Costco's Soft Quarter Belies Margin Improvement

For Rothbort's thoughts leading up to the call, click here.

Costco's (COST - commentary - Trade Now) quarter was clouded by foreign exchange and gasoline price volatility. Excluding those items, the quarter appeared a bit on the light side, but in light of tough comps and the economic slowdown, I am willing to give the company a pass on the quarter.

A silver lining for the period was the overall improvement in gross margins. This is a company that is slowly transitioning to a global model; as a result there will be hiccups as the metamorphosis to a true multinational organization takes place. The shares are off about 2.5% in midday trading today. I agree with the company's share buy-back strategy and would not look to buy COST until it got closer to $40.

The company reported fiscal third-quarter earnings of 48 cents a share on net sales of $15.48 billion. Same-store comparable sales declined by 7% (5% decline in the U.S. and 12% decline internationally). Excluding the negative impacts of gasoline sales and forex, same-store comps rose 2% (flat in the U.S. and higher by 8% internationally). Gasoline was the bigger impact. April sales felt the hit from the Easter shift. Cannibalization accounted for a 35-basis-point reduction in sales. May sales (which will be reported in the fiscal fourth quarter) were running "a shade" negative from those in April.

The strong U.S. dollar relative to foreign currencies hurt Costco by about 3.5 cents a share on an after-tax basis. If there are no major changes in forex rates for the remainder of 2009, the impact on earnings should be about 1 cent per month, or 3 to 4 cents in total.

Costco opened four new locations following additions of eight in the first fiscal quarter and zero in the second. Six new locations will be opened in the fourth fiscal quarter, including three in Asia and one in Mexico. The first Australian location will open in August. Three new warehouses were opened, and one warehouse was temporarily closed in the period.

Overall, the fiscal third quarter was a bit weaker than the second, but not significantly weaker. California was the weakest region (Southern California being weaker than the northern area). The Northeast U.S. was the strongest of the U.S./Canadian regions.

A few more points of interest:

• Merchandise categories (excluding forex) in percentage changes: Food and sundries up low to mid-single; tobacco down mid-single; hard lines negative mid- to high single digits; fresh foods were flat; meat and produce up low single digits.
• Electronics: Deflationary pressures exist; unit sales of TVs and laptops rose 30% to 50%; dollar sales were flat.
• Lawn & Garden: Starting to see some improvements, merchants believe that markdowns are fine; Costco canceled about one-quarter of its order commitment.
• Membership fees were down 6.4% on an as reported basis. Adjusting for the impact of forex and a legal settlement related to membership renewal practices, membership would have increased by 6%.
• Gross margins in the aggregate rose 45 basis points to 10.99%. The lower-margin gasoline business represented 10% of sales in the fiscal third quarter of 2008 (when gasoline prices were higher) vs. 6% in the just-reported quarter.

The company did not present a balance sheet and cash flow statement in its press release. Management blurted out some figures, but it was hard to follow. The company boosted its quarterly dividend in May to 18 cents, which equates to about a 1.5% annual yield. When the stock price dipped below $40, the company started to buy back some stock after halting the program in September. Costco sees itself as buyers of stock over the long run, but that is a matter of cash management and the company does not feel pressured to do so right now.

No positions.

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Know what you own: Other discount variety store stocks include BJ's Wholesale Club (BJ - commentary - Trade Now) Wal-Mart (WMT - commentary - Trade Now), Target (TGT - commentary - Trade Now), Family Dollar (FDO - commentary - Trade Now), Dollar Tree (DLTR - commentary - Trade Now) and Big Lots (BIG - commentary - Trade Now).

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At the time of publication, Rothbort had no positions in the stocks mentioned, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site TheFinanceProfessor.com.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.