbridge Inc. (ENB-T) and Restaurant Brands International Inc. (QSR-T).
However, having a good experience with a company isn’t a sufficient reason to invest. You also need to investigate fundamentals such as the company’s earnings and revenue growth, competitive position and the stock’s valuation.
So let’s do that now with Costco.
Shares of the membership-based warehouse retailer have indeed been on a tear, having gained about 50 per cent in the past year. At last check early on Friday afternoon, they were trading at about US$739 on the Nasdaq Stock Market.
For the current fiscal year ending in August, Costco’s earnings per share (EPS) are expected to climb to US$16.15, up from US$14.16 in the previous year, according to the average estimate of analysts surveyed by Refinitiv. Dividing the current stock price by expected fiscal 2024 EPS gives us a price-to-earnings multiple of just under 46.
That’s a relatively high number, but strong companies with steady sales and earnings growth typically command a premium P/E. However, a high P/E also makes a company vulnerable to a sell-off if results disappoint. That is precisely what happened to Costco’s stock earlier this month when second-quarter revenue rose 5.7 per cent to US$58.44-billion but missed estimates by about US$720-million, sending the shares down 7.6 per cent – their biggest drop in nearly two years.
The shares have recovered some ground since then, but they are still well below their 52-week closing high of US$785.59 reached on March 7, before the results were released.
Kelly Bania, an analyst with BMO Capital Markets, called the stock’s recent drop a “healthy breather.” She attributed the weakness, in part, to investor disappointment that Costco did not raise its membership fee, something that is “still an eventuality.”
“We continue to believe that Costco’s advantaged business model, consistency of results, and execution make it deserving of a premium multiple,” Ms. Bania said. Despite the disappointing results, she raised her fiscal 2025 adjusted EPS estimate to US$17.25 from US$17 and raised her target price to US$800 from US$770. She also reiterated her “outperform” rating on the shares.
One of Costco’s strengths is its ability to find novel ways to generate consumer interest and boost sales. For example, when the company added one-ounce gold bars last year to its vast selection of groceries, electronics and appliances, it sold more than US$100-million of the precious metal online in the three months ended Nov. 26. It has since added silver bars and coins, which it says are also selling briskly.
The company’s e-commerce business is also growing rapidly, with comparable sales rising 18 per cent in the second quarter, helped by big-ticket general merchandise items such as appliances and tires.
Regarding Costco’s dividend, the meagre yield of 0.55 per cent reported on financial websites doesn’t tell the full story. That’s because it is based on the company’s regular quarterly dividend of US$1.02, or US$4.08 over the previous 12 months. But Costco also pays special dividends every few years, including a US$15 dividend declared in December that returned about US$6.7-billion of cash to shareholders.
This was the company’s fifth special dividend in the past 11 years, and it probably won’t be the last. Costco has also been raising its regular quarterly dividend annually for many years, a pattern that will almost certainly continue.
While there is little doubt that Costco is an extremely well-run company whose sales, earnings and store count will continue to grow, the stock’s rich P/E multiple gives some analysts pause.
“We maintain our neutral rating primarily on valuation,” Michael Baker, an analyst with D.A. Davidson & Co., said in a note following the second-quarter results. Still, Mr. Baker hiked his price target to US$680 from US$600 previously. The new target is based on a multiple of 40 times his calendar 2025 EPS estimate. Even with the boost, however, his price target is still well below Costco’s current trading price. It is also well below the average price target of about US$775, according to Refinitiv. Most analysts remain bullish on the stock, which has 25 buy recommendations, 12 holds and no sells.
If you aren’t bothered by Costco’s valuation and still intend to invest, there are a couple of ways to go about it. You could purchase Costco shares directly, which would require you to convert your Canadian dollars into U.S. currency (assuming you don’t have U.S. funds already). Keep in mind that currency conversions are a profit centre for brokers and are typically done at an unfavourable exchange rate for the customer.
Alternatively, you could minimize currency conversion costs by purchasing Canadian Depositary Receipts (CDRs), which are shares of U.S.-listed companies that trade on a Canadian exchange in Canadian dollars. CDRs are also currency hedged, which will protect you from the negative impact of a sharp rise in the Canadian dollar. However, currency hedging will also blunt the positive effects of a falling loonie. Another advantage is that Costco’s CDRs trade at a much lower price than the stock itself – the CDRs were changing hands at about $34.60 on Friday afternoon on the NEO Exchange – making it easier to invest small amounts.
Finally, remember that there is nothing stopping you from waiting for a better entry point on the stock. Just as you look for deals when you shop at Costco, you can exercise the same frugality when considering an investment. The risk, of course, is that the stock will continue to rise, but that is beyond your control. Whatever you decide, remember to maintain a diversified portfolio to control your risk.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.