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.

“Where do you want to meet?”

“Let’s meet at Starbucks.”

My meetings take place more often at a Starbucks than anywhere else. The stores are conveniently located around Tucson, and there are a lot of them. Starbucks has become part of our society. The Company Stock Risk Profile™ asks the question, “Does the company produce a product or service that people need and use?” Of course we can do without coffee, particularly premium priced coffee from Starbucks, if we had to. Or can we?

Starbucks’ Company Stock Risk Profile™ rating is Medium, having failed 25 out of 50 categories.

Starbucks’ fundamentals are strong. The balance sheet is solid with hardly any long-term debt. Internally generated cash has been financing growth. Earnings have not disappointed the Street for the last four quarters and estimates have been stable. Management’s expectations for growth are quite favorable. Over the next three to five years, they are targeting sales growth of 20% annually and earnings per share growth of 20% to 25% annually. Management envisions 30,000 stores worldwide up from just under 9500 currently with China becoming the company’s largest market outside of the U.S.

Starbucks’ stellar growth record would seem to support the company’s ongoing success and the achievement of management’s goals. The key question then is what price should investors pay for this? I want to buy quality stocks that are on sale, much like I would buy anything else. Starbucks’ Risk Profile included failing 10 out of 12 valuation measures. Starbucks is a great company, but the shares are expensive. Moreover, their valuation reflects investors’ expectations that management will deliver on their forecast. I do not want to take on the valuation risk at the current stock price that they might not.