Although Costco's (Nasdaq:COST) earnings in the third quarter were up 20%, its revenues missed analyst expectations. The warehouse club for the most part continues to deliver for shareholders. Should you be concerned about Costco's miss? I don't think so. Here's why.
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Costco's business model is real simple: Keep prices as low as possible without losing money and then grow membership fees each year with the fees becoming your profit. In the first quarter it grew membership fees 11.8% to $531 million. Its net income in Q3 was $459 million. For the first nine months of the year its membership fees grew 13.7% to $1.57 billion. Not surprisingly, its net income for the first nine months was $1.4 billion. The two numbers shadow each other.
Former CEO Jim Sinegal has given many interviews in his time. One of the most memorable is a July 2005 article in the New York Times entitled How Costco Became the Anti-Walmart. In it Sinegal explains how Costco does business. Very different from Walmart (NYSE:WMT), whether we're talking the way it treats employees to the number of items it carries in its stores, the quote that struck me was when he stated, "When I started, Sears Roebuck was the Costco of the country, but they allowed someone else to come in under them … We don't want to be one of the casualties. We don't want to turn around and say 'We got so fancy we've raised our prices,' and all of a sudden a new competitor comes in and beats our prices." It's all about keeping markups to a minimum. In the third quarter its gross profit was 11%. Walmart's was 24% while Sear's Holdings (Nasdaq:SHLD) was 25.5%.
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Anyone who follows retail knows that comps are an important part of a store's success. Not vital mind you but nice to have. If you exclude changes in gas prices and currency differences, both its U.S. and International comps grew at 7% in the third quarter and 6% for the first nine months of the year. Dollar Tree (Nasdaq:DLTR), which announced record first quarter results May 23, had comparable store sales growth of 2.1%. You can go up and down the discount store lineup and no one is growing year-over-year revenue like Costco. Again, its business model is brilliant. Get more people in the doors spending more money and your profits keep growing despite a 2% net profit margin. Costco's taken the grocery store business model and turned it on its head.
Missed Revenue Estimate
The elephant in the room this quarter was Costco missing the consensus estimate for revenue. Analysts expected $24.21 billion and it delivered $24.08 billion, a difference of $131 million or a half of one percent. On the earnings front Costco delivered EPS of $1.04, a penny higher than expectations. The headline declaring the third quarter a mixed assortment is really a facetious jab at anyone who takes these analyst surprises, positive or negative, as anything more than noise.
Costco had another bang-up quarter; coming in $131 million below a revenue estimate that is just that--an estimate--is hardly worth mentioning, let alone a problem. If you want to nitpick, I'd be more concerned about its $4.94 billion in long-term debt, something it added to at the end of 2012 in order to pay a special dividend of $7 per share in advance of the pending tax changes in 2013. Even then, the rates of interest on the $3.5 billion varied from 0.65% to 1.7%, depending on the maturity date. None of the Senior Notes mature any later than December 2019. With $1.5 billion in free cash flow (FCF) annually, it won't have a problem paying down the debt.
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Costco is trading within 2% of its all-time high of $115.77. It's definitely not the cheapest stock on the block. But then again, it is arguably one of the best run retailers anywhere in the world. If you're an existing shareholder I'd continue to hold for many years to come. If you're thinking about buying its stock but don't want to overpay; strike that idea from your thoughts. Share prices follow earnings. In the past decade its compound annual growth rate for earnings was 11.6%. Its share price gained 13.2% on an annualized basis in that same 10-year period. It's hard to imagine anything but the same thing happening in the decade ahead. After all, you rarely overpay for quality.
At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.