Stuart Shaw, CFA

Coming in contact with many companies every day, you know when you are dealing with a good company, or not. Tap into these experiences and use them as a resource for investment ideas. But don’t rush out and buy the stock solely based on: “I like shopping in this store.” That is only a starting point.

Well, I do like shopping at Costco. The warehouse I frequent is always busy. They have a great return policy. The quality of their Kirkland brand products is consistently high. Prices are very competitive. And I’ll admit to loving the snacks throughout the store.

Using the Company Stock Risk Profile Fast Track™, I was able to screen Costco’s shares in just minutes. The Fast Track™ is comprised of 10 key categories, yielding a quick study from which to decide to do more intensive research, or move on to another idea. Costco failed 4 of the 10 categories. I usually like to see a stock failing no more than three categories before going further. But for the purpose of this article, and I do like those snacks, I put Costco through the entire Company Stock Risk Profile™ research process. Failing 22 of the 50 categories, the stock’s rating was “Medium” Risk.

The most positive variable of the analysis is Costco’s leading position in its industry. According to the company, Costco is the 2nd largest general merchandise retailer in the U.S., and 7th largest in the world. For the 12 months ended February 2007, Costco posted revenues of $62.4 billion, well ahead of Sam’s Clubs’ $41.6 billion and BJ’s $8.5 billion. With 510 warehouses versus 582 for Sam’s Club and 173 for BJ’s, Costco also delivers substantially higher sales per warehouse.

Costco’s balance sheet is solid and cash flow is healthy. The company ended its fiscal third quarter with long-term debt at 20.3% of total capital and cash and short-term investments of $3.8 billion. Cash from operations for the latest 12-months totaled $2.1 billion, and free cash flow (cash from operations less capital expenditures) was $809 million.

The negative variables that stand out are Costco’s profitability and the stock’s valuation:

The company failed 6 of the 7 categories related to profitability. While Costco is doing a much better job at its business than Sam’s Club and BJ’s, the company’s profit margins – gross, operating, pretax and net - are substantially below the retail industry and the S&P 500. Moreover, margins have been slipping since fiscal 2005, as has return on equity. As a result of low net profit margins - 1.7% versus the industry’s 7.3%, both trailing 12-months, Costco’s 11.8% return on equity is about half that of the industry’s.

The stock failed 7 of the 12 valuation categories. One of the 6 valuation methods that the Company Stock Risk Profile™ uses is the PEG ratio. The PEG ratio is the forward price / earnings ratio (P/E) divided by the company’s earnings growth rate (G) using the Street’s consensus expectation. You can find the PEG ratio at http://finance.yahoo.com. Enter the stock’s symbol at Get Quotes, click on Analyst Estimates under Analyst Coverage on the left sidebar, and then scroll down to Growth Estimates. Costco’s PEG is 1.8 versus 1.3 for its industry. The Street is looking for Costco’s earnings to grow at a 12.9% annual rate for the next 5 years, not quite on par with the 13.9% estimated for the industry. Costco’s no more than average earnings growth is selling for a premium P/E.

The Street is less than enthusiastic about Costco’s shares. Only 7 of the 25 analysts covering the stock are recommending purchase. I am a big advocate of contrarian investing, but this time I agree with the majority opinion. While Costco is an industry leader, I would also be buying profitability that is well below average and projected earnings growth that is no more than average. At the current price, Costco’s shares do not offer the value that I want for my money.