Costco (COST) enjoyed an impressive rally in the 11 months leading to early September, as it rallied 57% during that period. However, the stock has incurred a 10% correction in the last month. As Costco rarely incurs prolonged corrections and almost always trades at a premium valuation, the big question is whether the stock has now become a bargain.

The Cause of The Correction

Approximately half of the losses of the stock have resulted from its recent earnings report. While the retailer met the analysts’ estimates, it announced that it expected a material weakness in internal control. The weakness relates to general information technology controls in user access and is expected to be remedied before the end of fiscal year 2019. On the one hand, the market always punishes stocks that are surrounded by uncertainty over internal control. On the other hand, management of Costco stated that it did not expect any changes in its financial statements. In addition, this is certainly a non-recurring issue. Therefore, as soon as the issue is remedied, the stock is likely to retrieve its recent losses. In fact, the stock is likely to retrieve its losses long before it remedies this problem, when the dust from the announcement settles and the market realizes that this temporary setback does not affect the growth trajectory of the stock.

Business Overview & Growth

Costco has an exceptional business model. It charges its customers an annual fee to offer them access to its bargain prices. These membership fees, which are approximately $3.1B per year, seem negligible when compared to the $138B annual sales of the company. However, Costco sells almost all its products at prices just above its cost base so its annual earnings are approximately equal to its membership fees. As a result, membership fees constitute a vital component of the performance of the company. Moreover, thanks to the high renewal rates of memberships (~90%), these fees provide a strong support to the earnings of the company.

About a year ago, the stock of Costco plunged on fears that the acquisition of Whole Foods by Amazon (AMZN) would disrupt its business model. As Amazon has a similar business model, charging fees to its customers to offer them access to bargain prices, the market was afraid that the online giant would greatly impair the performance of Costco. However, these concerns have proved overblown. Costco has a wide moat in its business thanks to the unique “treasure-hunting” shopping experience it offers to its customers. This experience cannot be replicated by Amazon. The wide moat of Costco has been evident in its performance, as the company has grown its comparable sales by approximately 10% on an annual basis for more than 12 consecutive months. This impressive growth record also helps alleviate the concerns of some investors, who are afraid that the stock may find it hard to keep growing at impressive rates, as about 2/3 of its stores are located in the U.S., which is considered a relatively mature market.

Overall, Costco has an exceptional growth record, as it has essentially tripled its earnings per share in the last decade. Even better, there are absolutely no signs of fatigue and hence the retailer is likely to continue to grow at a significant pace in the upcoming years.

Valuation

Unfortunately for the investors who want to purchase Costco, the stock almost always trades at a premium valuation. It is currently trading at a forward P/E ratio of 28.6, which is much higher than the P/E ratio of the vast majority of stocks. Therefore, despite its recent correction, Costco is still trading at a rich valuation.

On the other hand, investors should not expect to find this stock at a much cheaper valuation. Its average P/E ratio during the last decade has been 24.3. As Charlie Munger, the famous business partner of Warren Buffett, has said, it is much better to buy a great business at a fair price than a fair business at a great price. Costco is certainly a stock that applies to this rule. In fact, Charlie Munger is a long-time member of the Board of Directors of Costco. (Investors can learn numerous precious investing lessons from Charlie Munger quotes.)

To cut a long story short, while Costco is not cheap, investors with a long-term horizon are likely to be rewarded by Costco even if they purchase the stock around its current rich valuation level.

Final Thoughts

Costco is an exceptional stock, with an impressive growth record and great momentum in its business. On the one hand, despite its recent correction, the stock is still richly valued so it has not become a bargain. On the other hand, as the stock almost always trades at a premium valuation, it is likely to reward even those who purchase it at its current price thanks to its promising growth prospects. Overall, while conservative investors may prefer to wait for a lower entry point, the stock has strong growth momentum and rarely incurs a prolonged correction.  As a result, it is likely to offer meaningful returns even from its current price.