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  • Walmart and Target's customers are struggling, but Costco's shoppers continued flocking to its warehouses last quarter.
  • Gross margin fell, but profit benefited from high-margin memberships.
  • A fee increase for members is being delayed, but member growth can still benefit from growing consumer interest and new stores.

Last week’s back-to-back retail disappointments from Walmart  (WMT)  and Target  (TGT)  sparked worry over Costco Wholesale’s  (COST)  results. However, the buy-in-bulk retailer updated investors on its quarterly performance after the bell yesterday, and the data was largely solid. Since Costco’s shares are trading significantly below their peak in April, is it a buy?

Best in breed

In “Let's Stock Up on Some Important Earnings Results,” Action Alerts PLUS co-Portfolio Managers Bob Lang and Chris Versace paint a positive picture, writing that results were “terrific with clear signs it continues to win consumer wallet share.”

The company appears to have managed its way through recent shifts in consumer spending away from general merchandise to food better than Walmart and Target. 

Costco’s revenue grew 16% year-over-year to $52.6 billion, significantly better than the 2% and 4% year-over-year revenue growth reported by Walmart and Target, respectively. For perspective, Costco's net sales for the first 36 weeks of its fiscal year are up 16.4% to $151.97 billion.

Although Walmart and Target pointed to slower growth in general merchandise sales, Costco noted strength among many categories. For example, home furnishings and apparel were among its best-selling products in the quarter, a stark contrast to what we heard from Walmart and Target.

Its membership fees are a big driver of the company’s strength. Those fees provide a steady stream of high-margin sales, and thanks to new store openings, and consumers' interest in stretching their dollars, membership grew 9.2% year over year in the quarter.

Back to Lang and Versace:

“Membership renewal rates hit an all-time with the U.S. and Canada renewal rate at 92.3%, up 0.3% sequentially. The global membership renewal rate rose 0.4% quarter over quarter, coming in at 90% for the first time. Exiting the quarter, the number of member households and cardholders stood at 64.4 million paid households and 116.6 million cardholders, both up over 6%, compared to a year ago.”

Costco’s bottom-line performance was better than Walmart and Target, too.

While those retailers saw a 23% and 41% year-over-year drop in EPS, Costco reported earnings per share of $3.05, up from $2.75 one year ago, good enough for 10.9% growth. 

Membership fees are a big reason for its solid performance, totaling nearly $1 billion, and accounting for 55% of its operating income in the quarter.

A couple of speedbumps

That’s not to say Costco escaped all the negative drag associated with inflation and consumer penny pinching, though.

The company’s gross margin fell, and its operating margin (operating income divided by total revenue) declined slightly to 3.4% from 3.7% in the same quarter ago. Here’s what Costco's management said about gross profit margins:

“Our reported gross margins in the third quarter were lower year-over-year by 99 basis points. This year coming in at 10.19% as a percentage of sales, and that compares to last year’s 11.18% that we reported a year ago, so the 99 basis points down year-over-year. And excluding the negative impact of gas inflation, we would have been down 53 basis points.”

Membership revenue does a lot of heavy lifting when it comes to profit, so Costco’s decision to delay increasing membership fees may disappoint some investors too. 

Costco usually bumps its member fees up every 5.5 years, so it’s about due for an increase. However, management doesn’t think the timing is right, given consumers are already navigating inflation at 40-year highs. It did leave the door open for an increase later on, though.

Furthermore, inventories may raise some eyebrows because they grew 26% versus one year ago.

That’s worrisome because, as we heard from Walmart and Target, it could mean markdowns. However, management offered up a thorough explanation for the increase.

Inventory climbed because of inflation, rather than unit growth, new stores, (20 in the past 12 months), easy comparisons against low inventory levels in some departments, and a strategic increase to support e-commerce expansion (e-com sales grew about 7.9% YoY in the quarter), and late-arriving holiday inventory that will be moth-balled until later in the year.

It admits it may be a little heavy in small appliances and domestics, but it blames that on “late-arriving merchandise.” 

Overall, management says, “We feel good about our current inventory levels. The additional inventory we're carrying is in the right departments, and they feel good about our ability to move it.”

Admittedly, what else would they say? Nevertheless, it ‘seems’ like they have a good handle on it.

The Smart Play

Consumers are facing tougher spending decisions. The personal savings rate soared in 2020 because of wage increases and stimulus payments. However, the rate is declining because wages aren’t growing faster than costs for goods and services anymore. As a result, it's at its lowest level since the Great Recession in 2008.

The squeeze pressuring spending makes it reasonable to assume retailers will see increasing, rather than decreasing, pressure in the coming quarter. Nevertheless, so far retailers like Costco who target higher-income households have held up better. As long as unemployment doesn't increase/spread to those households, that should remain true.

If so, then potential sales growth from new store openings, membership growth, and – eventually– an increase in member fees, make buying Costco's shares appealing.

Its shares are trading at 32 times next year’s earnings estimates. However, that’s on the lower side of its 5-year P/E range of 25 to 48. Additionally, the company’s expected to deliver 10% EPS growth next year, and it’s exceeded analysts' estimates in 10 of the past 12 quarters, so that's encouraging.

Last Wednesday, Lang and Versace bought more Costco for AAP’s portfolio near $431. If they didn't have a full position, they’d buy even more.

On Friday, they wrote:

“If the current position size weren't as large as it is we would be using today's pullback to add even more following the quarterly results. With COST shares still well off their recent highs, and the business firing on all cylinders, we would suggest members that are underweighted the shares use Friday's pullback to square up their position sizes relative to the portfolio's. We continue to rate COST shares a One and our long-term price target remains $620.”

If you want to follow in their footsteps, consider spreading out your orders. Costco’s rallied sharply this week, and they’re entering resistance, so they could see some short-term profit-taking. Regardless, I consider this a best-in-breed retailer that long-term investors ought to be buying on sale this year.

  • Walmart and Target's customers are struggling, but Costco's shoppers continued flocking to its warehouses last quarter.
  • Gross margin fell, but profit benefited from high-margin memberships.
  • A fee increase for members is being delayed, but member growth can still benefit from growing consumer interest and new stores.
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