Costco Living Up To Some High Expectations

One of the problems of having had a lot of success is that it can put expectations at unreasonable levels. That would certainly seem to be a risk for Costco (Nasdaq:COST), as analysts, journalists and commentators have often heaped praise on this warehouse format retailer. While the company may well find it harder to squeeze more efficiencies from an already highly efficient system, the international growth opportunity alone makes this a name worth watching.

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Delivering on High Expectations in Fiscal Q3
Costco had relatively high bars for this fiscal third quarter and management basically met them. Revenue rose more than 8% on a 5% comparables increase. Foreign comps were even stronger (8% in constant currency), while traffic trends in North America (up more than 3%) were pretty solid in their own right. Costco also saw a 9% increase in fee income, as a double-digit price hike works its way through.

Margins were alright, but mixed. Gross margin was a little bit stronger (and tends to be a closely watched metric), while operating expense leverage was perhaps a little disappointing. All in all, while operating income did grow 12%; per-share results would have missed expectations by a few cents, were it not for favorable interest income and tax expense.

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2012 Isn't Going to Get Easier
Costco has a good news/bad news situation for the rest of this year, in that last year's comp-store sales growth was quite strong (double-digits in many cases). That has established a pretty high bar for the rest of the year. I can't say that I understand how it's a problem to follow up a 10% increase in sales with a 5% increase in the following year, particularly, when most comparable companies like Walmart (NYSE:WMT) or Target (NYSE:TGT) aren't doing meaningfully better. Nevertheless, count on a few analysts bemoaning the "slowing momentum."

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Still an Organic Growth Story
While Costco is quite a bit larger than BJs in terms of store count, there are fewer Costcos than Sam's Clubs in the U.S. In fact, there are still entire states that have no Costco presence and many others that have minimal presence. Certainly there's a limit to the number of stores that a given area can support, but Costco doesn't seem especially close to that limit.

I believe that's even more the case when looking at the company's international prospects. Costco is pioneering the warehouse concept in many countries and it seems hard to imagine that there isn't more room around the world. It will be interesting to see, though, if the company can find the same sort of logistical efficiency in markets like Mexico or Australia that is has achieved in the U.S.

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The Bottom Line
If I'm bearish on Costco at all, it's that I'm not sure they can drive much more efficiency in the U.S. without starting to dismantle some of what makes the company so good (including reasonable wages and benefits for workers). Then again, Costco has always had its doubters and management has generally made them look foolish over the long term.

I don't think Costco shares are especially cheap today. Assuming mid-single digit compound free cash flow growth over the next decade, fair value would seem to be in the high $80s. That said, while Costco may not be impressively undervalued, I see nothing wrong with holding (or perhaps even buying) a great company at a fair price.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.