Here's Why Costco's Mixed Results Shouldn't Worry Investors

Costco put in a weak earnings performance last quarter, but investors need to look at the long run.

Jun 16, 2014 at 4:00PM

Wholesale warehouse club-driven businesses have been doing well. Executives in the consumer products industry expect this store format to deliver the highest growth during the next two years, according to new research from Deloitte. The slow-growing economy is pushing affluent customers to this channel, benefiting the likes of Costco (NASDAQ:COST).

Costco boasts of a terrific track record, and its third-quarter results highlight its strong position in the industry. However, it faces competition from Wal-Mart's (NYSE:WMT) Sam's Club and other discount retailers like Dollar General (NYSE:DG). Let's take a closer look at Costco and see how it stacks up against the competition.

Inconsistent, but strong
Fiscal 2014 has been a bit patchy for Costco, as it missed consensus estimates in the second quarter, and the trend continued in the third quarter. Its earnings have been under pressure due to an increase in selling, general, and administration expenses, and volatile gas prices.

However, Costco exceeded expectations on net sales by clocking $25.2 billion, representing year-over-year growth of 7.1%. The growth in the top line was fueled by a robust comps growth of 5% year over year in the U.S., and a 3% jump at international locations. Most importantly, its membership revenue, which contributes a major chunk to its profit, grew 5.6% versus the year-ago quarter, to $561 million. Despite the pressure on the margins, the robust top-line growth and a marginal decline in effective tax rates helped it deliver earnings growth, though not as much as analysts would have liked.

The road ahead
Despite weaker-than-expected earnings, Costco is working on initiatives to keep its long-term growth story intact. Expanding its footprint is one such initiative. In the third quarter, it opened four new locations, including two in the U.S., and one each in Japan and Korea. It is moving into Spain for the first time, and is also adding locations in Australia, Korea, and Japan, taking the total Costco store count to 657. By the end of fiscal 2014, it plans to add six more locations, taking the total to 663.

In the last year-and-a-half, the company has focused on e-commerce visibility, and has added mobile apps. It's bolstering the e-commerce channel -- Costco Online -- to woo Millennials by combining e-commerce merchandising with in-store buying efforts. It has added a few categories, like apparel, certain limited apparel items, and some limited health and beauty items. In addition, it has started shipping out of more than one depot to reduce delivery times.

Outside of the e-commerce channel, it has tested Google Shopping Express to offer same-day deliveries of Costco wares in New York, Los Angeles, and San Francisco. Its efforts to sell club memberships via social media initiatives, including LivingSocial and Zulily, are showing early, yet positive, results in wooing new members. Costco has a very healthy balance sheet, and it can easily afford to spend on these long-term growth initiatives, and position itself to counter threats from Dollar General and Wal-Mart.

Competitive threats
Dollar General, the largest of the dollar stores, is not a warehouse club like Costco. Still, it offers a credible threat to Costco on the back of its competitively low pricing. According to a Kantar Retail price survey last year, Dollar General's total shopping basket was the cheapest among the retailers surveyed, coming in ahead of Wal-Mart.

Dollar General is expanding at a very brisk pace, opening about 600 to 700 stores per year. Its increased visibility could be a thorn in the flesh for Costco. However, since Dollar General's performance is also dependent on government assistance, as its customers depend on food stamps, Costco has an upper hand. Costco's target customers are from the affluent section of society, enabling it to sustain its performance, even in troubled economic times.

Wal-Mart's Sam's Club, on the other hand, is a direct competitor of Costco. However, Costco has pioneered the concept of warehouse club retail model, and led Sam's Club in terms of revenue generated per club. Last year, Sam's Club generated $80 million per club versus $162 million  for Costco. Sam's Club announced a new credit card this month in order to woo online shoppers. This will make it the first major American retailer to switch to a more secure payment card technology. The Sam's Club MasterCard, issued by GE Capital Retail Bank, will be available on June 23.

Sam's Club has been trailing Costco by quite a distance. It had a tough quarter last time, with lower-than-expected sales. According to Faye Landes, a senior research analyst at the Cowen Group, a financial services company, "The divergence from Costco is striking, because they're basically in the same business -- but apparently they're not in the same business." The reason behind this anomaly is because Sam's Club is targeting customers who rely on government assistance, unlike Costco.

The bottom line
Despite putting in a weak earnings performance in the previous quarter, Costco is looking solid. The company enjoys an advantage over its peers. A robust business model means that its performance can improve going forward, driven by international expansion and social media initiatives. All in all, Costco looks like a solid long-term bet.

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Shirish Mudholkar 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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