Risks of Investing in Costco Stock (COST)

Costco Wholesale Corporation (NASDAQ: COST) goes against the grain. In today’s world of window shopping via smartphone and next-day delivery, Costco remains the largest warehouse retailer in the United States. Its secret is simple: Instead of trying to compete on margins alone, the company sells membership cards.

Costco currently counts roughly 42 million households among its members. Together, they hold almost 80 million membership cards and collectively pay $2.5 billion in fees. Plus, Costco boasts a membership renewal rate of over 90 percent, so even when sales are depressed, Costco is still bringing in a somewhat predictable revenue from membership fees. Ultimately, this creates a certain level of safety when it comes to the company’s profits.

That is good news for investors who have already bought in, but it also means that Costco's shares are never really priced low.

Investors are willing to pay more per share relative to the company's earnings because they believe the company will be able to continue to grow its earnings going forward. Right now, Costco is trading at over 28 times its earnings and has a forward price-to-earnings (P/E) ratio of over 24 – and that is fairly high. In comparison, the SPDR S&P Retail ETF has a P/E ratio of 20, and the average for the S&P 500 as a whole is closer to 21. Moreover, Costco's most similar competitor, Wal-Mart, is priced at less than 12 times its earnings and 13.5 times its forward earnings.

Costco pays a 1.14% dividend, which could help make up for some pricing, but other companies are priced lower and pay a higher dividend. For instance, Wal-Mart’s dividend is over 3%. Of course, Costco is also very consistent – it just keeps climbing – but if you do not buy in at the right price, it could take a long time to see a return on your investment.

While getting in at the right price is good advice for any investment, the risk is particularly pronounced in Costco stock, and that is not the only risk. There is also the gamble of whether the company will be able to keep up with its customers. Costco members are loyal right now, but shopping behaviors are steadily shifting online, be it via smartphones or browsing on the family desktop.

In Costco's 10-K filed Oct. 14, 2014, for its fiscal year that ended Aug. 31, 2014, the company reported that a multichannel experience is critical to remain competitive in the modern economy. The company identified the need to keep pace with its members' expectations as well as new developments in the retail space. Costco said that it is making technology investments in its website and mobile apps, but it cautioned, "If we are unable to make, improve or develop relevant member-facing technology in a timely manner, our ability to compete and our results of operations could be adversely affected."

However, keeping up with its competition on delivering a multichannel experience is only part of the issue. Costco's current business model just does not translate well into that hyper-connected reality – and the company is not exactly pushing for it, either.

Online shopping does not really work well for Costco, and the company is not exactly trying to make it work the way consumers might expect, either. "We're not going to be the company that delivers two different cereals to your doorstep at 7 a.m. as long as you order by 10 p.m. the night before," said chief financial officer (CFO) Richard Galanti in the third-quarter conference call. That could be why e-commerce makes up just 3% of Costco’s business, but that does not mean that customers will not want that type of instant shopping and delivery regardless.

Costco's business model is the issue. Everything is in a warehouse setting, and the selection is limited. Pricing is unique to each store or area, and it is based as much off of member habits and how quickly the product is likely to leave the store as it is on whatever deal Costco can negotiate. The value of being a member comes more from purchasing staples in bulk and maybe filling up your fuel tank on pantry-stocking trips. The margins on those items are low, but Costco makes it work through high-volume selling and the memberships. Adding in free shipping and the cost of maintaining a website and shipping infrastructure that allowed its members to complete Costco trips online would not work in that model.

Investors should understand Costco's business model before investing in the company's stock, because it is a very real risk given current trends. If Costco's members end up deciding that membership is not worth it – for example, if they find that they can find similar deals at Amazon or Wal-Mart without ever having to leave the house, or if they decide they can buy better-quality goods for a similar price – the company loses out. There is the issue of membership fees, which are essential to the company's business model. Also, there is Kirkland Signature, Costco's private label. Because Costco owns the brand, it earns a higher margin on its products. If there is a quality issue, and the company is no longer able to command loyalty to the Kirkland Signature brand, Costco's profits will suffer.

There is also the issue of geography. While Costco has roughly 700 warehouses around the world and plans to open another 32 warehouses in 2016 (according to its annual report), over 70 percent of its sales come from the United States. As such, its sales are vulnerable to the domestic economy, which is not an unusual risk. However, roughly one-third of Costco's domestic sales comes from a single state – California. The state's economy is strong right now, but if that changes, Costco's sales could take a hit.