Why Costco's bubble is about to burst

Poor results and poor management are just a couple of reasons investors should stay away from Costco.

By James Dlugosch Dec 7, 2009 1:50PM

Jamie DlugoschThe optimists may wonder why the wall of worry in the market is so high. With stocks up substantially and economic indicators on the mend, why is there so much concern?


Well, the bears in the market do have some legitimate reasons to believe some stocks have nowhere to go but down.


Those reasons have nothing to do with the sensational headlines. We are not about to be leveled by a double dip, inflation, a second wave of foreclosures or even unemployment.


Instead, the bears are correct that some stocks are priced too high, and they'll make some money by short-selling overvalued stocks. That's right -- the focus for all investors needs to be on valuations, and there are a lot of stocks out there that are frothy and headed for a fall.


And at the top of my list of overvalued companies is Costco (COST).


Get the complete list of reasons why Costco can't compete here.


The popular wholesaler is making a habit of poor monthly sales results, and yet the stock does nothing but go up and up and up. I guess that is what a cult following of true believers will do for your stock, so why fix problems when poor results are rewarded.


With stocks like COST going up in the face of poor results, poor prospects and poor management, the bears are correct in suggesting that stocks like COST should go down in value instead of up.


It is a dangerous game, though, to be short stocks like COST no matter your convictions. Just because a stock is overvalued does not mean that shares cannot go higher. They can and often do.


But in the case of COST, I would sell! Here's why:


Reason #1 -- Costco consistently disappoints in monthly sales


Costco has missed the number for so many months, I've lost count. Most recently, the company said that sales for November increased by 6% helped by inflation in gasoline prices. Analysts expected growth of 8%. Excluding gas, the increase was a paltry 2% versus an estimate of 6%. With such performance, it's hard to explain why the stock was up so much during the same period other than to say thank God for the believers. These folks love Costco so much that they will put their head in the sand no matter the performance. The sheer volume of monthly disappointments is not an anomaly. It is a troubling trend that will likely continue. Only those wishing to lose money would invest in such a trend.


Reason #2 -- Costco is losing the battle of the discounters


Wal-Mart (WMT), Big Lots (BIG) and BJ's (BJ) are doing exactly what they should be doing in order to grow business during a recession, and as a result are performing quite well and beating the pants off Costco. But only one of these stocks trades for more than 20 times earnings: Costco. Boy, I wish I could lose to my competition and still receive a premium valuation. Big Lots just reported a blow-out earnings quarter, and they are buying back stock feverishly due to its low valuation. I would bet heavily that Costco in its next earnings report struggles to meet expectations. I would sell this dog before the next earnings disappointment and focus on the competition instead.


Reason #3 -- Costco has too much online competition


The holiday shopping season is here, and it is a key gauge of economic activity and a critical time for retailers. Although it is early, the data suggest that brick-and-mortar retailers are still struggling -- what a beautiful excuse for Costco's poor execution. On the flip side, the online market is alive and well. Other than sundry items, Costco is competing with online players like Amazon (AMZN), Blue Nile (NILE) and Overstock.com (OSTK). Here, too, the company is losing to the competition. At a minimum, the growth prospects do not appear too bright for Costco. As such, does Costco really deserve a premium valuation? My answer is no!


Still not convinced that COST is overvalued? Check out the complete list of reasons to stay away from Costco here.


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