E Has Costco Become A Bargain After Its Recent Correction?

Costco (COST) enjoyed an impressive rally in the 11 months leading to early September, as it rallied 57% during that period. However, the stock has incurred a 10% correction in the last month. As Costco rarely incurs prolonged corrections and almost always trades at a premium valuation, the big question is whether the stock has now become a bargain.

The Cause of The Correction

Approximately half of the losses of the stock have resulted from its recent earnings report. While the retailer met the analysts’ estimates, it announced that it expected a material weakness in internal control. The weakness relates to general information technology controls in user access and is expected to be remedied before the end of fiscal year 2019. On the one hand, the market always punishes stocks that are surrounded by uncertainty over internal control. On the other hand, management of Costco stated that it did not expect any changes in its financial statements. In addition, this is certainly a non-recurring issue. Therefore, as soon as the issue is remedied, the stock is likely to retrieve its recent losses. In fact, the stock is likely to retrieve its losses long before it remedies this problem, when the dust from the announcement settles and the market realizes that this temporary setback does not affect the growth trajectory of the stock.

Business Overview & Growth

Costco has an exceptional business model. It charges its customers an annual fee to offer them access to its bargain prices. These membership fees, which are approximately $3.1B per year, seem negligible when compared to the $138B annual sales of the company. However, Costco sells almost all its products at prices just above its cost base so its annual earnings are approximately equal to its membership fees. As a result, membership fees constitute a vital component of the performance of the company. Moreover, thanks to the high renewal rates of memberships (~90%), these fees provide a strong support to the earnings of the company.