Costco Is Doing Almost All Things Right, But It’s Not a Buy Here

Stock Market

Costco Wholesale (NASDAQ:COST) is a classic example of a stock that many investors got interested in after COST stock saw a dip of around 20% in 2022. The company has consistent profitability, sales growth is strong and free cash flow generation is robust.

But is COST stock a buy after reporting a strong third-quarter fiscal-year-2022 earnings report that showed continued momentum?

No. I don’t see COST stock as a buy mainly because of one key factor — valuation.

COST Costco Wholesale $450.73

Costco Q3 and May Sales Were Strong

Costco reported Q3 FY 2022 earnings on May 26, 2022.

Revenue of $52.6 billion was a beat by $1.11 billion. The EPS GAAP figure of $3.04 was in line with expectations. Net sales for the quarter increased 16.3%, to $51.61 billion, from $44.38 billion last year.

Net income for the quarter was $1.353 billion, or $3.04 per diluted share compared to last year’s third-quarter net income of $1,220 million, or $2.75 per diluted share.

On top of that May sales results were also strong.

Costco reported net sales of $18.23 billion for the four weeks that ended May 29, 2022, an increase of 16.9% year over year. For the thirty-nine weeks that ended May 29, 2022, Costco reported net sales of $165.56 billion, an increase of 16.5% year-over-year.

The earnings and May sales results show momentum in revenue that is bullish for shares of Costco. However, the stock has not made any significant rally following these strong results. This is not good news if combined with a key economic indicator: U.S. retail sales.

Costco Sales Are a Proxy for the Health of the Economy

I argue that Costco, being an exceptionally large company and a dominant retailer with a strong business model, is a barometer for the health of the U.S. economy. Higher sales means the consumer confidence is high and higher economic growth expressed in the gross domestic product should be expected.

The U.S retail sales as of January 2022 have been increasing despite high inflation, supply chain problems, and rising energy prices.

The bad news is that the U.S retail sales growth has been slowing for the past three consecutive months.

Therefore, sales of Costco should be monitored closely, as any slowdown will confirm the broader weakness in the U.S. retail sales that should lower economic growth.

COST Stock’s Valuation Is Worrisome

I am skeptical due to two facts and trends. “ Costco reported that its total third-quarter inventory was up 26% year-over-year” and “Senior Vice President of Finance Bob Nelson told analysts on Thursday’s earnings call that the company is purposely building inventory in its e-commerce business.”

Building inventory is not bad, but not being able to sell it quickly is bad for the business. Costco is building inventory in its e-commerce business. Does this mean that it expects to pass the inflation to its products? It could well be the case. This could mean lower sales.

Apart from the inventory trend, the valuation of COST stock is not too attractive. The stock trades mostly at a large premium in terms of key financial ratios compared to the relative to the Consumer Staples sector. The PEG GAAP (TTM) of 1.94 does not support a stock that is undervalued.

On the date of publication, Stavros Georgiadis, CFA  did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn.

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