Costco (NASDAQ:COST) had an eventful second-quarter earnings report, in which it not only announced that the cost of its memberships would increase in the United States, but it also reported somewhat disappointing earnings.

The wholesale club saw its revenue for the quarter climb 6% to $29.77 billion, but its net income also fell 6% to $515 million. That took earnings per share (EPS) to $1.17, down from $1.24 in the same period a year ago, and below analyst consensus expectations of $1.36 a share.

Sales were up, but profits were down. That was something CFO Richard Galanti addressed aggressively during the company's Q2 earnings call, which was transcribed by Seeking Alpha (registration required). Essentially, the CFO explained the reason EPS dropped, while also touching on membership and how the increased prices will hit the company's balance sheet.

The outside of a Costco

Costco raised its membership fees for the first time in five years. Image source: Costco.

Why were profits down?

Galanti noted that gas profitability helped drag down EPS, as they finished the quarter lower by $42 million, or $0.06 a share.

"This was primarily a function of last year's very strong second-quarter gas profit results and is consistent with the impact of the gas profitability that rises in gas prices will cause on our earnings from gas," he said.

In addition, the company reported an increase in IT expenses as part of selling, general, and administrative expenses of $26 million, or $0.04 a share. This reflected "both the direct expenses for the quarter, as well as increasing levels of depreciation and amortization on major completed projects that are now in service," Galanti explained. Costco also took a $0.15 hit per share because of stock compensation expenses, which the CFO said becomes less of a negative impact each year.

The warehouse club also experienced higher-than-normal foreign currency exchange expenses of $0.04 a share, along with a $0.03 negative impact per share from paying a slightly higher tax rate. The increased taxes, which were partly due to product mix sold by country, along with most of these other drags on earnings, all helped bring earnings down below last year, and at least some of the things were beyond the company's control.

Galanti never quite said, "Don't worry, things are better than they look," but he certainly made an attempt to explain why the profit picture was not what people expected. And given the unique nature of Costco's business compared with other retailers, his efforts largely make sense. The company grew sales and increased comps, and while the earnings were below expectations, they were certainly not the big story many analysts and journalists made them out to be.

Membership remains strong

Total accounts grew from 47.9 million at the end of Q1 to 48.3 million when Q2 closed. In addition membership revenue rose 5% and the total number of cardholders increased from 87.3 million at the end of Q1, up from 87.3 million when the previous quarter ended. Paid executive memberships -- which cost twice as much but come with 2% back on purchases up to $750 -- increased by 200,000, and Galanti pointed out, as he does most quarters, that the pricier membership represents about a third of Costco's membership base but account for two-thirds of its sales.

Renewal rates were down a tenth of a percentage point in the United States and Canada to 90.2%. Overall, worldwide across all categories, renewals were basically flat and certainly in line with normal results. 

"We feel these are pretty good numbers, and don't really see a lot of impact," Galanti said.

The impact of the membership fee hike

For the first time in about five and a half years, Costco will raise its membership fees in the United States and Canada, markets that make up roughly 88% of its membership base. The cost of a basic Gold Star membership will increase $5 to $60 a year as of June 1, while an executive membership will go up $10 to $120. In addition, the ceiling for cash back on the pricier membership will rise from a $750 cap to $1,000.

"So in terms of how it hits our P&L, our membership income line, approximately one-twelfth if you will, or one month worth of the increase in fees from the June renewers," Galanti said. "That will be the first group that gets this fee increase; approximately 1/12 of the increase will be booked to the income statement in that first month of June, with an additional 1/12 being booked in each of the succeeding 11 months."

The full impact of the increase, the CFO explained, will take quite a while to be felt. "The full P&L impact of these increases will be over a 23 month time line, such that the last group of members to be billed at these new levels will be next May of 2018, with a booking if you will, of those $5 and $10 increases being recorded over that month, and its succeeding 11 months, i.e., 23 months out," he said.

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