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Alex Morris
Alex Morris

Costco: Solid Quarter... Falling Stock Price?

March 02, 2011 | About:

Costco Wholesale Corp. (COST) reported earnings on Wednesday, and it appears to be business as usual; strong sales growth, growing membership and retention rates, and an increase to the bottom line. This all begs the question: why was the stock down more than 3% on strong results in a flat trading day?

Net sales for the quarter increased 11.4%, to $20.45 billion, from $18.36 billion during Q2 2010. For the first half of the year, sales increased 11% to $39.27 billion ($35.28 billion last year). There are a couple ways to look at sales for COST; my favorite to use is without the impact of gas and currency, especially in this environment. In this case, both had a positive effect on COST’s sales number, and comps excluding these items paint a slightly different picture: 3% increase in the United States, 9 % in international and 5 % overall.

Net income for the quarter was $348 million, ($.79 per diluted share), which was an 18% increase compared to $299 million in Q2 2010. Before we settle there at 18%, have a couple of one time items to back out: first, there was a $22M ($0.03/share) employee benefits charge from Q2 2010 that should be removed for an "apples-to-apples" comparison. However, the mix of one time/non-operating charges (which include gasoline profitability, legal fees, LIFO effect, and currency) for this quarter also negatively affected results (by $0.02/share). In aggregate, our adjustment is 3 cents higher in 2010 and 2 cents higher this year; overall, the comp is still strong (15.7%).

Net income for the first half was $660 million, or $1.49 per diluted share; compared to $1.27 per diluted share in 2010, the company increased EPS 17% for the first six months of the year.

Looking to the back half of the year, the company is set to kick off on what will likely be a long term expansion of the growth strategy, with an emphasis outside of the United States. In fiscal 2009 and 2010, the company opened roughly 15 stores per year. So far this year, the company has kept on that pace, opening 9 (net) new locations in the first six months of the year. However, looking to the back half of 2011, the company has plans to open 15 additional units, with 3 in Canada, 5 in Asia, and 2 in Australia (which will be the 2nd and 3rd on the continent). Expect this increased growth to stay, especially in places like Asia, as the global economy (hopefully) strengthens.

Two key metrics for Costco continue to strengthen, suggesting that they are operating effectively and meeting customers’ needs. Membership fees for the quarter were $426M, which is up $40M YOY, or 10% in dollar terms. This is representative of the increase in additional members added over the quarter, along with amazing customer retention. For Q2, renewal rates reached 88.8%, an increase from 87.7% at the start of the year. Worldwide, this number is slightly lower (86%), but still very impressive, and indicative of one of the best management teams in corporate America.

Despite their success, the question mark still remains about the economy. Richard Galanti, CFO of Costco, had this to say about the business and how it is faring: “It doesn’t seem like anything is causing it to get better fast, but also not another big shoe about too drop”… “We feel confident in the face of not terribly exciting expectations about the economy.”

As usual, the analysts had their favorite question: when can we expect a membership price increase? As usual, Richard had his answer: when it happens: “We have not made any decisions, and are in no rush to do it.” With that being said, he believes that in a 3-4 year model, the increase is likely. My hunch is that they are waiting for things to get better in the U.S. and in the U.K. (where they are having some trouble) before they push any increases in the membership fees.

From all that has been said, the sense is that it was a strong quarter with strong prospects ahead. Which brings us back to the original question: why the 3% decline today? My thinking is that it was caused by some “investors” who got scared off by the mid-20’s P/E, especially for a retailer in a tough economy that really isn’t what you would call a “growth stock” (at least not yet). Based on today’s close and backing out the excess cash in the balance sheet, we’re looking at 21.5x trailing earnings; while this is still a bit expensive for my tastes, it is starting to pull back towards the high end of the range where it gets attractive again.

Management, like a smart long term investor, looks at the downward volatility as an opportunity to add to their purchases. As Mr. Galanti noted, they are continually comfortable to buy stock, and are usually in the market picking up shares everyday; however, when they see a pullback, they step up the activity and buy a bit more.

In the last five years, they have bought nearly 100 million shares for roughly $5.37 billion; in Q1 and Q2, they picked up an additional $250 million worth of shares, but slowed the activity towards the end as the stock continued to increase significantly over a short period. Now that the momentum has seemed to disappear, management is back and ready to buy.

Overall, I think the 30% run since against is overdone, and COST was due for the pullback (coming from someone who is admittedly terrible at trying to guess what will happen in the short term – and why I never would seriously consider making an investment on such hunches). But that is based on the long term fundamentals, not on some short term guess of whether or not they will beat analyst expectations by a penny; Costco "only" hit the expectation number. The reaction of the market suggests that their strong results did not meet some traders illogical expectations. Regardless, if the market decides to punish COST for a strong performance in Q2, management will be waiting to purchase shares; as long term investors, I suggest you keep your eye on COST and consider doing the same.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 3.9/5 (15 votes)


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