SA: Costco & Walmart: The Big-Box Bubble

Seeking Alpha‘s Jordan Sauer writes:

Summary

– Big-Box retailers are trading at stretched valuations and may prove to be more cyclical than investors believe.

– An intensive look at what drives growth at Costco and Walmart allows for an estimate of future returns.

– We believe the bubble peaked early this year, and a tough decade awaits the shareholders of COST and WMT.

No Price Too High

The valuations of big-box retailers may have peaked at the beginning of this year. Costco’s valuation reached nearly 50x earnings in April as investors rushed into defensive stocks. An eerie reminder for investors is the Nifty-Fifty bubble of the early 1970s, where the likes of Kmart traded at 53x earnings. According to famed investor Howard Marks, the mantra of the time was that there was no price too high for quality. It was thinking like this that led to the brutal decline, which bottomed a decade later in 1982.

Costco (NASDAQ:COST) and Walmart (NYSE:WMT) have become markedly more expensive over the years on a price to earnings basis.

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In the decade ahead, underwhelming returns may await the shareholders of Costco and Walmart.

The Underlying Growth

A high price can be justified if the growth opportunity is large and enduring enough. Let us dig into what makes Walmart and Costco grow.

Costco

Although Costco is a simple business, there are intricacies which make it great. Costco has a strong brand, loyal customers, operating efficiencies, low prices, motivated employees, and psychological systems. The gasoline and pharmacy offer heavy discounts. The Kirkland house brand is great. The company uses free food samples, cheap hot dogs, strategic product placement, and bulk items to draw in customers and get them to spend like there is no tomorrow. Customers join the club and pay fees, which motivates them to shop for everything at Costco. All of this drives growth forward… 

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