Why the Market Repriced Costco Shares

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In the equities markets, sudden stock price movements to the downside tend to be described with violent relish. Shares buckle, tank, dive, or crater, because they are getting pummeled, punished, beaten down or otherwise manhandled by frustrated investors. Such movement is also portrayed in terms of departure, as shareholders desert or simply flee a losing ticker in waves.

I admit to using most of these cliches myself when discussing plunging stocks. They provide a convenient shorthand; moreover, I'm certain my editors would frown on characterizations like "Investors in Subscription Box Wonderland resembled a motorcycle gang abandoning a roadhouse brawl in a soon-to-be-canceled Netflix dystopia."

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But all this colorful and emotional rendering of fervid selling masks what's often really happening when a stock stumbles badly. That is that the market, through the collective best guess of institutional and retail investors, is repricing shares to a more accurate fair market value on a near-term basis.

Consider Costco Wholesale (NASDAQ: COST) shares, which pulled back nearly 9% last Friday following the company's fiscal first-quarter 2019 earnings report. It's rare for Costco stock to move so dramatically in a single session. With its stable cash flow and status as one of the world's largest retailers, Costco usually weathers its earnings release periods with equanimity. The company revealed a minimal deviation from anticipated results this quarter, so it wasn't a victim of a wide earnings miss that amplified market doubt regarding its future earnings.

Instead, last week, certainty about Costco's earnings and related market value likely increased among investors. Confidence that near-term upside may be limited is one reason shareholders with shorter holding periods often readjust their positions. This is true even of a bellwether like Costco, which has a huge market capitalization of $88 billion yet has appreciated at nearly twice the rate of the S&P 500 index over the last five years.

Two factors limiting Costco's share price

Pressure on profit margins which may not soon relent is one of two significant factors contributing to Costco's repricing. On the company's earnings conference call last week, CFO Richard Galanti attributed a 50-basis-point drop in gross margin in part to a weaker performance in fresh foods, due to competition from other grocers.

My Fool.com colleague Jeremy Bowman cites an acceleration into delivery services from competitors like Walmart and Kroger, and the continued strength of Amazon.com-owned Whole Foods Markets, as specific instances of these competitive hurdles.

Deflation is also contributing to margin weakness, particularly in fresh food. Direct wholesale competitor B.J.'s Wholesale Club (NYSE: BJ) informed investors in its own earnings report in late November that it's experiencing cost deflation. In the grocery business, lower costs from suppliers tend to get passed on to customers in the form of promotions and discounts. The consumer packaged goods conglomerates that sell to grocers and wholesale club operators, like J.M. Smucker, for example, have also recently cited deflationary impacts on earnings.

Even though Costco hasn't indicated material cost variances from its suppliers, a deflationary environment forces it (and other grocery peers) to compete with the grocers that are already passing on savings to customers via discounted stock-keeping units.

While for now, such competitive action appears to be confined to fresh foods, it could spread to Costco's broader food and sundries business, and this could cause more palpable discomfort for Costco's management team. Last year, the retailer's food and sundries and fresh foods merchandise categories, which together replicate a typical grocery store's offerings, made up 41% and 14%, respectively, of total company revenue.

A second compressing force weighing on operating margin exists in Costco's membership fees. Galanti reminded investors on the earnings call that of the company's 9.5% membership revenue improvement in the first quarter, roughly half was due to the membership fee increases that originated in June 2017. This effect will decrease in the coming quarters. Galanti stated:

Reduced leverage from fee increases in the near future is somewhat problematic, as Costco manages its wholesale business at near-breakeven to derive company operating profit from its membership fee revenue. Absent a fee increase tailwind, Costco will have to find marginal cost savings in overhead operations in 2019 to keep its basic earnings model intact.

The company could alternately rely on producing higher comparable sales in upcoming quarters, however, comps are already quite healthy -- they improved 9.5% in the recently concluded fiscal 2018 year. Thus, sales performance in 2019 is already up against a tough comparison base from the prior year.

Rationality, not fear

Shareholders favoring an extended holding period for Costco's shares likely already understand that last week's reaction to earnings reflected a rational repricing of the stock rather than a fear-based exodus. The market, which allowed Costco to trade at 33 times forward earnings as recently as this summer, has pulled Costco's forward P/E ratio from 29.5 to 26 following the company's earnings report on Dec. 14. This expresses a pragmatic assessment of limited upside for at least a quarter or two.

The sell-off can also be seen as adjusting the share price closer to the S&P 500 sector average for consumer staples stocks. The current forward P/E of this sector rests at 18, according to market advisory firm Yardeni Research. Of course, over the years, Costco has exhibited a knack for regaining a higher earnings multiple in the rare instances in which its premium to peers has been trimmed in this fashion.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Asit Sharma has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends AMZN and NFLX. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.