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Costco Dropkicked

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By LouAnn Lofton (TMF Bling)
August 5, 2003

Warehouse retailer Costco (Nasdaq: COST) is in an unenviable position. Workers' compensation costs are again haunting the company, while gross margin pressure is pinching profitability. As a result, Costco announced today that its fourth-quarter earnings will fall short of previous guidance. The market responded by dropkicking Costco shares over 16%, to around $30.

Costco now expects to earn $0.46-$0.48 a share for the period ending August 31. The company's previous guidance was for $0.54-$0.56. It earned $0.52 per share in last year's Q4.

Costco's total and same-store sales results were strong for the first part of the quarter. But that top-line strength won't translate into earnings growth for the giant, unfortunately. It looks like a repeat of what we saw back in the second quarter, when earnings were hurt by a $16 million after-tax charge for shoring up workers' comp reserves.

Management didn't say how much of today's warning was directly attributable to higher employee costs, but the situation isn't likely to abate anytime soon. Although only one-third of Costco's employees work in California, California claims make up two-thirds of all claim costs. And the company has yet to figure out a way to temper the effects of this.

Costco is resistant to an obvious solution -- higher prices in its stores. That's evidenced by its admission today that gross margins trended lower than the company had hoped for.  While it's known for being an honest company that will always charge the lowest prices no matter what, at some point those skinny margins may need to be reexamined.

Chief executive officer Jim Sinegal does recognize this, though. In a recent Fool radio interview, Tom Gardner (who recommended Costco for the May 2002 issue of the Motley Fool Stock Advisor) asked Sinegal, "If the higher worker's comp costs trend continues, will you consider passing the costs on in the form of higher prices?"

Sinegal responded, "If it continues, we'll have no choice. Our business has to be profitable. We look first at how we can mitigate that expense. How can we operate better? As you know, we're not very quick to raise prices. But if this becomes a cost of doing business and it's not going away, then we're going to have to account for it."

So far, Costco (and its shareholders) are still taking it on the chin for customers. That can't last forever, though. It will be interesting to watch how Costco handles this situation going forward.

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