There’s More to Costco’s Story Than Its Latest Earnings Show

Costco missed EPS estimates for the second quarter, but the company’s solid operating strategy should maintain long-term profitability.

Mar 19, 2014 at 1:52PM

Long-term investors shouldn't panic over the latest earnings report from Costco Wholesale (NASDAQ:COST). While sales grew in the second quarter, they were offset by weak sales in non-food merchandise, lower gross margin in fresh foods, and lower profits overseas . This is not surprising for a low-cost retailer that tends to absorb higher costs to maintain low prices.

The company reported weaker-than-expected results, as its sales decreased overseas along with revenue from non-food merchandise. The company missed EPS market estimates for the second quarter by $0.12 and reported actual EPS of $1.05. Shares closed down 2.8% to end the day at $113.26. Net income for the first six months of fiscal 2014 dropped 8% to $888 million from $963 million in fiscal 2013. Diluted EPS was $2.01 versus $2.19 in fiscal 2013. However, comp store sales for the second quarter and first half of fiscal 2014 rose 3%.

Costco is focused on expansion, especially overseas
A closer look at the numbers reveal that year-over-year comparison of net income with fiscal 2013 was less than ideal. This was due to a tax benefit reported of $0.14 per share from a special cash dividend paid in December 2012 to the company's 401(k) plan participants. Without this tax benefit, results would have been more in line with fiscal 2013.

Despite the weakness, the company still plans to open 14 additional warehouses before the end of the current fiscal year of August 31. Nine new stores were opened during the first quarter alone. Costco is considered a pricing authority, allowing the company to compete well with rivals Target (NYSE:TGT) and Wal-Mart's (NYSE:WMT) Sam's Club; it also has a loyal cardholder base. Cardholders total 72.5 million, and the renewal rate for U.S. and Canada customers is 90%. The company has also rewarded investors with a dividend that has risen 12.7% per year since 2004.

Costco has also been aggressively expanding overseas and its business model is showing acceptance in places like Asia and Australia. Target, on the other hand, has mostly focused its operations in the United States. Fiscal 2014 was the first full year of operations for Target's Canadian stores, and it has been dealing with significant backlash brought about by a massive data breach that forced the company to grant promotions to the customers affected. Its comp sales for the fourth quarter ended Feb. 26 decreased by 2.5%. They were on a positive track until the Dec. 19 announcement of the customer data theft, which led to softer results during the holiday quarter.

Future expenses related to the theft of 40 million credit and debit card records, along with 70 million other records, haven't been estimated but are expected to be "material" on operating results. According to Reuters, during the holiday quarter Target reported costs related to the breach of $61 million; most of this was covered by insurance. Since the start of the year, Target's shares have dropped about 3.1%.

Rival Wal-Mart has more geographical diversity and strong web presence
Wal-Mart's warehouse club Sam's Club net sales grew by 1.6% over fiscal 2013 to $50.6 billion. Sam's Club also posted a higher increase of 3.8% in its comp store sales for the fiscal year ended Jan. 31, 2014. While Wal-Mart Stores has a well known global presence, Sam's Club's 621 clubs are centered in the U.S. and Puerto Rico. This gives Costco an edge as it expands overseas. Costco's expansion can help to diversify the location of its U.S. business, which has thus far been concentrated around California; Sam's Clubs are more spread out throughout the 50 states .

Long-term growth for Costco is expected to also come from online sales. E-commerce has been an area that Wal-Mart has placed a lot of attention on and its online sales have shown faster growth than sales at its retail locations. Wal-Mart is ranked fourth in terms of sales on Internet Retailer's Top 500; its online sales grew 30% over fiscal 2013 and surpassed the $10 billion mark. Costco is also doing well online, posting 24% and 20% growth in e-commerce revenue during the first and second quarters of fiscal 2014. Costco's online business is not as mature as Wal-Mart's, so its online business should prosper, especially as the company offers more product categories and improves its inventory management .

Foolish conclusion
Costco recent drop in net income should not be interpreted as weakness in the overall business. The company appears poised to perform well over the long-term and has a variety of factors working in its favor, such as its international expansion and the further development of its e-commerce site. The recent drop in price presents an interesting buying opportunity for investors.

What other great retail picks are out there?
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they’re planning to ride the waves of retail's changing tide. You can access it by clicking here.

Eileen Rojas has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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