Investors didn't react well to Costco Wholesale's (NASDAQ:COST) second-quarter earnings report. Its shares dropped after the company's earnings per share (adjusted for tax effects) came in at $1.42, $0.05 lower than the average analyst estimate.
However, the comparison between Costco Wholesale's adjusted EPS and the analysts' estimates may have been skewed by the implementation of the U.S. tax reform bill during the quarter. (CFO Richard Galanti hinted at this possibility in the recent earnings call.) Moreover, Costco continues to post remarkably strong sales growth, and its profitability is very stable. This bodes well for its future earnings.
Robust sales growth continues
Costco's sales growth has accelerated dramatically in the past year, following a slowdown in late 2016 and early 2017. During the first half of fiscal 2018 -- i.e., the 26-week period that ended on March 4 -- comp sales surged 9.4% year over year. New warehouse openings pushed Costco's sales growth well into double-digit territory.
Excluding exchange rate fluctuations and gasoline price inflation, Costco still would have posted a strong 6.6% comp sales increase for the first 26 weeks of the fiscal year.
As part of its second-quarter earnings release, Costco also reported its February sales results. The company's sales growth actually accelerated relative to the year-to-date pace, with comp sales up 10.5%, or 7.7% excluding gasoline price and foreign currency fluctuations. The bulk of this acceleration came outside the U.S. and Canada. The timing of the Lunar New Year boosted sales in Asia last month, but Costco also saw strong sales growth in Mexico.
The recent closure of dozens of Sam's Club warehouses may have boosted Costco's February sales. The sales gains could continue to build over the remainder of 2018 as more Sam's Club members switch their allegiance to Costco.
EPS misses expectations: So what?
As would be expected, Costco's strong sales growth last quarter allowed it to reduce its operating expenses as a percentage of revenue. Gross margin also improved modestly year over year, excluding the impact of gasoline price inflation. Additionally, Costco continues to benefit from outsized membership fee growth, after raising prices in the U.S. and Canada last June.
The net result was that operating income surged 20% year over year in the second quarter. That's nothing to sneeze at, even if adjusted EPS did fall short of expectations.
Furthermore, of the $74 million in tax benefits that Costco highlighted, only $22 million relates to one-time effects of the new tax law. The rest reflects ongoing savings that Costco will capture from a lower federal corporate tax rate. Excluding only the $22 million nonrecurring tax benefit, Costco's adjusted EPS would have been $1.54, $0.07 ahead of the average analyst estimate.
Looking ahead, Costco Wholesale's tax savings will increase. In recent years, its effective tax rate has averaged 34%-35%, excluding one-time tax benefits in years that it has paid a special dividend. Going forward, management expects the effective tax rate to average about 28%. This would provide a long-term EPS boost of approximately 10%.
The fundamentals are solid for long-term investors
As long as Costco Wholesale can continue growing comp sales at a mid-high single-digit rate -- which could be a long time, given the company's widening cost advantage over rivals -- it should be able to grow earnings even faster than that.
For example, whereas many retailers are getting squeezed by a tighter labor market and rising wage levels, Costco already raised its starting wage to a minimum of $13 an hour two years ago. Within four years of joining the company, most workers are paid roughly $22.50 an hour. As a result, Costco should have no trouble retaining its employees.
Additionally, while the company will use some of its tax savings to boost wages, it still won't face the same level of wage pressure as most rivals. Indeed, Costco could be a net beneficiary of a tighter labor market, if higher paychecks lead to increased consumer spending.
In short, the retail giant's moat is alive and well. This is a recipe for solid long-term stock performance, notwithstanding Costco Wholesale's relatively high valuation.