Consumers Pull Back From Costco

In similar fashion to many retailers, discount warehouse titan Costco (Nasdaq:COST) cut prices to move product in its most recent quarter. The fact that a discount chain felt the need to be more promotional speaks to just how difficult the operating environment is these days. Falling gasoline prices also took a bite out of margins this quarter, while a strong U.S. dollar crimped overseas results. Fortunately for investors, these challenges will prove to be short-lived, with the wild card being how quickly or slowly consumers open up their wallets again.

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Quarterly Recap
Second quarter sales fell 1% to $16.59 billion, as domestic same store sales declined by the same amount and deteriorated as the quarter progressed. Specifically, same store sales at U.S. locations grew 7% in September, but dropped 1% in October and 5% in November. International comps dropped a dreary 11%, but management conveyed that overseas divisions were positive in terms of local currencies. The higher mix of domestic stores (406 of 553 total company warehouses) meant total comps declined only 3%.

Continued promotions in non-food sales categories dented margins, which already were razor-thin, as Costco passes along low prices to its more than eight million customers who, in return, pay an annual membership fee. Revenue from memberships grew 4% to $355.6 million. Costco managed to hold purchasing costs in check, but SG&A expenses rose 3% to $1.7 billion due to management's inability to adjust the cost structure fast enough to account for slowing top-line trends. (For more on this sector, be sure to read Analyzing Retail Stocks.)

Lower sales, higher costs and lower interest income resulting from lower interest rates being paid on Costco's investments all contributed to the 26% drop in diluted earnings to 55 cents per share. Having missed analyst estimates, Costco expects to remain promotional to support the top line, which means margins and overall profitability will be sacrificed, if necessary.

Market Environment
With a debt-to-capital ratio of only 21% and plans to open new locations in the U.S. and abroad, Costco will easily survive the difficult retail climate. However, it is suffering more than rival Wal-Mart (NYSE:WMT), for example, which is seeing sales hold up well, as consumers focus on cost and necessities-centered shopping. Wal-Mart's February U.S. sales rose 5% against flat comps at Costco. Meanwhile, Target (NYSE:TGT) saw a 4.1% drop in February sales and continues to struggle with difficult sales and an in-house credit card portfolio that is being hit hard by rising default rates. (Learn everything you need to know in our Debt Ratios Tutorial.)

Bottom Line
Looking at the discount warehouse rivals, Wal-Mart's Sam's Club posted a 5.9% increase in February comps, while BJ's Wholesale (NYSE:BJ) saw a 5% increase in recent quarterly sales on strong food sales. Unfortunately, Costco is finding that much of its merchandise mix is not necessity and that consumers are not willing to buy in bulk when the future remains so uncertain.