Insiders Are Selling This Stock, Should You?

Tim Begany's picture

Friday, November 7, 2014 - 12:00pm

by Tim Begany

While insider activity is often a helpful guide in the decision to buy or sell, it certainly shouldn’t be considered gospel. Just because the CEO or other key insiders are buying or selling their firm’s stock doesn’t necessarily mean you should.

For instance, investors could be making a huge mistake by following insiders out of the stock of one of the world’s most successful discounters. In October, key insiders at this firm sold nearly $11 million of the company's stock.

But don’t take that as a bearish sign for Costco Wholesale Corp. (Nasdaq: COST). My interpretation is insiders are simply taking some profits because Costco has done so well, rising around 13% year-to-date and more than 130% during the past five years.

Insiders certainly aren’t abandoning the stock, not by a long shot. Overall, they still hold more than 2.2 million shares worth almost $300 million, and as a group they’ve actually increased their ownership a bit during the past 12 months.

Indeed, there are plenty of reasons to remain bullish on Costco over the long-term, like very solid revenue growth despite the firm being on the larger, more mature side -- it was founded three decades ago and has a market value of $60 billion. Still, from fiscal 2009 to fiscal 2014, which ended in August, annual sales rose to $112.6 billion from $71.4 billion, nearly a 10%-a-year growth rate.

The bottom line has done even better, with earnings per share expanding more than 13% annually to $4.65 from $2.47 in fiscal 2009. By contrast, discounting industry behemoth Wal-Mart Stores, Inc. (NYSE: WMT) only grew earnings 7.6% a year during the past five years. Although typically thin, operating and net margins are currently on the high side of what Costco historically delivers.

In part because it’s proficient at containing costs, the company also usually boasts an impressive return on invested capital, or ROIC. This metric, which gives a sense of how effectively a company allocates capital to generate profits, is generally well above 10% in Costco’s case. As the following table also shows, several other measures of the firm’s financial health have typically trended much higher including book value, free cash flow and dividends.

Costco Financial Metrics
  2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Operating Margin (%) 2.8 2.7 2.5 2.7 2.5 2.7 2.7 2.8 2.9 2.9
Net Margin (%) 2.0 1.8 1.7 1.8 1.5 1.7 1.6 1.7 1.9 1.8
ROIC (%) 11.7 11.5 10.9 12.1 9.7 10.9 11.3 12.7 14.2 12.8
Book Value per Share $18.53 $19.54 $19.69 $21.14 $22.99 $24.98 $27.64 $28.59 $24.81 $28.11
Free Cash Flow per Share $1.60 $1.28 $1.51 $1.30 $1.91 $3.87 $4.31 $3.59 $3.07 $4.50
Dividend per Share $0.43 $0.49 $0.55 $0.61 $0.68 $0.77 $0.89 $1.03 $1.17 $1.33
Source: Morningstar

At $5.1 billion, long-term debt is more than twice 2009’s $2.2 billion total. However, Costco’s debt-to-equity ratio of 0.4 is still low in absolute terms and a bit less than the industry average of 0.6.

According to Morningstar, the company’s earnings before interest and taxes (EBIT) is more than 29 times the interest payments on its debt. That’s even better interest coverage than Wal-Mart, which has enough EBIT to make its interest payments about 11 times over.

Costco should remain dominant in the discount store space because its customers are highly loyal -- the result of management’s willingness to minimize product markups even though it depresses margins. The loyalty factor is reflected in a couple key metrics, including same-store sales, which climbed at a very solid 4% pace in fiscal 2014. Membership renewal rates remain around 90% despite a $5 hike in the price of a regular Costco membership to $55 per year a couple years ago.

What’s more, Costco has been seeing steady gains in executive members, who pay $110 annually for a 2% reward on their purchases (with a $750 per-year maximum). Executive members now account for nearly 40% of total revenue, compared with 33% in 2009. Approximately 250,000 such members were added in fiscal 2014’s fourth quarter alone, according to a recent article in Forbes.

To facilitate expansion, Costco has made capital investments of about $2 billion in each the past two years. Capital outlays will probably be even greater in fiscal 2015, since management plans to open 31 new locations -- 19 in the United States; three in Korea; two each in Mexico and Japan; and one each in Canada, the U.K., Spain, Australia and Taiwan. This will bring the total number to 694, up from 527 in fiscal 2009. Because Costco’s balance sheet and cash flows are so strong, I’m confident the firm can comfortably absorb the expansion costs of roughly $80 million per store, or nearly $2.5 billion overall.

Costco has some exciting prospects in e-commerce, an area it’s seeking to augment since online sales are currently only about $3 billion a year. However, they could soon get a substantial boost from Asia as management ramps up operations on TMall, an extensive online platform run by the Chinese e-commerce giant Alibaba Group Holding Ltd (NYSE: BABA). The plan is to focus on food and healthcare products initially and then gradually expand TMall offerings as Costco becomes more familiar with Chinese consumers.

Of course, it’s too soon to say how much this will benefit the firm. But I suspect a TMall presence could be huge. Costco is gaining highly visible access to the world’s largest consumer base, and it’s taking the time to find out what those consumers like rather than simply flooding them with options.

Risks To Consider: As solid as Costco is overall, it could be much better diversified geographically. The firm gets most of its revenue from North America, with 32% coming from California alone.

Action To Take --> Based on its long-term performance and plans for the future, Costco should keep doing very well -- especially since so many strapped consumers are probably more reliant than ever on the types of bargains the company offers. Upside for its stock should at least be in the 50% range in the coming five years, and the dividend could easily rise 10% annually during that time. Rather than selling Costco like insiders recently, the best course for long-term investors is to hold the stock and consider buying more on large pullbacks.

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Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.