The Costco Stock Drop: Is This Bad Earnings Report a Buy Opportunity?

by Samuel Taube, Managing Editor, Investment U
costco drop

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Costco (Nasdaq: COST) built its business on passing bulk discounts on to the consumer. And in the last couple weeks, Costco stock has been selling at a discount as well.

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Why has the stock dropped almost 10% since the beginning of the month? The company’s disappointing Q2 earnings report is partially to blame. Low food prices have also played a role.

But for Costco shareholders, the biggest question isn’t “why did the stock drop?” It’s “when will it go back up?” There are many reasons to believe that this tumble is a buying opportunity for Costco stock.

Below, we’re looking at the malaise that led to this drop... and Costco’s prospects for a recovery.

The Forces Behind the Costco Stock Drop

Times are tough for grocery store operators. A prolonged glut in food prices has pushed down earnings across the industry. And competition from cheap and convenient grocery alternatives like Wal-Mart (NYSE: WMT) and Amazon (Nasdaq: AMZN) have made matters even more difficult.

As a result, Costco isn’t the only grocery stock to sink on a recent earnings miss. In fact, Target (NYSE: TGT) and Kroger (NYSE: KR) are doing considerably worse.

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Aside from low food earnings, there are a few other forces pushing Costco stock down at the moment. The company is one of the nation’s largest gasoline retailers, and it has seen its gas margins fall as the price of oil rebounds from its 2016 lows.

Some investors have been spooked by Costco management’s solution to these problems. After the missed earnings report, the company announced that it will raise membership fees by $5 per year.

The news did not play well with the investing public. It came off as a desperate response to serious problems faced by the bulk retailer.

Why This Sell-Off Could Be a Buying Opportunity

Let’s unpack the bearish narrative about Costco. Skeptics believe this price hike was a disastrous decision that will scare away customers, thus making the firm unable to recoup its losses from food and gas sales.

But this narrative is full of holes. For one thing, the price hike is so small that many customers may not even notice it. An extra $5 per year comes out to less than $0.50 per month. If you’ve bought something at a vending machine in the last month, then you’ve spent more than the new monthly Costco markup. And Costco’s members are nothing if not loyal. It will take more than a $5 annual fee to get them to quit the retailer.

What’s more, the company’s financial data disputes the notion that Costco is bleeding money on food and gas. In Costco’s most recent earnings call, CFO Richard Galanti explained that the low earnings numbers have temporary causes.

Gas did drag down Costco’s profitability in Q2 of 2017 - but not in the way you’d think. During the depths of the oil glut in 2016, Costco saw unusually high gas profits. Analysts quickly priced these exceptional numbers into their expectations. In the process, they set Costco up for a big letdown once oil prices (and thus Costco’s supply costs) started to recover.

Notably, oil prices have fallen sharply since Costco’s earnings report. If oil prices stay below $50 a barrel, that should help restore margins on the firm’s retail gasoline sales.

The company also lost a few cents per share on higher-than-expected foreign exchange expenses. These tend to be short-lived market effects. If Deutsche Bank could survive the currency market turmoil in the aftermath of Brexit, then Costco can survive this.

When you really dig into Costco’s troubles, one thing becomes clear: They’re all temporary. The price increase is much ado about nothing. And the earnings problems will pass as the commodities market self-corrects.

Costco stock may not have bottomed out yet - some analysts expect the price to get as low as $150. But when it does hit bottom, picking up some shares may be a wise move. It would give Costco fans yet another way to buy useful things at a discount.

Good investing,

Sam

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