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Costco Delivers Another Earnings Beat -- Will the Momentum Last?

By Adam Levine-Weinberg – Updated Oct 7, 2019 at 5:18PM

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Double-digit adjusted EPS growth has been the norm for Costco in recent years, but this streak isn't likely to continue in fiscal 2020.

Costco Wholesale (COST -1.65%) has been on a roll over the past two years, consistently posting strong sales growth and expanding its profit margin. As a result, Costco's adjusted earnings per share jumped from $5.89 in fiscal 2017 to $8.19 in the company's recently completed 2019 fiscal year.

Not surprisingly, investors have rewarded the company by snapping up its shares. In fact, Costco Wholesale has been one of the top-performing large-cap stocks over the past two years, nearly doubling over that period from less than $160 in October 2017 to almost $300 today.

COST Chart

Costco Wholesale stock performance. Data by YCharts.

Costco continued its run of outstanding performance last week, reporting double-digit growth in adjusted EPS for the final quarter of fiscal 2019. However, the warehouse club giant probably won't be able to continue to grow its earnings at this rate, making the stock seem too pricey right now.

Another quarter of strong sales and earnings growth

In the fourth quarter, Costco's sales rose 7% year over year to $46.45 billion. Membership fee income increased 5.3% to $1.05 billion, bringing total revenue to $47.5 billion (also up 7% year over year). Comparable sales rose 5.1%, driving most of the increase in total revenue. Excluding the impact of foreign currency fluctuations and changes in gasoline prices, comp sales growth was fairly consistent across all regions of the world.

Operating income rose just 1.2% year-over-year last quarter, due to a $123 million pre-tax charge related to product taxes for the period between January 2009 and July 2016. (Costco is disputing this tax assessment, but accounting rules require it to record the special charge now.)

Excluding the special charge, operating income increased 9.7% to $1.59 billion, indicating that Costco's operating margin improved modestly last quarter. Net income jumped 14.4% to $1.19 billion -- helped by some favorable one-time tax items -- and adjusted EPS rose 14% to $2.69. This easily beat the average analyst estimate of $2.54.

Higher gross margin (partially offset by slightly higher operating expenses) enabled Costco's margin expansion last quarter. The primary driver of this gross margin improvement was an increase in gasoline margins.

The entrance to a Costco warehouse

Costco recently reported another quarter of strong growth in adjusted EPS. Image source: Costco Wholesale.

Recent earnings tailwinds are fading

Over the past three years, a few key factors have driven much of Costco's earnings growth. First, Costco ended its long-standing credit card partnership with American Express in mid-2016, in favor of a new, more lucrative agreement with Citigroup and Visa. Second, the company increased its membership fees in the U.S. and Canada -- its two largest markets -- in mid-2017. Third, the reduction of the federal corporate tax rate at the beginning of 2018 lowered Costco's tax bill.

Much of the benefit from the credit card switch came in fiscal 2017, but there were certainly some incremental gains over the past two years, as Costco has continued to market the new Costco Anywhere Visa card heavily. The biggest chunk of the membership fee increase flowed through to the bottom line in fiscal 2018, with a significant incremental benefit in the first three quarters of fiscal 2019. Finally, Costco lapped the reduction of the corporate tax rate in the second quarter of fiscal 2019.

Costco managed to achieve double-digit adjusted EPS growth last quarter with little benefit from these previous earnings tailwinds. That said, its margin expansion was driven primarily by strong gasoline margins, with smaller contributions from higher interest income and favorable foreign exchange items.

Gasoline margins tend to be very volatile, so the improvement logged last quarter won't be sustainable. Furthermore, interest rates have plunged over the past few months, which will likely reduce Costco's interest income going forward. (The company's foreign exchange gains were also one-time in nature.) In other words, investors can't count on similar tailwinds to lift Costco's earnings over the next few quarters.

Plenty of long-term growth potential, but the stock is too expensive

Analysts are currently calling for Costco Wholesale's adjusted EPS to increase 4.3% (to $8.54) in fiscal 2020. For fiscal 2021, the average analyst estimate stands at $9.17, 7.4% higher than the average fiscal 2020 estimate. These estimates shouldn't be taken as gospel, but they seem reasonable in light of the lack of clear margin catalysts for Costco.

Costco stock currently trades for more than 35 times its adjusted EPS for the recently completed 2019 fiscal year. That's an exceptionally high valuation for a company that is likely to generate mid-single-digit EPS growth over the next two years.

To be fair, Costco does have ample long-term earnings growth potential. It still has tons of room to expand -- particularly internationally -- as evidenced by its highly successful launch in China in August. However, investors should probably wait for a better entry point to consider investing in the top warehouse club operator.

Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Visa. The Motley Fool is short January 2020 $180 calls on Costco Wholesale and long January 2020 $115 calls on Costco Wholesale. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.

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