This big box retailer has been the best of breed for years. But recent signs of a slowdown in sales suggests its business model may be coming outmoded. The chart also is forming a big top suggesting a bearish option play will pay handsomely.

Among the biggest gainers in the stock market’s most recent rally have been retailers. A variety of name such a Urban Outfitters (URBN), Abercrombie & Fitch (ANF), Dollar General (DG) and even JC Penny (JCP) all powered to new 52 week highs of late.   And many of the beaten down big box retailers such as Wal-Mart (WMT), Macy’s (M) and Target (TGT) have enjoyed rebounds of 20% or more thus far this year.

But there is one notable laggard; Costco (COST) is actually down 8.5% from its January high. This quite a turnabout for a stock that has been among the best performers for over a decade which included a nearly straight line 100% gain for the two-year period from early 2013 to early 2015. Then, even though it eventually made a new high in December of 2015, the road got a bit bumpy.

Indeed, the price action over the prior few months seems to have been a precursor to the most recent second quarter results reported on March 2, which showed a concerning slowdown in several key areas. Revenues and earnings increased a meager 2.5% and 2.1% respectively but these numbers were dragged lower by gas prices and the stronger dollar.

More concerning was the slim 1.3% increase in same store sales indicating a slow down and traffic. Most troubling is the continued decline in membership growth. The membership fees are mother’s milk that allows Costco to sell goods at deep discounts and near zero margins yet still enjoy overall profits. The trend does not bode well.

Executives downplayed the occurrence citing the broader slowdown in the economy on the earnings call, but any sane investor would need to view sluggish traffic and slip in member growth at the usually reliable Costco with some concern.

Big Box Bust?

Customers are going online much more than into stores these days. Further, younger consumers seem to shy away from Costco as they drive less than their parents did and live more in large cities than in the suburbs. Costco has tried to develop e-commerce platform but only about 5% of its sales come on line, and about half those take the form of customers simply ordering in advance before they come and pick it up. In a world of just in time deliveries the tide may be going against Costco’s buy in bulk model.

The company is clearly aware of the trend as it added only one net new store, bringing its total to 698 globally, and is now exploring a different concept from the traditional warehouse. The overwhelming majority of warehouses – 614 of 698 – are located in the U.S and Canada, and the bulk of expansion continues to be focused there as well. No matter what the format, North America seems pretty saturated.

The biggest challenge is likely to come later this summer when it’s expected to increase the membership rate. The last price increase came in 2011 and before that, 2006, so it seems the company is almost due for another raise. Shoppers pay an annual fee for of $55, or $110 for the executive level, for the privilege of shopping there. Costco has enjoyed a nearly unprecedented retention rate of 91% over the past three years. I think there is real chance even a modest increase, which analysts expect to be a hike to $75 and $150 respectively, could result in sharp drop-off as consumers decide it’s not worth it the added expense.

Big Top in Chart

Costco’s powerful bull run from late August to early December ended with a very damaging breakout gap. After gaining nearly 25% off the September low, Costco left behind an ominous spike high after taking a 5% dip in early December. In immediate post-earnings trade, shares were sharply lower after gapping lower on the bell. Costco has struggled since, and with the first week of March over, a third straight lower monthly high is taking shape.

As long as it stays below $155 this big top is in place. A close below 200 dma at $147 could open up the flood gates.  There is very little support beneath this level. If Costco is unable to bottom near the 2016 lows the stock could have much further to fall.

I would play this through the straight purchase of longer dated puts.

A purchase the January 2017 $145 Puts for $7.50 a contract looks attractive.

I have a downside target of $120 per share which would give these puts a minimum value of $25 or $10 or 130% gain.