Will Costco Live Up to Its Hefty Valuation?

By Markets Fool.com

Costco Wholesale (NASDAQ: COST) reported its fiscal 2016 year-end results late last month. The stock initially jumped 3.4% on the earnings news but has shed those gains as it appears the market has grown wary of coming challenges for the company.

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In this segment of Motley Fool Money, Chris Hill, Jeff Fischer, and Jason Moser discuss the longer term headwinds that both Costco management and shareholders should be considering as they form their outlook for this retail giant.

A full transcript follows the video.

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This podcast was recorded on Sept. 30, 2016.

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Chris Hill:We begin this week with retail and beverages.Costco'sfourth quarter profits came in higher than expected thanks in no small part to the lower costs from its new credit card deal with Visa. It looks like a good deal, but what else did you think about the quarter, Jason?

Jason Moser: Yeah. I think it was good to see that they were able to present this whole transition with Visa in a positive light. I mean, there have been some questions, I think, at least over the quarter in how it was actually working out. I do think the market is probably making a bit more of this quarter than it's probably warranted. I think Costco is a great business, no concerns there. I think it's very difficult to make the case from today's evaluation, that it's actually a market beating investment.

That was the concern we had in Million Dollar Portfolio for quite some time, so we did actually end up selling it, from the portfolio, but again, I must reiterate, it wasn't because we think it's a bad business, we love this business. It's just the evaluation presented a tough case, there. We had questions like how much longer is the market going to assign a premium multiple to the business. How are younger generations, actually, viewing Costco, given the move to e-commerce and the other opportunities that are out there. What kind of pricing power do they ultimately have? I think it's worth noting that they have a very high premium on these executive memberships, which, I know our guy behind the glass, here, not Steve, but Mack is a big Costco addict, is that safe to say, Mack?

Hill: I'd like to say enthusiast.

Moser: Enthusiast. Okay. I don't know if Mack's an executive member, but ultimately, while it accounts for one-third of their member base, it actually accounts for about two-thirds of their sales. I think the idea over time is trying to get people to move up to that executive membership, and I'm not sure how well they are going to be able to execute on that front. There are just some questions there in regard to growth that we ultimately felt like presented more challenges than opportunities. Again, good quarter, I think the market is probably a little bit overly enthusiastic about it, but what are you going to do?

Hill: In terms of the pricing power, what we have seen in the past is any time they have moved that basic membership fee up, members don't bat an eye. That is one more lever they can pull at some point if they need to.

Jeff Fischer: Jason, are they attacking the e-commerce market, or are they letting that go toAmazon?

Moser: I think it's safe to say that they, I think, they can be doing better on this front. It ultimately accounts for a very small sliver of the business, and it's growing at fairly anemic rates when you compare it to something like Amazon. They are definitely on picking up share in that world, but by the same token, a lot of qualities with Costco, they share a lot of the same qualities with Amazon. I think an interesting little nerdy statistic here, but if you go through the most recent quarterly earnings call, some form of the word member appears 64 times in that call. This is a very member-centric business, much like Amazon. I think when you have businesses that are very member-centric like that, they tend to make very good decisions that insure long-term sustainable success. Again, I think this is an attractive investment. I think you have to be very particular with the valuation. Again, positive quarter, we would just love to see the top, take a big hit, obviously.

Fischer: Mack, here, gets a lot of his dress shirts from Costco, so if he starts to change his shopping habits, then we know.

Moser: He looks pretty sharp.

Fischer: He's the canary in the coalmine.

Hill: There's the red flag, for all of us.

Chris Hill owns shares of Amazon.com. Jason Moser has no position in any stocks mentioned. Jeff Fischer owns shares of Amazon.com and Visa. The Motley Fool owns shares of and recommends Amazon.com, Costco Wholesale, and Visa. 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.