Shopping for Costco Calls

Costco (COST) has become not only the dominant big box discount store but also a touchstone of American consumerism. So it may seem odd that its next great expansion opportunity is taking place in China but that is exactly what is quietly occurring.

In October Costco announced it would be entering the Chinese market for the first time. The company has struck a deal with e-commerce giant Alibaba (BABA) to offer select products over its T-Mall marketplace. This deal is a crucial move in establishing a beach head for future penetration into the humungous Chinese market. It could provide a Costco with a green field of double digit sales and earnings growth just as the North American market has become saturated.

The store, where consumers can buy Costco baby care goods, beauty items, dietary supplement as well as household products, will mail purchases directly from the U.S. to consumer doorsteps, a process that takes five to 20 days, according to the store website.

China’s growing middle class not only has more spending power but also a growing appetite for imported and quality food and other consumer goods. A lot of the demand stems from safety about domestic products. The country’s urban residents are increasingly turning to imported food as food safety woes- such as melamine-tainted infant milk formula and rat meat disguised as lamb- hit the country time and again. Costco is initially focused on such products to generate a fresh wave of sales.

A Measured Approach

Initially Costco will only sell selected items online. This gives it a chance to analyze consumer data provided by Alibaba and give Costco a good look at the Chinese opportunity with nominal capital investment. ”

Costco does have a presence in Asia which includes, 19 shops in Japan and 10 each in Taiwan and Korea through majority-owned subsidiaries, so it seems likely it will eventually open physical stores. But like rival Wal-Mart (WMT) which bought a 51% stake in grocer Yhd.com and currently operate 10 brick-and-mortar Sam’s clubs on mainland China, it will need finding the right partner. In Alibaba, which completely dominates online commerce, it gains great distribution channels right off the bat.

Indeed Costco has gotten a taste of the monstrous numbers that can be generated; after it sold $3.5 million worth of goods over a 24-hour period on Singles Day, which occurs on Nov. 11, through its Alibaba channels it has ramped and accelerated its expansion plans.

I wouldn’t buy Costco solely for its expansion into China as revenue there is still a drop in the bucket to Costco’s $112 billion in annual sales. Costco is already the best in breed of the big box discounters as its membership model provides a steady annuity like income stream allowing to offer the most competitive prices to customers and attractive wages to workers.

The growth in China should be in the high 20% range for the next few years. For a mature company with razor thin margins finding new markets gives investors a new reason to keep awarding Costco a premium valuation. It should provide the type of incremental tailwind allowing Costco shares to continue out performing the market in coming months.

With the stock currently trading at $141 a share I’ve identified the July $145 calls as offering the best balance of price, leverage and time.

These calls cost $5 a contract and expire July 18th 2015. They are only slightly out-of-the-money meaning their value will increase rapidly as the underlying share price increases.

My target is for Costco to hit $160 or a 14% gain by July. This would give the calls a value of at least $15 or a 300% gain in just seven months.

— Steve Smith

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About the Author: Steve Smith