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.

SEE: The 4 R’s Of Investing In Retail

Membership Fees
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%.

SEE: Top 6 Mindless Money Wasters

Comparable Sales
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.

SEE: How To Choose The Best Stock Valuation Method

Bottom Line
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.

Related Articles
  1. Fundamental Analysis

    The 4 R's Of Investing In Retail

    In retail, successfully managing return on investment (ROI) and other financial indicators is the key to a healthy business.
  2. Fundamental Analysis

    Analyzing Retail Stocks

    To analyze retail stocks, investors need to be aware of the most common metrics used. Find out what they are.
  3. Fundamental Analysis

    Valuation Of A Preferred Stock

    Determining the value of a preferred stock is important for your portfolio. Learn how it's done.
  4. Personal Finance

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  5. Bonds & Fixed Income

    Equity Valuation In Good Times And Bad

    Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value.
  6. Markets

    Investment Valuation Ratios

    Learn about per share data, price/book value ratio, price/cash flow ratio, price/earnings ratio, price/sales ratio, dividend yield and the enterprise multiple.
  7. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  8. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  9. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  10. Stock Analysis

    The Biggest Risks of Investing in Amazon Stock

    Find out which risks are most important to Amazon's shareholders. Learn which operational risks impact share prices and which financial risks affect investors.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!