Iceberg, excellent post. Glad you are still out there paying attention to Costco and sharing your analysis. Become a Complete Fool
You are right, of course, that earnings growth has lagged book value growth since 1999, and that this is not a good thing.
Breaking it out further into the primary components of Costco's earnings, let's see if can find any clues to where the problem has been during 1999-2002.
1998=440M (1.8% of net sales)
2002=769M (2.0% of net sales)
1998=21,380M (89.7% of net sales)
2002=33,983M (89.4% of net sales)
1998=2070M (8.7% of net sales)
2002=3575M (9.4% of net sales)
1998=460M (1.9% of net sales)
2002=700M (1.8% of net sales)
1. Net sales growth over this four-year stretch has been 59%. This actually is better sales growth than the 47% over the prior four years.
2. Member fee revenue has grown by 75% over the last four years. The growth rate during the prior four years was only 38%. This jump is probably the result of more aggressive fee increases and the Executive membership program introduced within the last four years (under which one pays $100/yr and gets a 2% rebate).
3. The member fee item is VERY important to Costco's bottom line. Note that in 2002 member fees of 769M actually EXCEEDED after-tax earnings of 700M. The former is 2.0% of net sales. The latter is 1.8% of net sales. Stated otherwise, ex the member fees, the company would be operating at a loss of 20 cents for every $100 of net sales. (In 1998, ex member fees, the company made 10 cents for every $100 of net sales.)
4. Gross margins were 10.3% in 1998 and improved to 10.44% in 2002. The trend going back to 1992 has been gradual improvement in gross margins, from 9.1% in 1992 to 10.67% in the quarter just ended for Q1 FY03. This part of the moat seems secure. Even with the 2% rebate for Executive members, which hurts gross margins, Costco is doing a good job at maintaining or slightly improving gross margins. According to the CFO, more of the same gross margin improvement is projected for FY03 as Costco continues to buy better and pass along most, but not all, of the savings to its members.
5. SGA expense has been a big problem. From 1993 to 2000 it was at 8.7% of net sales most years, then it jumped to 9.2% in 2001 and 9.4% in 2002. In Q1 FY03 it hit 9.86% according to my notes from the conference call. The main culprit according to the CFO is higher health and worker's comp insurance costs. The slippage here over the last two years has been remarkable, and it has had a very negative impact on the bottom line, more than offsetting the improvements in gross margins and fee income. The negative swing from 8.7% in 2000 to 9.86% last quarter represents 116 basis points of margin degradation. That is huge for this kind of low margin business.
6. Of course, Costco's competitors (actually all retailers) are facing the same problems of higher health insurance costs. I don't know whether Sam's and BJ's are trying to pass along more of the pain to their work forces by reducing benefits and/or increasing co- pays, compared to Costco. It would not surprise me if Costco were adopting a somewhat more pro-employee stance than the other two warehouse clubs, as that seems to be its culture. Good for the employees, not so good for margins and the stock price, I guess. But it doesn't seem like a permanent franchise-threatening kind of problem to me. All retailers are facing the same problem and eventually will have to pass these costs on to consumers one way or another. So will Costco.
7. Turning to your suggestion that we focus on whether the true earnings power of the newer Costco stores has not yet kicked in, I agree this is a critical issue to analyze. My initial gut reaction is that Costco's invasion of "Sam's territory" over the past several years surely has been (and remains) a tough battle. I want to study that triangle chart in the new 2002 annual (being mailed next week) where they show sales per warehouse broken out by year opened. The $64 question is whether the new clubs in Texas, the Midwest and other Sam's strongholds are able to ramp up sales at a pace comparable to Costco's historical averages. If these newer clubs outside of Costco's traditional territory can ramp sales and achieve the same kind of operating leverage that Costco has enjoyed with other new units, that will spread the higher SGA over more sales and help the margins for the entire company. If, on the other hand, greater competition results in these clubs being perennial laggards, that will mean that we won't get the returns targeted by management. I think the market may be looking at Costco's decision to tilt the mix of new stores in 2003 toward more infilling in traditional Costco territory and less invading of Sam's country, and reading between the lines that Costco is a bit disappointed with how the invasion has gone thus far. That thought certainly has crossed my mind. The triangle chart may provide some clues.
That's enough for this installment. Would love to hear from ctm and bsilly as well as iceberg and others here who have helped us all understand Costco better.
As a teaser for another day's discussion, is anybody else wondering what Walmart is going to do with Sam's? Sam's is dragging down the rest of Walmart's operations and making it harder for the mother ship to achieve double-digit earnings growth. I think they are intent on "fixing" Sam's and I never underestimate the combined power of the institutional imperative plus testosterone. But if Sam's continues to be a drag on WMT's bottom line growth, will WMT keep throwing capital into Sam's, or will it try something new? They obviously have a huge investment in all the existing Sam's warehouses and they aren't going to mothball them. But what if they decided to abolish (or drastically cut) member fees and effectively converted the Sam's clubs into regular old hypermart giant boxes that sold cheap stuff to all takers? Would that be a rational competitive response for WMT to take? What would the impact be on Costco?
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Iceberg, excellent post. Glad you are still out there paying attention to Costco and sharing your analysis.
Become a Complete Fool