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Costco Cheers Up

After recently cutting guidance, the retailer beats targets and gives a rosy view of the holidays.
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Costco

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vaulted Thursday after the warehouse club chain posted better-than-expected earnings and gave an upbeat outlook for the holiday season, offsetting any concerns about the company's admission that dates on some past stock-option grants weren't properly documented.

Costco posted a 1% gain in fourth-quarter profits, along with a 19% jump in revenue and an 8% increase in same-store sales, or sales at stores open for at least a year.

The big sales gains served to assuage fears of a consumer spending slowdown that spread through the markets in August after the retailer lowered its expectations.

"At the moment,

the holiday shopping season looks promising," said Costco CEO Jim Sinegal on a conference call with analysts. "Certainly more promising than we would have expected five or six weeks ago."

When Costco

cut its guidance in August, the retailer said that its margins were being squeezed by markdowns on big-ticket, discretionary items in response to weakness in demand for items such as furniture and electronics. The lowered forecast caused a big selloff on Wall Street at the time.

Since then, retail stocks have rebounded as more recent sales from the sector have suggested that the market's fears about the economy were unfounded. Costco's fourth-quarter sales and earnings results helped to lend to the momentum, and its shares recently were up $4.06, or 8.1%, to $54.13.

"This is a classic case of under-promising and over-delivering," says Morningstar analyst Anthony Chukumba. "Costco reacted to what looked like some unpromising trends developing, but since then, those trends appear to be reversing to some extent."

Sinegal didn't indicate on the call that furniture sales have rebounded, but he did say that sales for toys, winter apparel and electronics were showing strength.

Costco reported earnings of $355.6 million, or 75 cents a share, for the quarter ended Sept. 3, up from $354.7 million, or 73 cents a share, for the same quarter last year. Excluding various items in last year's fourth quarter, earnings per share rose 14%.

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In August, the company predicted it would earn 71 to 74 cents a share. Analysts, on average, had expected 73 cents a share, according to Thomson First Call.

On its top line, Costco reported quarterly revenue of $19.5 billion, up from last year's $16.4 billion and surpassing analysts' expectation of $19.1 billion.

Despite the sales beat, Chukumba says the company's profit margins were a bit disappointing. That aside, he says Costco's approach to analyzing its stock option granting practices in the midst of the options backdating scandal that is raging on Wall Street should encourage shareholders.

Costco said it embarked on a thorough analysis of its options granting practices led by some high-profile, independent directors, including

Berkshire Hathaway

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Vice Chairman Charlie Munger, William Gates (father of the

Microsoft

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chairman, Bill Gates) and a former U.S. senator from Washington, Daniel J. Evans. While the study did find some grants that weren't clearly documented, the study found no evidence of wrongdoing.

In April of 1997, Sinegal and Costco's chairman, Jeff Brotman, received, as part of a broad grant to hundreds of employees, one grant without proper documentation that may have benefited each by up to $200,000.

Other grants in question were made to Chief Financial Officer Richard Galanti and Chief Operating Officer Richard DiCerchio.

Costco won't restate earnings based on the findings of the investigation, but the company said it has transferred $116.1 million of net worth shown on its balance sheet from retained earnings to paid-in capital, and it increased its deferred tax asset account by $31.5 million. For 2006, the company increased its after-tax stock options expense by $2 million.

"Given the lack of historical documentation, it is not possible to precisely determine the amount of the adjustments that should be made," Costco said in a press release. "The actual adjustments made are based on assumptions that are more likely to overstate than understate the effects of the imprecisions identified in the company's option grants."

"This sounds like maybe they were a bit sloppy, but this is not fraudulent activity in any way shape or form," Chukumba says. "These guys have always been great when it comes to corporate governance. Sinegal has always had ridiculously low compensation for his job, and this investigation sounds like one more instance when the company is being particularly transparent in their approach."