Recent third quarter results from Costco were generally positive. They showed a rise in net sales of 12.1%, an increase of $31.6 billion. Operating income moved 10.2% higher to $1.07 billion, while diluted earnings per share were $1.70. This was 7% higher than in the third quarter of fiscal year 2017, and marginally ahead of analyst forecasts of $1.69.
Comparable sales were 10.2% higher, with growth of 9.7% recorded in the domestic market. Comparable sales in Canada increased by 11.3%, with international markets recording growth of 11.8%. Traffic was up by 5.1% versus the comparable period from the prior year, while e-commerce sales increased by 36.8% as the company continued to invest in its omnichannel capabilities.
Growth potential
Since the release of its third quarter results, Costco's stock price has risen by 10%. This takes its capital growth in the last year to 39%, which is a stronger performance than the S&P 500 during the same time period. The index has risen by 15% in the last 12 months.
Costco’s future sales and profit growth could be catalyzed by its online operations. It continues to refine the products that are available to customers and is gradually learning which departments and items resonate best with its membership. It is also becoming more effective with regards to site traffic conversion, with a rising number of customers opening emails from the company and then acting upon them. Around half of online customers also shop for other items before collecting the products they have ordered online for pick-up in store. This provides evidence that the omnichannel strategy being pursued by the company is having a positive impact on its sales performance.
Innovation forms a key part of the company’s online strategy. For example, it rolled-out two-day delivery on non-perishable goods as well as same-day delivery on fresh items through Instacart in October. Demand for the service is growing strongly. It is also seeing rising demand due to a larger range of its products being available online all year round. One example is furniture, which can now be bought at any time of year and is seeing incremental sales that could continue to grow.
Membership potential
Costco’s financial performance may also be boosted by strong membership renewals. They stood at 90.1% in the third quarter of the year, which is the same level as in the previous quarter. There was an improvement in worldwide membership renewal rates. They increased to 87.5% from 87.3% in the second quarter of the year. Growth in international renewal rates was led by the performance of the business across Asia. The company’s solid membership renewals come despite a rise in membership fees in 2017. Continued robust renewals could provide the company with improving financial performance.
The company is also increasing total membership numbers. In the third quarter it added 500,000 new members to take its total to 50.9 million. With a paid executive member base that now stands at 19 million households, the company looks set to experience resilient demand for its range of products over the medium term.
Potential threats
While the performance of the business in the third quarter was generally positive, its gross margin came under pressure. It declined by 28 basis points excluding gasoline price inflation. This created a degree of concern for some investors following the earnings release, and may cause some volatility in its stock price in the near term. The company continues to invest in price as it seeks to drive a higher volume of traffic to its warehouses. This could contribute to further gross margin pressure in the near term.
A major contributing factor to a falling gross margin in the third quarter, though, was a change in the mix of products sold when compared to the same period of the previous year. When that product mix is factored in, the gross margin decline for the company’s core categories was around 4 basis points. Therefore, the overall strength of its operating model seems to be sound.
Costs could increase over the next couple of quarters. The company is planning to increase wages for its warehouse workers. This is set to add between $100 million and $120 million to its operating costs each year. The company, though, has a track record of paying higher wages than some of its rivals. This can lead to lower levels of employee turnover, as well as higher levels of productivity and customer service. Since the cost of rising wages is set to be funded at least partially from a reduced tax rate, the overall impact on the business may prove to be positive.
Verdict
The investment prospects for Costco seem to be improving, with online sales having the potential to act as a catalyst on its financial performance. Rising membership levels through high renewal rates and the addition of new members may also aid the company’s sales and profit growth. Although margin pressure and higher costs could threaten the company’s near-term outlook, the long-term prospects for the business seem to be strong. As a result, the company seems to have investment potential after its 39% stock price rise in the last year.
