Costco Faces Headwinds

Updated to 11:32 a.m. EST

Costco ( COST) posted strong earnings and revenue gains in its latest quarter, thanks in part to a strike faced by its competitors and the dollar's decline. But will the company be able to keep its momentum going without as much wind at its back?

Even with that assistance, the company saw its gross profit margins fall slightly as a portion of sales. While its operating profit rose sharply, part of that improvement was due to lower store-opening costs, an indicator that Costco's expansion is slowing, which could curtail future revenue growth. Part of the improvement also came from an easy comparison with last year, when the company's operating profits took a hit due to a large one-time charge.

"I thought Costco's report was somewhat disappointing," said one hedge fund analyst, who asked not to be named. "If they have a declining sales trend, they're not going to make their numbers."

The company expects to meet analysts' expectations more or less in its coming two quarters. Costco expects third-quarter earnings to range from 35 cents to 37 cents a share and its fourth-quarter profits to range from 56 cents to 58 cents a share. Analysts have projected that Costco will hit the midpoint of both ranges.

While the analyst's fund doesn't hold any Costco shares, the company's investors seemed to share his concerns. Despite beating Wall Street's earnings per share estimates by a penny, Costco shares were recently down $1.42, or 3.6%, to $38.29. For much of the last month, the shares have been trading near their 52-week high of $40.42.

To be sure, the wholesale-club chain posted impressive overall numbers in its fiscal second quarter.

Good Quarter, But Concerns

The company earned $226.79 million, or 48 cents a share, in the period. On a per-share basis, Costco's earnings were up 23.1% from a year ago, when it earned $182.07 million, or 39 cents a share.

Sales at Costco rose 14.2% to $11.33 billion in the quarter. Same-store sales, which compare results at like outlets open more than one year, increased 10% at the firm's U.S. stores and 11% at all of its stores. Meanwhile, the company's membership and other revenue grew 12.9% to $218.76 million.

Those results outpaced analysts estimates. Analysts surveyed by Reuters' MultexNet service were expecting the company to earn 47 cents a share on $11.29 billion in total revenue.

The company said it benefited from the recently ended grocery strike in Southern California. The strike, which began Oct. 11, involved 70,000 grocery workers and negatively affected the three big grocery chains in the area, to the benefit of alternatives such as wholesalers.

Costco's overall same-store sales were 50 to 100 basis points higher because of the strike, said Bob Nelson, Costco's vice president of finance and investor relations. Costco did not quantify the bottom-line effects of the strike, for which a settlement was reached late last week.

Nor would Nelson say how much the dollar's decline affected the company's net earnings, although he did say Costco's same-store sales would have been 2.7 percentage points lower if the dollar had maintained the same value vs. a year earlier. The dollar's decline vs. other major currencies increases the nominal dollar value of products sold by the overseas operations of American companies. Costco operates stores in the U.K., Japan, South Korea and other countries.

Meanwhile, Costco's product costs slightly outpaced its sales growth last quarter, rising 14.3% to $10.10 billion. That brought the company's gross margin down by about 5 basis points to 10.84% of sales. Gross margin is the difference between what a company charges customers for its products and its direct costs of acquiring and providing them.

Costco more than made up for the gross margin decline by holding the line on operating costs. The company's marketing, general and administrative expenses increased by 12.2% to $1.08 billion. But as a portion of sales, such costs fell 18 basis points to 9.57%.

But that gain was attributable to a charge the company took last year. In order to bulk up its reserve for workers compensation losses, Costco took a $26 million charge in the second quarter last year. Excluding that charge, Costco's marketing, general and administrative expenses increased by 15.25%, or 9 basis points as a portion of sales.

In the past several quarters, Costco's operating costs have swelled as its health and workers compensation costs have grown. A recent reform of the workers compensation system in California should help reduce costs in that area, company officials have said. Meanwhile, the company has changed its health insurance system to require workers to pay a greater portion of their health care costs.

Costco should start seeing the benefit of those changes starting next quarter, said company CFO Richard Galanti on a conference call with analysts and investors. For the year, the company expects its marketing, general and administrative costs to be flat to slightly up from last year, he said.

"We know that the things we have in place should start to help that," he said.

In addition to declining general and administrative costs, the company's bottom line benefited from a decline in its store-opening expenses. Such costs fell 41% overall from the year-ago period to $4.22 million.

Costco now plans to open some 18 new warehouses this year, down from the 25 it originally planned, Galanti said. Many of those stores openings simply slipped into next year, when the company plans to open far more warehouses, he said.

But on the conference call, analysts noted that this marks at least the second straight year that Costco's warehouse openings have slipped below its original estimates. Last year, the company gave a similar explanation -- that some of its openings had been delayed until this year.

As concerns about urban sprawl have grown, the company has faced increasing regulatory difficulties in opening up new stores, Galanti said. The company has also had trouble at times finding good locations, he said.

Many of the stores included in the company's estimates of openings include those that are nearly completed, Galanti said. The rest are based on the company's "best guess," he said, acknowledging the company is sometimes overly optimistic about the number of stores it can open.

"This is a lot of shoot from the hip. It's not necessarily scientific," he said.

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