Costco Likely To Report Strong Results Following Three Quarters Of Earnings Miss

Leading U.S. warehouse club Costco (NASDAQ:COST) is scheduled to report its Q3 fiscal 2014 results on May 29. Based on its March and April sales results, which easily trumped consensus estimates, we expect the company to report strong quarterly growth. Following a weak holiday quarter, the retailer’s comparable sales increased by 5% in March and April backed by an increase in membership base in the U.S. and strong sales in International markets. Although the retailer’s EPS had missed market expectations in the last three quarters, it is likely to be in line with the estimates this time around.

Driven by the weak economic environment, U.S. buyers in numbers have switched to Costco to take advantage of its attractive bargains. This has translated into significant improvement in new membership signups and renewal rates, which have subsequently boosted comparable sales growth in the U.S. In international markets, Costco has found tremendous acceptance due to its cost-saving shopping model. As a result, the company’s international revenue and comparable sales growth, have outpaced its domestic growth for four consecutive years.

In the last quarter, Costco was behind analysts’ estimates in terms of earnings per share by almost 12 cents per share due to disappointing holiday sales, low gross margins in fresh foods and unfavorable currency fluctuations. However, with strong revenue growth and better gross margins in Q3, the company is expected to report an EPS of $1.09, which is in line with consensus estimates. We will look for additional details related to Costco’s underlying performance and future strategies during the earnings call.

Our price estimate for Costco stands at $121, implying a premium of less than 5% to the market price.

See our complete analysis for Costco

Attractive Bargains And Improving Market Conditions Helped Costco

The warehouse club industry sales have grown at a higher rate than general merchandise store sales over the last decade. Some consumer reports suggest that buyers can save up to 55% while shopping at warehouse clubs. Costco is the largest retailer in this industry which places it at an advantageous position. As a warehouse retailer, Costco offers products at lower prices than its competitors. It does so by keeping the product markups low at 15% while most supermarkets and department stores markup their goods by more than 25%. Also, it changes the brands it offers regularly, and therefore, customers always find something new at its stores and get a ‘treasure hunt’ experience. To add more appeal, the retailer from time-to-time offers high-end products such as Coach (NYSE:COH) purses and Dom Perignon champagne. Costco is also focused on serving its customers based on the local tastes and demand. It grants its local store managers some discretion over the products that are kept in stores, which enables it to keep sufficient inventory of products with high selling frequency. With its enticing bargains, Costco is able to attract customers even when consumer confidence isn’t at its best. In fact, weak economic environment often drives customers to Costco and they continue shopping there even when the market conditions improve.

Lately, the U.S. retail market has started to recover with renewed consumer confidence and better economic data. Consumer confidence index in the U.S. reached 100 in the first quarter, propelled by better employment data, and rising equity and home prices. ^[1] Applications for unemployment benefits dropped to their lowest level in more than three months in early March and average job growth in February and March (195,000) was much better than what it was in the prior two months. In fact, first time jobless benefits applications in early April were at their pre-rescession levels. ^[2] With improved consumer confidence, retail sales in February improved marginally by 0.7%, followed by 1.1% jump in March, which was their biggest gain in over 18 months. U.S. buyers were less reluctant to spend on furniture, clothing, general merchandise, health and personal care, food and beverage, sporting goods etc. which helped Costco’s results. Interestingly, while retail market growth slowed down to 0.1% in April, Costco sustained its growth momentum exhibiting tremendous resilience to market fluctuations. ^[3]

Growing Acceptance Is Driving International Growth

Over the past four years, while Costco’s revenues in the U.S. have grown at an average annual rate of 5%, its international revenues have increased by almost 15% annually. It appears that consumers in international markets are welcoming the retailer’s business model, which promotes cost saving. In fact, early signups in Asia and Australia have been very strong, which is encouraging Costco to continue its expansion in these regions. Most of Costco’s growth is coming from its biggest international market – Mexico, where the recent economic slowdown hasn’t troubled the retailer. In constant currency terms, Costco’s international comparable sales increased by almost 7% during April 2014, following 9% growth in the prior month. Such robust and consistent growth indicates that the company is gaining momentum in key international markets. During March 2014, Costco’s international results benefited from heavy store traffic and increased value-per-transaction in Japan. Since sales taxes were set to rise in the country from April 1, Japanese buyers bought more during March. ^[4] However, since the retailer operates less than 20 stores in the country out of its 173 international stores, Japanese buyers’ reluctance in spending in April didn’t have a big impact on Costco’s growth.

While the company’s growth in local currency is quite pleasing, unfavorable currency fluctuations have had a negative impact. After factoring in the exchange rate fluctuations, Costco’s international comparable sales growth comes crashing down to 4% in March and 2% in April. This is likely to be a drag on the company’s Q3 fiscal 2014 earnings per share.

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1. U.S. consumer confidence rebounds to pre-crises levels in first quarter: Nielsen, Reuters, Apr 29 2014 [↩]
2. Bullish U.S. retail sales brighten growth outlook, Reuters, Apr 14 2014 [↩]
3. Retail sales slow, but growth outlook still upbeat, Reuters, May 13 2014 [↩]
4. Costco March same-store sales beat estimates, Reuters, Apr 10 2014 [↩]