Retail giant Costco Wholesale (NASDAQ:COST) is set to report its Q2 results for the 2016 fiscal year on Wednesday evening.
For Q1, Costco unexpectedly reported a year-over-year decline in earnings per share despite solid adjusted comp sales growth. Many of the same headwinds -- and perhaps some new ones -- probably kept a lid on its earnings growth in Q2 as well. Here are three things that investors should pay attention to in Costco's upcoming earnings report.
What's the impact of credit card disruption?
One key item that held back Costco's earnings in Q1 was disruption related to the impending shift of its co-branded credit card from American Express (NYSE:AXP) to Citigroup (NYSE:C).
Costco CFO Richard Galanti explained a few months ago that American Express had stopped signing up new customers for its co-branded Costco credit card. This cut off what had been a steady stream of incentive payments to Costco, reducing EPS by $0.02 during Q1.
The credit card headwind will continue until Citigroup starts issuing Costco credit cards. That's scheduled for June, under a transition agreement that American Express and Citigroup finally nailed down this week.
Investors should keep an eye out for whether the EPS impact of this credit card transition increased in Q2. However, the most important thing to listen for on the Costco earnings call is any commentary from Galanti on how the switch from American Express to Citigroup in June will affect earnings growth thereafter.
Did sales rebound in February?
A second issue that investors should watch is Costco's sales trend. For the past few years, Costco has posted fairly consistent comp sales growth of 6%-7%, excluding the impact of fluctuations in gas prices and currency exchange rates. Costco stayed within this range during Q1, posting 6% adjusted comp sales growth.
However, Costco's comp sales trend has deteriorated in the past few months. In December, comp sales increased 4% year over year, and in January, comp sales rose just 1% year over year. Costco attributed this slowdown partly to bad weather and a shift in the timing of the Super Bowl.
If that's true, then sales trends should have rebounded in February. Costco will announce its February sales results within the Q2 earnings report. If adjusted comp sales growth doesn't return to at least 5% -- and hopefully better -- investors will be left wondering whether Costco's high-growth days are ending.
How did margins hold up?
Finally, investors should pay attention to Costco's margin performance. Slower sales growth makes it harder to offset normal inflation in operating expenses. Since Costco survives on very thin profit margins, even small changes to its profit margin can have a significant impact on its earnings.
During Q1, Costco benefited from very good cost control, particularly after excluding the impact of stock-based compensation, which was unusually high that quarter. Core gross margin also increased year over year, as the strong dollar has driven down commodity costs in the U.S.
If Costco was able to maintain its gross margin momentum in Q2 while keeping operating expenses under control, it may have returned to (modest) earnings growth last quarter despite its sales slowdown. That would bode well for a return to faster earnings growth later this year.