Will Better Sales Boost Costco Wholesale's Bottom Line?

Costco Wholesale (NASDAQ: COST  ) reported strong June sales numbers on July 10. While the warehouse giant seems to be extending its lead on Wal-Mart's (NYSE: WMT  )  Sam's Club, some investors are still concerned by Costco's tight margins and recent earnings. While there is no way to tell what Costco's next earnings release, on October 9, will bring, there are reasons for investors to be optimistic that Costco is doing well. 

Source: Costco

June sales numbers were strong
So how strong was Costco's June?  Costco's June same-store sales rose 6% (vs. expectations of 5.4%), on higher gas prices and a strong 7% jump in international comps. If not for a negative foreign currency effect, international comparable sales would have been even higher (8%). The numbers beat analyst expectations across the board. 

In addition to the strong same-store sales, Costco's net revenues soared 10% in June, totaling $10.89 billion. 

Gas inflation: a net positive for Costco
Higher gas prices are typically a good thing for Costco. If you are unaware, Costco earned a whopping $11.2 billion in fuel sales last year. However, the benefit of high gas prices is more than simply the revenues Costco generates on its gasoline sales. 

Costco considers gasoline sales an ancillary business, and it sells it gas at a lower margin than other products. Costco's strategy is to lure customers in with ancillary sales, and keep them at the store to buy other (higher margin) products. There's evidence that this strategy works. In a 2011 issue of The Costco Connection, the company noted that 30% of customers who came to Costco for cheap gas, ended up buying higher margin goods in the store. Costco also points out that membership renewal rates lean higher when gas prices spike; members will renew just for the cheap gas. For more information on this, see the 2011 issue directly, or visit HHC publishing, for a summary on all of Costco's ancillary business benefits. 

We've also seen Costco mention higher gas prices as a catalyst for better profits and membership renewals (after strong quarters), and they've mentioned lower gas prices as the culprit for poor results. As the chart below shows, gas prices have risen in recent months. Could this spike in fuel costs drive traffic, and thus profit, for Costco this quarter?

.  

US Retail Gas Price Chart

US Retail Gas Price data by YCharts

Of course, you can also get cheap gas (with a membership) at Sam's Club but, for whatever reason, customers like Costco more. Fellow Fool Jayson Derrick recently pointed out that Costco has a big lead on Wal-Mart's Sam's Club, when it comes to fuel, as it does anything else. While Sam's Club recently unveiled a cash back fuel incentive, it still had weak -0.6% first-quarter comparable sales.

I actually don't think this discrepancy is due to differences in the gasoline. I think that Costco's store experience is better; customers prefer to shop at Costco over Sam's Club (whether they're buying gas or cereal). If someone is on the fence about a wholesale membership, and high gas prices push them to buy one, they'll probably pick Costco.

Thanks to higher gas prices, I'm expecting a strong new membership number in Costco's next quarter. 

Looking beyond sales
Costco always leads with their sales numbers in earnings releases; it's clear they want investors focused on that. .

Each month, Costco issues a report, like this one, with their monthly sales numbers. They don't mention margins, or anything else in terms of operations. Costco's earnings releases, similarly, lead with sales figures. It makes sense, given that the company has a business model that is built on high volumes and tight margins. Sales and membership renewals are the keys for Costco; yet, we still need to know if these sales will fall to the bottom line. 

Analyst's are only expecting a very small increase in EPS for Costco's next quarter, but its sales are much higher (year over year). If we look at Costco's sales for June of last year we see same-store sales of 6% and net sales of $9.92 billion. That means that this June's net sales are nearly a billion dollars ahead of the same period last year. This lead has expanded since May. 

The hard part, in determining what earnings will be, is that Costco's operating margin has slid a bit. This metric measures profitability after most operating costs (labor, etc.) are factored in, but before interest and taxes are accounted for. As the chart below shows, things have become a bit tighter for Costco. 

COST Operating Margin (TTM) Chart

COST Operating Margin (TTM) data by YCharts

If both of these trends (much higher sales and slightly tighter margins) are to continue, I think Costco will still do fine. Analysts are only expecting an earnings boost of 3 cents per share for Costco in the fourth quarter, easily attainable if these positive sales trends continue. 

Stick with Costco
Costco may be working on a strong quarter. It doesn't really matter if they meet analysts short-term expectations. What matters is that Costco's growth story, and the health of its underlying business, appear to be intact. 

Costco looks strong compared to most retailers, because it gives customers value and quality they can't get elsewhere. That's why they're fairly well in this tight retail environment. I think June's sales numbers are a positive sign, and I expect that Costco's business results (sales and earnings) will be satisfactory for the foreseeable future.

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