Costco (NASDAQ:COST) recently reported weaker-than-expected results due to heavy promotions, changes in gasoline prices and foreign currency fluctuations. The company’s Q1 fiscal 2014 net sales increased by 5% to $24.47 billion, which was below the analysts’ estimate of $25.35 billion.  Its comparable store sales grew by just 3% and profits rose from $416 million (Q1 fiscal 2013) to $425 million, trailing the market’s expectations of $447.5 million.  This was due to 17 basis points rise in SG&A rate and 5.5% increase in operating expenses. However, a detailed analysis of the company’s results suggest that its performance was actually good. It also appears to be well poised to propel its long term growth. Costco still has healthy room for improvement in several areas such as U.S. expansion, online channel and International growth.
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Our price estimate for Costco stands at $125, implying a premium of about 5% to the market price.
Costco’s Performance Was Actually Good
A closer look at Costco’s results indicates that the retailer performed better than what the aforementioned figures suggest. Excluding the impact of foreign currency fluctuations and change in gasoline prices, Costco’s comparable store sales increased by 5%, which is in line with its previous quarters’ growth. Even as heavy discounts weighed on the retailer’s sales, its gross margins improved by 13 basis points.
Costco’s membership base, which is an important factor for its comparable store sales, continued to grow in the first quarter. The retailer’s membership income increased by $30 million as compared to Q1 fiscal 2013 and an additional $8 million due to membership fee increase. Its North American renewal rates reached 90% in this quarter from 89.9% in Q3 fiscal 2013. The renewal rate in international markets also remained strong at 87%. New membership signups rose by a healthy 17% and the number of executive members increased by 330,000. 
Room For Growth In The U.S.
Costco operates close to 450 stores in 40 states of the U.S. and Puerto Rico, which leaves 10 states untouched. In comparison, its counterpart Sam’s Club operates more than 620 stores which are spread throughout the country. This indicates that Costco still has to travel a long way to catch up with Sam’s Club’s domestic presence. During the past four years, Costco’s domestic expansion has been slow, opening just nine new warehouse stores annually (average) in the U.S. However, the retailer is stepping up its expansion as it added nine new stores in Q1 fiscal 2014 and plans to add another seven during the rest of the year. Aggressive expansion in the U.S. appears to be a lucrative strategy for Costco given that its revenues are already higher than Sam’s Club’s revenues despite a smaller presence.
Currently, Costco’s domestic store fleet is not evenly spread across the country, but is highly concentrated around California. The retailer earns close to 24% of its revenues from this region.  Although higher demand in California might be the reason behind this substantial presence, it increases the chances of self cannibalization. Despite this, Costco’s annual revenue per store ($133 million) is significantly more than Sam’s Club’s ($91 million). Therefore, we believe that a well planned expansion strategy will only ensure Costco’s growth and help it dilute the threat from Wal-Mart‘s (NYSE:WMT) warehouse club. It will also assist the retailer in acquiring a larger customer base.
Costco’s Online Channel Is Set To Boom
During the quarter, Costco’s online business continued to grow at a robust pace backed by its website re-platforming and several new mobile apps. Following 20% and 15% growth during the last two quarters of fiscal 2013, the retailer’s e-commerce revenue rose by 24% in Q1 fiscal 2014. We believe that this growth is likely to continue in the future as Costco’s online channel is at a nascent stage and accounts for just 2.5% of its net sales. Furthermore, the company’s e-commerce strategy, increased product categories and better inventory management will assist its online growth. About 80%-90% of products offered on Costco’s website are different from its store inventory. This prevents self-cannibalization between these two channels. Over the last year, Costco has added new product categories to its website and improved its shipment timings to increase the speed to market. 
Apart from Costco’s efforts, growth in online retail industry will also drive its e-commerce business. According to Forrester, online retail sales in the U.S. are likely to reach $370 billion in 2017, up from $262 billion in 2013.  Costco now operates its e-commerce business in four countries – the U.S., Canada, the U.K. and the most recent – Mexico. As the company continues to enter new geographies in the future, its online business will get bigger.
International Markets Present Huge Opportunities
Looking at the average revenue growth for the past four years, we note that Costco’s international revenues have increased by almost 15% annually. In comparison, the annual growth in the U.S. has averaged around 5%. This looks promising considering the fact that the company has not expanded aggressively in international markets. Consumers in these developing economies are welcoming the retailer’s business model, which promotes cost saving. For instance, the management had stated in its previous earnings calls that early signups in Asia and Australia have been very strong.  With such customer response, the retailer has been witnessing healthy comparable store sales growth in its international business. During Q1 fiscal 2014, Costco’s international comparable store sales rose by 6%.
We believe that apart from comparable store sales, Costco can generate significant revenues by expanding aggressively. Currently, the company operates just 173 stores in seven countries, out of which 120 are in Canada and Mexico. Therefore, Costco has a strong opportunity to increase its reach in the U.K., Japan, Taiwan, Korea and Australia. Alongside, it can enter new markets as well. Overall, the company plans to open 15 international stores in fiscal 2014.
During the next summer, the retailer will open its first stores in Spain, where the economic environment is particularly weak. We believe that given the right marketing, Costco can acquire a strong customer base in the region by providing cost saving options. Moreover, demand for essential items such as groceries is quite strong in the region despite the overall retail weakness.  This should assist the retailer’s growth since it earns more than half of its revenues from groceries.Notes:
- Higher Operating Expenses Pinch Costco Profit, The Globe And Mail, Dec 11 2013 [↩]
- Costco Net Misses Estimates As Chain Boosts Discounts, Bloomberg, Dec 12 2013 [↩]
- Costco’s Q1 fiscal 2014 earnings transcript, Dec 11 2013 [↩] [↩]
- Costco’s SEC filings [↩]
- US Online Retail Sales To Reach $370 billion By 2017, Forrester, Mar 12 2013 [↩]
- Costco’s Q4 fiscal 2013 earnings transcript, Oct 9 2013 [↩]
- Retailing in Spain, Euromonitor International, Mar 2013 [↩]