Great Results But is it Already in the Price?

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I’m a great advocate of ignoring short term price movements in favor of focusing on the underlying value in a stock but in the case of Costco Wholesale (NASDAQ: COST) this week  I am going to break that principle. I think the price action told you all you need to know. In other words, a strong set of results was met with a nice rise and then a negative statement from Dollar Tree (NASDAQ: DLTR) hurt the sector and immediately wiped out the gains. Costco closed lower just before the results. Go figure.

Now I know what you are thinking. Here is going to be another boring article which can be summarized as ‘great stock but fairly valued, no buying opportunity here.’ If so, you would be right, but I’m not going to apologize for this. If you want to read writers that laud jubilant pom-pom praise on a stock because they know it gets attention then you can find that elsewhere. I happen to invest my hard earned money in the things I write about, so forgive me if I express caution on occasion.

 

Costco Delivers

That said, the important thing is to monitor developments here, and I think it is positive for Costco. If you agree with my general investment thesis of the risk weighted towards US upside/China downside then the big box retailers like Costco, Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) are well worth looking at.

The general idea is that as credit conditions ease in the US and employment gains slowly increase we should see stronger end market demand coupled with some margin increases from deflation caused by a relatively weaker China. If you buy the argument that emerging market (EM) demand growth is behind the marginal increases in certain commodities, then if GDP growth is slowing in the EM world so commodity and raw material costs should moderate too.

For example, I have fleshed out this argument with regards to oil/gasoline in an article linked here. You don’t have to read the whole article, just note the contributions to oil demand growth made by Asia/Pacific in recent years and then think about what could happen if that slows.  Similarly go and look what companies like Cree and Intel are saying about falling demand and prices for things like LEDs and semiconductors and this is partly due to weaker than expected EM demand.

Before I develop this argument I want to demonstrate how things are trending with Costco. Here is a chart of comparable sales growth, revenue growth and gross margin movements.

 

There appears to have been a trade off between revenue growth and gross margin movement since the start of 2011, but the market got excited by the combination of margin improvement and revenue growth in the last quarter. As the chart demonstrates, this looks to be more about contributions from new stores, because comparable same store growth wasn’t as strong as revenue growth. No matter, these metrics are trending in the right direction.

 

How the Industry is Performing

Going forward the likely benefit from deflationary input costs is going to come from apparel and electronics. The drought in North America has contributed to soaring feed costs, and protein costs are inevitably rising as a consequence. This is inevitably going to hold back margin expansion but opportunities still exist.

For example Wal-Mart recently pleased the market by lowering its future capital expenditure plans and confirming it is on track to reduce its operating expense margins by 100 basis points from 2013 to 2017. Margins matter, and if gross margins reduce going forward then Wal-Mart will find itself in a favorable position.  Similarly, Target has performed well this year as its strategy of store remodeling has brought about favorable same store sales growth. In common with Wal-Mart and Costco the stock has hit a new 52 week high recently.

 

The Bottom Line

So if top line growth looks good and margins are likely to expand then why aren’t these stocks raging buys?  As ever, I don’t think you can divorce a stock’s prospects from its evaluation, and it’s hard to conclude that they are cheap. All it took was for Dollar Tree to give a disappointing update, and Costco retracted pretty sharply. Dollar Tree's problems look more company specific (it has trailed rivals sales per store growth for a while) but even this is enough to scare investors. Turning back to Costco, on a PE of around 25 it looks fairly valued to me and fairly valued stocks tend to not tolerate any earnings disappointments. The good news does look like it has already been baked into the price.

With that said, the outlook does appear good here and it fits within an overall investment theme that is working this year. My guess is that any significant dip in the share price will be met by buying, but value orientated investors might want to wait for that dip first.


 SaintGermain has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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