Last week, Costco Wholesale Corporation (NASDAQ:COST) reported strong earnings for Q2 of its 2015 fiscal year. EPS rose 29% year over year to $1.35 -- $1.25 adjusting for tax items -- beating the average analyst estimate of $1.18. This represented the third straight quarter of strong EPS growth after several quarters of stagnant earnings.
Following the earnings release, Costco CFO Richard Galanti spent more than an hour discussing the company's results and outlook with Wall Street analysts. Here are 5 key points that he emphasized.
Lower income tax boosted earnings
Our company tax rate this quarter came in at a ... very low 30.2% versus 35% last year. Again, the income tax line benefited primarily from a $57 million tax benefit in connection with the special cash dividend. -- Costco CFO Richard Galanti
Costco paid out more than $2 billion in a $5 per share special dividend last month. It gets a tax credit for the special dividends paid on shares held in the company's 401(k) plan, and this reduced the company's tax rate significantly in Q2.
The total tax benefit from the special dividend equaled $0.13 per share. This was partially offset by a separate $0.03 negative tax item. The net result was a significant earnings tailwind, representing about a third of the company's year-over-year earnings growth.
Sales growth accelerating
So excluding gas, our reported 4% U.S. comp sales increase in Q2 would have been plus 8%. Our reported minus 2% international comp, assuming flat year-over-year FX rates, would have been plus 8% as well. -- Richard Galanti
Costco has posted fairly steady sales growth in the high single-digits or low double-digits in the past few years.
If anything, its underlying sales momentum is improving, perhaps due to stronger economic growth and lower gas prices. You can't see this from Costco's raw sales growth numbers, though. In Q2, sales rose 4% and comparable sales rose only 2%.
However, Costco's revenue growth is being artificially depressed by volatility in gas prices and foreign exchange, or FX, rates. Excluding these two factors, comparable sales would have risen 8% rather than 2%: an even better result than the 7% underlying comparable sales growth reported in Q1.
Within operations, excluding gas and other warehouse businesses ... payroll and benefits represented an improvement of 16 basis points of this 29-basis-point improvement. So again, strong sales overall certainly helped us improve payroll and benefits as well and get some leverage there. -- Richard Galanti
Costco's strong sales performance is allowing it to leverage its cost structure. In addition to spreading fixed costs like utilities and corporate overhead over more revenue, Costco is also leveraging labor costs: i.e. increasing labor expense slower than sales growth.
This contributed significantly to the company's margin expansion and earnings growth. The 16 basis point (or 0.16 percentage point) improvement in payroll and benefits expense seen last quarter wouldn't be much for most companies. But for a $100 billion-plus behemoth like Costco, it means close to $200 million in incremental profit on an annualized basis.
Falling gas prices means rising profit
And certainly, gas prices give us plenty of room to be -- to continue to be aggressive. Although with gas prices going up the other way right now ... you don't expect to see those kind of outsized gas profits in the next quarter. -- Richard Galanti
Another major contributor to Costco's earnings growth last quarter was falling gas prices. In periods of falling gas prices, gasoline retailers' margins tend to expand. This allows Costco to save money for its customers while also making a little more money.
Galanti refused to quantify the exact benefit to earnings from the drop in gas prices over the past six months or so. However, he admitted that it was significant and that the year-over-year benefit (if any) would be a lot smaller in the second half of the year, as gas prices have started to creep back up.
A new credit card to drive member loyalty
We think [switching credit card providers is] a big positive over a long period of time, but recognizing big positives, that means giving most of it back to the customer, in this case, most of it back to the co-branded user of a credit card. -- Richard Galanti
Last month, American Express announced that it had been unable to reach an agreement with Costco on terms to renew its long-running arrangement to be the exclusive credit card accepted at Costco. Last week, Costco revealed that it will partner with Visa and Citigroup beginning next year instead.
Many companies have profited from rising demand for co-branded credit card deals in the past few years. As credit card issuers fight for these valuable deals, their partners -- whether they be retailers, airlines, or hotel chains -- have leverage to extract better terms.
Costco's demands ultimately drove AmEx to drop out of the running. However, Costco isn't trying to get rich by negotiating a new credit card deal. Instead, it chose to use its bargaining power to get more benefits for members who use the co-branded credit card. That should foster greater member loyalty and higher long-term sales growth.
In other words, it's just one more way that Costco is keeping its eye on long-term growth rather than short-term profit.