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Can Costco Wholesale Corporation Maintain Its Earnings Growth?

By Adam Levine-Weinberg - Sep 22, 2015 at 10:40AM

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Sales growth has slowed in the past couple of quarters, but long-term investors shouldn't worry.

Discount warehouse titan Costco Wholesale (COST 1.24%) is scheduled to report earnings for the fourth quarter of its 2015 fiscal year next week. Through the first three quarters of the fiscal year, Costco's adjusted earnings per share rose 15% year over year. Can it maintain this strong growth rate going forward?

Sales growth takes a small step backward
Earlier this month, Costco reported its sales results for the month of August and the fourth quarter as a whole. For the second straight quarter, Costco's comparable store sales fell by 1% year over year.

This comp sales decline was driven by the strong dollar -- which reduces the value of sales in Costco's foreign markets -- and falling gasoline prices. Excluding these two volatile factors from Costco's sales results, the company posted comp growth of 6% in the fourth quarter, consisting of 6% growth domestically and 7% growth internationally.

Costco's underlying sales growth remains solid. Photo: The Motley Fool

That is a very healthy level of underlying growth. On the other hand, it's slightly slower than the 7% adjusted comp sales growth Costco delivered in the first three quarters of the year. Comp sales growth also slowed further to 5% (excluding changes in fuel prices and foreign exchange) in August.

Earnings growth moderating
Due in part to the modest slowdown in sales growth, as well as some tough comparisons to last year, analysts expect Costco's EPS to rise only 5% year over year in Q4. That would be a far cry from the 15% growth Costco has reported year-to-date.

Costco CFO Richard Galanti also warned investors last quarter that the retailer will continue to face tough comparisons in the first half of fiscal 2016. Analysts currently project that EPS growth will slow to just 3% in the first quarter of fiscal 2016 and 9% for the full fiscal year.

However, before shareholders start to worry, it's important to recognize that Costco's earnings growth can be quite lumpy. (The volatility of fuel prices and exchange rates is one major reason for that.) For example, adjusted EPS increased less than 4% year over year in fiscal 2014, but that wasn't a sign of long-term weakness, as earnings growth accelerated again in fiscal 2015.

What will drive the next round of earnings growth?
There are a few reasons to expect Costco's latest bout of sluggish earnings growth to pass. First of all, the strengthening of the dollar has cut into Costco's earnings growth over the past year. When the dollar finally stabilizes relative to other currencies, this headwind to earnings growth will disappear.

Second, Costco is replacing its long-standing exclusive credit card partnership with American Express with a new deal with Visa and Citigroup as of April. The new agreement will cut Costco's credit card fees almost to zero, down from about 0.6% under its current agreement.

Considering that Costco operates on extremely tight margins, the savings on credit card fees will really add up. Some of it will fall to the bottom line, but Costco is likely to reinvest a significant portion of its savings by lowering prices even further to attract new members and gain wallet share.

Third, Costco may increase its membership fees in the U.S. and Canada within the next year or two. Costco last raised its membership fees in these markets in late 2011, and it has tended to increase the fee by $5 ($10 for executive members) every five years or so.

Since Costco generates the bulk of its income from membership fees -- fee revenue totaled $2.4 billion in fiscal 2014 -- membership fee increases tend to produce big jumps in earnings. A membership fee increase could therefore accelerate EPS growth in fiscal 2017 or fiscal 2018.

Meanwhile, Costco plans to continue adding new warehouses at a steady rate of about 30 per year for the foreseeable future, thereby expanding its market. Thus, investors should look beyond what may be a few quarters of slower earnings growth. Costco still has plenty of catalysts available to drive double-digit earnings growth over the long term.

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