Watch Costco's Costs

Warehouse club operator Costco Wholesale (Nasdaq: COST  ) reported first-quarter results this morning that were stronger than expected. The announcement also highlighted Costco's ongoing challenges, however -- a prime example of why you should dig deep into a company's earnings release, rather than take sales and earnings figures at face value.

For the quarter, net sales (which exclude revenues from membership fees) climbed 14% to $10.31 billion. Same-store sales increased an impressive 11% for the quarter, while earnings jumped 10% to $160.2 million.

While Costco should be commended for its superior sales growth and strength in same-store sales in particular, the fact that earnings grew at a slower rate than sales should be the first tip-off that there might be more here than meets the eye. Costco's inability to benefit fully from exceptional growth in sales implies that between the top line and the bottom, costs must have risen.

That's just what you find, too, when looking at Costco's gross margins and selling, general, and administrative (SG&A) expenses. If you've been following the story over the past few quarters -- Costco has battled rising workers' compensation costs in California and increased competition from Wal-Mart's (NYSE: WMT  ) Sam's Club -- this comes as no surprise.

In fact, gross margins shrank year over year from 10.67% to 10.57%. That might look like a modest decline, but a margin contraction of 10 basis points for a company like Costco (where margins are already thin) is disappointing. Moving further down the income statement, SG&A expenses rose to 10.01% of sales from 9.86% last year. Higher health-care and other employee costs continue to plague Costco.

Costco will benefit from California's supermarket strikes as long as they continue, and net sales and same-store sales will reflect that. However, longer-term issues remain, and Costco's war with Sam's Club isn't over. Celebrate its sales successes, but don't lose sight of Costco's gross margins and expenses as it faces the challenges ahead.

Costco was Tom Gardner's May 2002 recommendation inMotley Fool Stock Advisor.

Want to talk about Costco with other Fools? Check in on our Costco discussion board.


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