Investors should cash out of Costco

By Robert Walberg

When the nation's retailers reported generally disappointing February sales this morning, Costco Wholesale (COST, news, msgs) was no exception. Investors should take the cue and cash out of the warehouse club's stock.

Costco said sales at stores open at least a year rose 4%, well below the consensus estimate of 5.1% growth. Earnings also failed to impress Wall Street, with a 16% year-over-year drop in net income on an underwhelming 7.3% jump in revenue during the company's fiscal second quarter.

To be fair, the earnings numbers included about $95 million in one-time charges. Excluding those, Costco earned 66 cents a share, a 6% improvement over the same period last year and in line with Wall Street estimates. Yet there was nothing in the company's monthly sales numbers or its quarterly earnings report to excite investors.

Here's why investors should see the disappointing news as a sign of things to come and get to the checkout stand.

More competition

Costco's strength is its brand name and reputation for quality, higher-end merchandise. Consumers can find everything from fine wine to plasma-screen televisions. As a result, the company tends to attract higher-income customers than its rivals, Wal-Mart Stores' (WMT, news, msgs) Sam's Club and BJ's Wholesale (BJ, news, msgs).

• Video: Behind the scenes at Costco

Yet despite these advantages, Costco's margins aren't much better than its competitors. In fact, operating margins (minus special charges) fell an additional 0.37 percentage point year over year to 2.7%. The decline flies in the face of management's stated goal of bolstering margins by at least 1 percentage point over the next five years. Costco will have a hard time realizing that goal considering tougher competition from Sam's and BJ's -- both are adding higher-end product offerings -- combined with relatively high energy costs and growth efforts. Look for margins to continue narrowing -- a pattern that has persisted for a few years now.

Another concern is the threat of cannibalization from additional store openings. Costco currently operates 504 warehouses, including 371 in the United States. That's not a very big number for most retailers, but when you consider that there are about 570 Sam's Clubs and 165 BJ's stores -- both chains plan to expand -- the potential for additional membership-based store openings is becoming increasingly limited. Costco said it plans to open 13 to 14 stores this year. It may not be an immediate concern, but there's a long-term, growing risk of saturation, which can only mean slower top- and bottom-line growth.

Maybe it is this concern over future growth potential, as well as the company's inability to grow operating margins consistently, that explains why Costco's valuations are running a bit below its historic norm of about 22 times earnings. I don't see the discount as a sign that the stock is cheap at these levels. Costco might be the best of breed, but it faces an increasingly uncertain future and shows no signs of knowing how to improve operating efficiencies. The stock will do well just to keep pace with the broader market in the months ahead.

To have success in the retail sector, investors should focus their attention on companies that routinely grow same-store sales, margins and earnings at a rate better than the competition, while at the same time maintaining firm controls over inventory. There also should be plenty of room for store openings to drive top-line growth. Costco fails to meet enough of these benchmarks to receive a passing grade.

Given that the stock is up by more than 18% over the past six months and that it is trading just off its 52-week high, traders should take their cue from today's reports and cash out. There's near-term risk of the stock trading around $50, with a potential retest of last September's low of $46.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.