[ad_1]
Introduction
In my previous report, I highlighted Costco Wholesale Corporation‘s (NASDAQ:COST) exorbitant valuation as a sign of irrational exuberance in the financial markets:
Costco is trading well above its historical median P/E ratios, and we are getting pretty close to the 1999 peak valuation for COST stock. While we may or may not be in an artificial intelligence bubble, Costco certainly appears to be bubblicious.
Reverse DCF exercise
Based on its current stock price of ~$732 per share, Mr. Market is currently pricing in a 5-year CAGR revenue growth rate of ~23% into Costco’s stock! Given Costco’s mid-single-digit growth rates, the market pricing in ~5x faster growth into COST stock for the next five years is simply ridiculous. Yes, Costco is a serial growth compounder; however, such pricing is a tell-tale sign of irrational exuberance in the stock market.
In QQQ: Prepare for Turbulence, I highlighted the role of abundant liquidity in the ongoing melt-up in financial markets. If liquidity dries up, Costco’s stock could struggle big time, as investor expectations built into the stock are completely out of touch with business reality. Costco is a mature (slow-growing) retailer priced for hypergrowth.
Source: Costco Is Dead Money
Since the publication of that report, the big box retailer’s shares have rallied by +16% over the last three months:
In this note, we will examine the key driver of this latest leg up in Costco stock and re-evaluate its long-term risk/reward to formulate an informed decision.
Demystifying COST Stock Rally
While Costco bulls will point to its high-quality business model and healthy financial performance in order to justify the ongoing rally in COST stock, the single most important driver of this run-up is a wild expansion in trading multiples. Over the last three months alone, Costco’s forward P/E multiple has expanded by +15.5% from ~46x to ~53x, which is more or less the entirety of COST’s recent move higher!
Now, Costco outperformed top and bottom line estimates for Q3 2024, and consensus revision trends have largely been moving in the right direction. However, the quantum of Q3 revenue and EPS beats were de minimus, and analyst estimates for upcoming quarters are only slightly higher than where they were three months ago. Hence, Costco’s business performance and near-term outlook do not justify its trading multiple expansion.
In the financial markets, irrational exuberance knows no bounds, and so, Costco’s bubbilicious valuation could potentially go even higher in the short run. That said, over the long run, a negative equity risk premium [as measured by FCF Yield minus 10-year US Treasury yield] is simply unsustainable.
Costco is a cash-cow business with an incredible moat; however, Mr. Market pricing COST stock as a safer asset than risk-free US Treasury bonds is quite simply ridiculous as Costco cannot tax the American public or print money out of thin air. Now, some may point to Costco’s past compounding and future growth potential to defend its premium valuation. While I understand the quality growth aspect, paying up ~53x forward earnings for a mature retailer growing at single-digit rates doesn’t seem like a bright idea.
Costco Fair Value And Expected Return
After recording healthy double-digit top-line growth during the inflationary wave in 2020-22, Costco has seen its growth rates slow back down to mid-to-high-single digits over recent quarters. And, according to consensus street estimates, Costco is projected to compound sales growth at 6-7% per year for the next 5 years.
Considering Costco’s footprint expansion plans of 25-30 clubs per year and comparable store sales growth of 3-5% per year, I believe Costco can deliver 6-9% CAGR sales growth over the next five years. While our growth assumption is slightly higher than street estimates, I think a 7.5% CAGR sales growth assumption is reasonable. Like in our previous evaluation, we have used a 5-year modeling period and generous assumptions for steady-state free cash flow margin [+3%] and terminal growth rate [+5%]. While these model assumptions are quite straightforward, please feel free to share your questions, thoughts, and/or concerns in the comments section below.
Here is our updated valuation model for Costco:
From our previous assessment, Costco’s fair value estimate has increased to ~$402 per share [from ~$394 per share]. However, with COST stock trading at ~$850 per share, Costco now has a downside of roughly -53%.
Assuming a somewhat generous P/FCF exit multiple of ~25x [accounting for Costco’s economic moat], we get to a 5-year price target of ~$722 per share, which implies a CAGR return of -3.21%.
In light of its latest leg up, Costco’s long-term risk/reward has deteriorated even further, with Costco stock now looking worse than dead money for the next five years. With COST’s base case expected 5-year CAGR return falling well short of my investment hurdle rate (of 15% per year), long-term market (SPY) returns (of 8%-10% per year), and risk-free treasury yields (of 4%+), I continue to view COST stock as a tactical “Sell” for long-term investors.
As the German proverb goes – “Trees do not grow to the sky”
With animal spirits running wild in the financial markets, Costco’s exorbitant valuation could stretch even further in the near term; however, ascribing hypergrowth to a mature retailer is irrational. Taking profits on a serial compounder like Costco is a tough decision, but nobody ever lost money taking a profit, even after accounting for taxes! A negative equity risk premium is unsustainable, i.e., Costco will suffer a mean reversion sooner or later. With risk-free treasuries yielding ~4-5% right now, long-term investors have a solid hiding spot as they wait for Costco’s stock to come back in line with business realities.
Key Takeaway: I continue to rate Costco a “Sell” in the mid-$800s.
Thank you for reading, and happy investing! Please share any questions, thoughts, and/or concerns in the comments section below or DM me.
[ad_2]
Source link