Option Trade 
Costco Wholesale Corporation (NASDAQ:COST) Puts 
Tuesday, 27th September, 2016

** OPTION TRADE: Buy the COST DEC 16 2016 145.000 put at approximately $3.50. Place a pre-determined sell at $7.00.

Note: No protective stop losses added -- but if you wish to do so make it $1.40.

by Ian Harvey

September 27, 2016

Costco Wholesale Corporation (NASDAQ: COST), with its subsidiaries is engaged in the operation of membership warehouses in the United States and Puerto Rico, Canada, the United Kingdom, Mexico, Japan, Australia, and through majority owned subsidiaries in Taiwan and Korea, is scheduled to report its fiscal fourth-quarter results on September 29 after the market close. Analysts forecast earnings of $1.73 per share, in-line with the same period last year.

Costco has had a tough go of it lately. The stock has been trending sharply lower over the last month, and shares are currently down 5.3% on the year. Costco’s sales growth has started to slow, which is a big concern for the company moving forward. A big reason for the concern is that for years Costco enjoyed same store sales growth in a range of 6% and 7%, but that figure has fallen to around 4% in recent months, in part a result of the strong dollar that has led to deflation in many product categories.

For the 52-week fiscal year which closed Aug. 28, the warehouse club reported net sales of $116.1 billion, a 2% increase from the $113.7 billion reported last year. Those numbers aren't awful, but they hint at weakness.

When it comes to comparable sales, the numbers weren't great either, though they look better after adjusting for falling gas prices and foreign currency exchange. After the adjustment, the increase in the United States jumps from 2% to 3% and the Canada numbers go from a 3% decline to an 8% gain. International numbers were similar, moving from a 3% dip before adjustment to a 4% positive move after. Still, overall, before the adjustment, 52-week growth was 0%, and after it was only a 4% gain.

Those are mediocre results, which point to things that could hurt Costco's stock price going forward.

The company recently started offering new credit cards with Citibank, and is still suffering from some initial problems. Analysts see very little earnings growth this year.

Costco Wholesale Corp.’s 50 day moving average is $160.14 and its 200 day moving average is $156.44. The company has a market cap of $66.23 billion, a PE ratio of 28.57 and a beta of 0.59. Costco Wholesale Corp. has a 12 month low of $138.57 and a 12 month high of $169.73.

Why Costco?

Costco is facing some major headwinds this year. For two-consecutive years deflationary pressures have been negatively impacting on the company's results. Whilst cheaper prices are great for shoppers, it isn't great for its shareholders.

Revenue growth has been slowing over the last few years. The current consensus estimate is for earnings per share to come in at $5.29, just two cents higher than last year's earnings per share of $5.27. Whilst the retailer should deliver on this, it is hard to justify the premium the market is currently willing to pay for its shares over Wal-Mart and the rest of the market.

Costco has traditionally traded at a significant premium to Wal-Mart and deservedly so. In the last decade it has delivered stunning growth and has been one of the best performers on the S&P 500. But at this point in time it is very hard to justify paying 29x earnings for a company that is growing earnings at the smallest fraction of a percent.

A multiple of 29x earnings is not only expensive in comparison to Wal-Mart and the rest of the market, but it is also a premium to where Costco's shares have traded at in the last decade when earnings growth was stronger.

It is expected that the Fed will raise rates in December and then upwards of three times (all being well) in FY 2017. If this does eventuate then the US dollar index has the potential to break through the $100 mark once again. Therefore, deflationary pressures and currency headwinds will continue to plague the company and hindering its growth for the foreseeable future.

Although the market has been very patient recently, it is felt that another year of slow growth may cause many investors to head for the exits and drive the share price down to a more respectable level.

Ultimately management's guidance for the year ahead at the next earnings call will make or break the stock. If management appears overly bullish on FY 2017 and is able to expand margins to stimulate earnings growth then things may well be okay. But if it is reliant purely on a lift in sales to drive earnings growth then they may have a problem on their hands.

At the current price in this current economic environment, this discount retailer is simply too expensive.

As a warehouse club, the Costco model is built on offering great prices but limited selection. In the past, that made other warehouse clubs such as Wal-Mart's (NYSE:WMT) Sam's Club its only real competition. Now, however, the chain increasingly has to deal with traditional stores offering aggressive pricing.

Wal-Mart specifically has committed to spending billions to lower prices. That's a big problem for Costco, because the traditional retailer's deals don't require buying food in specific large quantities.

If a regular grocery store will sell a box of cereal at a price close to what Costco charges, but the warehouse club requires buying two extra-large boxes, it's easy to see why consumers may shy away from bulk purchases. That's not a big problem if it simply costs Costco some sales, but it becomes a much bigger issue if consumers stop believing Costco consistently has the best deal.

If that happens, people will drop their memberships -- and fees from people paying their annual dues accounts for 75% of the chain's profits.

Costco has mostly ignored the Internet because it's built its business around driving people to its stores. That makes sense because once people hit a warehouse; they can be enticed into buying things they'd not planned on. In addition, part of the Costco mystique revolves around bargain hunting in its stores.

That's generally been a strong formula. People join Costco partly because it's fun to shop in the stores even when you don't buy anything. Add that to the fact that prices are generally below other options (albeit with the hassle of having to buy in bulk), and you can see why the chain has thrived.

Amazon.com (NASDAQ:AMZN) has already taken away one of those advantages. It has comparable, and in some cases lower, prices than the warehouse club chain. It also has improved delivery to the point that it can get pretty much anything to consumers in two days or less.

Harvey’s Options Volatility Indicator

Conclusion

The big concern is that problems have been evident for a long time and management hasn't done much to address them. Price competition has been a reality since Amazon became a major player, and it's doing a better job getting consumers to buy more than they intended to or purchase items just because the price is right.

Costco has a long runway. It's not a retailer being obliterated by discounters or the internet, but there are signs of weakness.

Therefore, based on the facts above, and Harvey’s Options Volatility Indicator, the following option trade is recommended…..

** OPTION TRADE: Buy the COST DEC 16 2016 145.000 put at approximately $3.50. Place a pre-determined sell at $7.00.

Note: No protective stop losses added -- but if you wish to do so make it $1.40.

”Success is simple. Do what's right, the right way, at the right time.”

Option Tip for your Success!
Options traders are not successful because they win.
Options traders win because they are successful.



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