Costco’s Profits Fall But Its Future Still Looks Bright

-10.83%
Downside
733
Market
653
Trefis
COST: Costco logo
COST
Costco

Warehouse giant Costco (NASDAQ:COST) recently reported its Q2 fiscal 2014 results with a sharp decline in its earnings per share. The company’s EPS came in at $1.05, which was significantly below its Q2 fiscal 2013 figure of $1.24 and analysts estimate of $1.17. Costco’s profits declined by 15% due to heavy discounting in non-food categories, lower margins in food categories, negative impact of foreign currency exchange and higher employee wages. [1] These results mark the third consecutive quarter where Costco’s profits have failed to impress.

However, a deeper analysis of these figures indicate that the retailer’s results were not weak as first seems. Costco’s prior year EPS included $0.14 per share income tax benefit related to its special cash dividend and $0.03 per share in certain positive discrete items. The retailer’s Q2 fiscal 2014 EPS had a negative impact of $0.02 per share on account of weaker foreign exchange rates. Taking these items into account, Costco’s second quarter earnings per share at $1.07, was inline with its EPS in the same quarter last year ($1.07). Considering that the U.S. retail market has been highly promotional lately, this performance looks good. Moreover, the retailer managed to sustain a steady sales growth momentum in Q2 as its comparable sales increased by 5% (excluding the impact of foreign currency exchange and gasoline pricing). [1]

Although Costco did not provide any future guidance, we believe that it will continue to do well driven by its growing membership base, global expansion and higher online sales.

Relevant Articles
  1. Does Costco Stock Have More Room For Gains After Rising 40% in 2023?
  2. What To Expect From Costco’s Stock Post Q4 Results?
  3. Costco’s Stock Up 23% So Far, What’s Next?
  4. What To Watch For In Costco’s Stock Post Q3?
  5. What’s Next for Costco Stock?
  6. Company Of The Day: Costco

Our price estimate for Costco stands at $124, implying a premium of about 10% to the market price. However, we’re in the process of updating our model in light of the recent earnings release.

See our complete analysis for Costco

Domestic Expansion Is Gaining Momentum

After opening nine new domestic locations in the first quarter of fiscal 2014, Costco added another two stores in the second quarter. For the remainder of the year, the company plans to open six more stores in the U.S., which will bring the total store openings for fiscal 2014 to 17. This figure is significantly higher than the average number of U.S. stores Costco has opened in the last four years, indicating that the retailer is speeding up its domestic expansion. The warehouse giant 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. This 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. ((Costco’s SEC filings)) 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.

International Markets Provide Several Opportunities

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. The company opened two stores in Australia in the first quarter and plans to add another two by the end of fiscal 2014. Also, Costco will open two locations in Japan and Korea during the next six months. [1] 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 Japan, Taiwan, Korea, Australia and the U.K, and enter other lucrative markets.

This spring, the company will be opening its first store in Spain, where the prevailing economic weakness can work in its favor. [1] We believe that given the right marketing, Costco can acquire a strong customer base in the region by providing cost saving options. Demand for essential items such as groceries in Spain is quite strong despite the overall retail weakness. [2] This should assist the retailer’s growth since it generates more than half of its revenues from groceries.

Online Growth Will Bolster Store Sales In The Long Run

During the second quarter, Costco’s online business continued to grow at a robust pace backed by its website re-platforming, several new mobile apps and launch of new product categories. Following 24% growth during the first quarter of fiscal 2014, the retailer’s e-commerce revenue rose by 20% in Q2 fiscal 2014. [1] 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 such as apparel, health and beauty aid. The retailer has also improved its shipment timings by shipping three depots instead of one. [1] Costco currently operates its e-commerce operations in three international geographies – Canada, the U.K. and Mexico. As the company enters new markets such as Japan, Australia, Korea etc. in the future, its online business will get bigger.

See More at TrefisView Interactive Institutional Research (Powered by Trefis)

Notes:
  1. Costco’s Q2 fiscal 2014 earnings transcript, Mar 6 2014 [] [] [] [] [] []
  2. Retailing in Spain, Euromonitor International, Mar 2013 []