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Costco Drives A Hard Bargain

Posted: Oct 10, 2008 13:38 PM by Ryan C. Fuhrmann

Tickers in this Article: BIG, TJX, SPLS, BBY, TGT, BJ, WMT, COST

Membership warehouse operator Costco (Nasdaq:COST) released second-quarter earnings October 8 that continued to demonstrate why it is one of the safest bets in retailing these days. Given the diminished value of real estate, investment accounts, higher commodity costs and anemic economic-growth prospects, consumers are looking to stretch their dollars as much as possible, and Costco is one of their primary destinations. But is it the best destination for investors?

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The Quarterly Recap
Total quarterly sales improved 13% on new store growth and reported same-store sales of 9%, which would have still been an impressive 6% when stripping out the impact of higher gas prices. Management cited particular strength in the Midwest and Southeast, with both less affected by the housing bubble and the former representing a newer market for Costco and subsequent favorable comp trends.

On the cost side, gross margins fell slightly, which was attributed in large part to lower gasoline profitability given volatile oil prices and some weakness in ancillary businesses such as photo, food court and optical. Fortunately, oil and food commodity costs have moderated, but management was quick to concede that this could change quickly. (Speaking of margins, be sure to check out Analyzing Operating Margins.)

The bottom-line result was an increase in quarterly diluted earnings to 90 cents per share, up from 83 cents a year earlier, which would have been higher were it not for a couple of one-time charges. This was enough to exceed analyst projections, though overall market malaise has kept the stock firmly below $60. Costco expects full-year earnings of $3 to $3.25, a range sufficient to give it wiggle room if the economy worsens or commodity inflation again starts to rear its ugly head.

A Safe Retailer These Days
The company is proving that it is relatively immune to North American economic woes, which is where about 93% of its store base is located, the vast majority in the U.S. Increasing price consciousness among consumers is driving them into the arms of Costco, archrivals BJ’s Wholesale Club (NYSE:BJ), Wal-Mart’s (NYSE:WMT) Sam’s Club and discount chains such as Big Lots (NYSE:BIG) and TJX Companies’ (NYSE:TJX) Marshall’s, T.J. Maxx and HomeGoods chains.

Costco hasn’t escaped completely unscathed, however. Management mentioned during the earnings call that one of its enhanced money-market funds had broken the buck, tying up $190 million of approximately $1.1 billion held in the category. The obvious risks that has placed on company liquidity was a key reason Costco decided to place its share repurchase program on hold for the time being. (Interested in more information about repurchases? Check out A Breakdown Of Stock Buybacks.)

Bottom Line
Overall, Costco easily remains one of the least-risky retailers out there. Understandably, the stock is not trading at bargain-basement levels - current full-year guidance places it at about 18 times earnings. That may not be an unreasonable price to pay for peace of mind right now, especially if you have exposure to the financial and industrial industries. Plus, Costco has decent growth prospects - it plans to open 25 stores this year and 26 to 30 next year, which represents about 10% growth on the current base of 544 stores. In addition, it is just getting warmed up with its international expansion.

I can easily understand the argument for owning Costco in the current uncertain environment, especially if it falls to the low $50s again. But I also can’t help noticing that preeminent retailers such as Target (NYSE:TGT), Best Buy (NYSE:BBY) and Staples (Nasdaq:SPLS) are trading at low-teens multiples off consensus earnings expectations for this year. I am personally more inclined to hunt for these types of bargains right now given the upside potential, but the best bet might be to wait and see what happens in this sector as the economy continues to struggle.

By Ryan C. Fuhrmann

Ryan C. Fuhrmann, CFA, has a background in portfolio management, overseeing assets for high-net-worth individuals and covering a broad array of industries from a generalist perspective. An active student of investing, he focuses on communicating his ideas as an investment writer and learning from the financial community. Ryan is also actively involved with the CFA Institute. Feel free to visit his website at www.rationalanalyst.com.

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