Costco Stock Upgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Up more than 13% in price over the past 52 weeks (and up more than the S&P 500 as well), Costco (NASDAQ: COST) shares sell for a premium valuation of more than 31 times earnings. But one analyst thinks Costco stock is worth the premium -- and thinks it could rise even more in the year ahead.

This morning, Barclays Capitalannounced it is upgrading Costco stock to overweight and raising its target price by $10. At the new price target of $185 per share, Barclays is promising buyers of the stock about a 9% profit, which added to a 1% dividend should yield a nice round 10% gain. Is Barclays right about that?

Here are three things you need to know.

Could this be Costco's secret weapon in the battle against Image source: Getty Images.

1. Stagnating sales

Costco's sales haven't exactly been tearing up the track lately. In fact, over the past two years, sales gains have averaged less than 3%. On the other hand, profits have been rising twice as fast. 2016 profits were fully 14% higher than 2014 levels. If Costco can just find a way to goose its sales a bit, and if profits continue coming in faster than sales grow, then the company's bottom line should fatten up nicely.

In fact, that's what Barclays believes will happen. As reported on this morning, Barclays is predicting that both foot traffic and same-store sales will accelerate in the second half of 2017 -- and look even better when compared to the anemic sales growth seen in H2 of 2016.

2. Fueling profits

Helping to boost both sale and foot traffic, says Barclays, are expected "seasonally higher gas prices" this summer. When gas prices rise, Costco shoppers tend to seek bargains -- and since Costco offers discount gas prices to its members, that makes Costco a logical place to go for gas. (In fact, a recent survey shows that among grocers and warehouse store operators who also sell gas, Costco is the No. 1 place to go for gas.)

Not only does this trend bode well for sales receipts from gas purchases, but it also tends to convert gas buyers into Costco shoppers. (Since they're already filling up, they might as well go into the store and pick up some groceries while they're at it.)

3. And about those groceries...

That's another thing that Barclays finds appealing about Costco. In the midst of a retail war between online e-tailer (NASDAQ: AMZN) and basically everyone else in retail, Barclays notes that its survey of 800 Costco shoppers shows that more than 80% of these consumers visit Costco warehouses specifically to buy food.

According, Barclays says this fact means that Costco's sales are "very protected" from, which has struggled to break into the grocery business big time. To date, Amazon has tried a variety of gambits to separate grocery consumers from their dollars, includingPrime Pantry, Amazon Dash, Amazon Fresh, and most recently Amazon Go.

So far, none of these initiatives has gone very far. Despite years of trying, if there's a magic formula to selling groceries online, Amazon has yet to stumble upon it. (We should also note at this point that yesterday, Wolfe Research downgraded Amazon stock, arguing that Wal-Martand other brick-and-mortar retailers are fighting back and cutting prices in a manner that will "pressure" Amazon's sales growth in the near future. Wolfe cut estimates for Amazon's earnings this year and next, and downgraded Amazon stock to "peerperform".)

The most important thing: Valuation

But enough about Amazon. We were speaking about Costco. Between its ability to sell gas (which Amazon doesn't) and its ability to sell groceries efficiently (which Amazon also doesn't), Barclays is right that there's a lot to like about Costco stock.

The one thing I don't like about the stock, though, is the thing that Barclays so casually dismisses: Its price. Barclays says that given its 80% immunity to Amazon, Costco's premium valuation is deserved. To an extent, I agree with that. Costco stock should cost more than a brick-and-mortar retailer like, say, Bed Bath & Beyond or Best Buy, which sell products that can just as easily be bought on Amazon -- shipped for free, and often at a lower price.

My only quibble is that deserving a premium valuation is not the same as deserving a huge 31 times earnings valuation, when a stock is only expected to grow those earnings at 10% annually over the next five years -- as is the case with Costco. Until Costco proves itself capable of growing faster than that, or until its stock price falls to a level more in line with how fast it can go, I'll be ignoring Barclays' advice -- and staying away from Costco stock.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon and Costco Wholesale. The Motley Fool recommends Bed Bath & Beyond. The Motley Fool has a disclosure policy.