Costco: The Bargains Are Inside the Stores

Costco shoppers love to save on everything from bling and pianos to steaks and toilet paper. Costco shareholders, on the other hand, don't react with such equanimity when the warehouse retailer's stock goes on sale, as it did on Wednesday. The shares sank $2.07, or 4.2%, to $47.18 after the company's brass warned that fourth-quarter earnings would be 10% below earlier company forecasts. Costco (symbol COST) dropped its earnings forecast for the fiscal year that ends on September 3 to between $2.23 and $2.26 per share, down from the earlier estimate of $2.33. (Costco is due to report its actual year-end numbers in October.)

The good news for Costco shareholders is that the markdown could have been worse. Double-digit percentage drops are more the norm these days when a company issues a profit warning (not to mention the cruel 24% plunge in women's apparel chain Chico's after it warned). Wednesday's decline puts Costco down 4% so far this year, about equal to the 5% decline in Standard Poor's retail index. Until the latest news, Costco had been outperforming the typical retail stock in 2006. If you consider Costco's closest competitors to be Best Buy, Target and Wal-Mart, Costco's shares are running barely behind the first and well ahead of the other two for the year to date. On a long-term basis, Costco shares are now 22% below their all-time high, set in 2000.

So, is this the time to take some money you might spend inside a Costco warehouse and give it to your broker to buy some shares instead? Perhaps you might check your tires and your wine rack first.

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Unlike its competitors, Costco has long run its business at extremely tight profit margins, a testament not only to its commitment to treat customers and employees fairly but also to the tough nature of retail. It is hard to find quick ways to boost profits, while the reverse seems to be easy to accomplish. For example, as Costco's chief financial officer Richard Galanti explained in a conference call with analysts, Costco now sells 7% of the gasoline in America. It pumps this gas as cheaply as it can, partly because its philosophy is to sell most goods at low prices and also to draw people to Costco's stores. But this has the effect of holding down the company's overall profit margins, which analysts want to see expand, not contract, before they would argue that Costco deserves much further share-price appreciation. The stock already sports a higher price-earnings ratio than do the stocks of Wal-Mart and Target, despite Costco's substantially thinner margins. Next year's earnings forecasts are up in the air because it's hard to peg the economy or consumer spending habits.

Costco's immediate reason for trimming this year's profit estimates is slower sales over the past few months of big-screen TVs, computers, furniture, jewelry and other big-ticket items. This has forced the company to cut prices even more, lest it get swamped with unwanted inventories. At the same time, Costco is building dozens of new stores, many near existing ones. This is far-sighted planning, but it eats at the company's chances of reporting strong year-over-year sales gains at older nearby stores, one of the things retail-stock analysts and investors look for. Then there's the economy, which appears to be pinching consumers' willingness to spend money freely. Gas prices are falling, but that might mean drivers who have filled up at Costco may go back to any old station -- and skip the trip inside to buy megasize packages of bottled water, muffins and steaks.

Costco executives took some heat from analysts and portfolio managers after they delivered the bad news, but the company is sticking to the business-as-usual theme. That is to sell enormous quantities of quality stuff at low prices and let Wall Street judge if that makes it a stock worth owning. Well, as the saying goes, there are great companies and great stocks, and there are great companies and average stocks. Need a big screen TV? By all means, visit a Costco store or its Web site. Want a stock? You might want to look elsewhere.