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3 Things Costco Management Wants Investors to Know

By Daniel B. Kline – Updated Oct 14, 2016 at 3:38AM

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The company had a better-than-expected quarter, and one big potential problem looks to be behind it.

Costco reported its first full-quarter results since switching rewards credit card providers. Image source: author.

Costco (COST 0.46%) has done a good job confounding expectations.

Many analysts expected the company to take a big hit when it switched credit card providers from American Express (AXP 1.42%) to Visa (V 0.35%) in June. That move, which led to short-term customer dissent, and the ever-present threat of people deciding it's easier to shop online, loomed over the company's Q4 results.

And while those fears were legitimate, the warehouse club managed to persevere despite its problems. The chain reported higher-than-expected profits in Q4, partly because it paid lower fees to its new credit card partner versus its previous one.

Costco delivered earnings of $1.77 a share, up 2% (or $0.04) over last year's Q4 earnings of $1.73 a share. In addition, when factoring out gas sales, the company posted 2% comparable-store sales growth in the United States, 5% growth in Canada, and 1% in the rest of the world, for a total gain of 3%.

Those were very strong numbers, suggesting that even though it keeps getting easier to shop online with ever-faster delivery being offered by the leader in that space, people still want to shop in Costco stores. That's very good news for the the company, and CFO Richard Galanti seemed very happy during the during the company's Q4 earnings call, which Seeking Alpha transcribed (registration required).

During the call, the CFO shared a number of things he wanted investors to know.

What's selling well?

Overall Costco reported sales of $35.7 billion, up 2% from Q4, 2015 sales of $35 billion. Aside from gas sales, which were a drag on the overall number because of lower prices, Galanti noted that spirits, sundries, and deli were top sellers, while a category that's received a lot of negative publicity has started to show major weakness.

"Tobacco was the big negative, of course, as we have talked about that, and that was down 21% year-over-year as we continue to see lower sales in that category," the CFO said, adding that he expected to continue to see tobacco affecting results into the early spring.

Hardline goods, he added, were up by mid-single digits.

"The departments with the strong results were majors, electronics, sporting goods, health and beauty aids, hardware, and tires," he said. "Within softlines, which was up in the low single-digits, apparel, small electrics, and home furnishings were the standouts. Within fresh foods, produce and deli were the strongest of the four departments."

Galanti also told those on the call that meat and other types of protein were weaker because of deflation, while the company's strongest ancillary businesses were hearing aids, pharmacy, and optical.

Membership revenue was strong

Since Costco makes the majority of its profit from membership fees, watching those numbers gives a good window into the health of the chain.

"[In] membership fees, we saw good results for the quarter," said Galanti. "Reported were $832 million, up 9 basis points, and $47 million, or up 6% in dollars versus last year's fourth quarter. It would -- the $47 million would have been up $50 million if you would adjust it for FX."

The company closed its fiscal year at 86.7 million people carrying a Costco card at year end, up from 85.5 million at the close of Q3.

The credit card switch worked

Short of doing a celebratory dance while yelling "I told you so," Galanti couldn't have been more happy when talking about how the switch from American Express to Visa went. He did acknowledge "a few operations glitches during the first few weeks after the cutover" but said that those problems were in the past.

"The new card is fantastic for our members. In terms of increased cash-back rewards, the estimate is about a 40% to 50% improvement in the reward program," he said. "And it's also great for us in terms of driving member value and sales over the next years and of course lowering our effective costs of accepting credit and debit cards."

The CFO also shared that there are approximately 11.4 million American Express co-branded cards, representing about just under 7.5 million accounts that were transferred to the new Visa card. About 85% of those cards had been used within the past 60 days, which is what the chain considers an "active" account.

"Currently, over 85% of the accounts transferred over have now been activated with Costco," he said. "And since June 20 and just the past many weeks, 1.1 million members have applied for the new card and over 730,000 new accounts have been activated."

That's around 1 million new cards in circulation, according to the CFO, who added that after 14 weeks "we are beating our initial expectations in terms of conversion, usage, and new sign-ups to the card."

Daniel Kline has no position in any stocks mentioned. He does not care for pumpkin. The Motley Fool owns shares of and recommends Costco Wholesale and Visa. The Motley Fool recommends American Express. 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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