Why Costco Is Still a Buy After Earnings

Source: Costco.

Costco delivered lower-than-expected earnings last week. However, the company is still outperforming competitors such as Wal-Mart and Target by a considerable margin, which shows that Costco is a superior player in the industry with rock-solid competitive strengths. The long-term bullish case for Costco is still pretty much intact.

The numbers
Total revenues during the third quarter of fiscal 2014 increased by 7% to $25.8 billion, above analysts' expectations of $25.7 billion for the period. Product sales grew to $25.2 billion, versus $23.5 billion in the same quarter of 2013, while membership fees increased to $561 million, versus $531 million.

Same-store sales during the quarter increased 4% on the back of a 5% increase in the U.S. and a 3% growth rate in comparable-store sales in international markets. Performance was materially better when excluding the negative impact from foreign exchange fluctuations and falling gas prices: Same-store sales in the U.S. grew 6% and international comparable-store revenues jumped by a big 8% during the period, for a total increase of 6% in comparable-store sales excluding negative impacts from gasoline price deflation and foreign exchange volatility.

Gross margin was 10.62% of sales during the quarter, down marginally versus 10.67% of revenues in the same period during 2013. Operating margin declined 10 basis points to 2.9% of revenues, while operating income increased by 2.1% versus the same quarter in the prior year to $737 million.

Earnings per share came in at $1.07, a bit lower than the $1.09 per share Wall Street analysts forecasted on average.

Industry context
Retailers in different categories are going through a remarkably challenging period because of the unusually harsh winter, lackluster consumer spending, and aggressively promotional pricing environment. In fact, competitors such as Wal-Mart and Target are doing considerably worse than Costco.

Wal-Mart reported an increase of only 0.8% in sales during the quarter ended on April 30, while earnings per share declined by 3.5% year over year. Wal-Mart attributed its weakness during the quarter to the particularly challenging industry environment: "Like other retailers in the United States, the unseasonably cold and disruptive weather negatively affected U.S. sales and drove operating expenses higher than expected."

Target is still being hurt by the data breach that affected the company in December, so its performance can't be attributed solely to industry conditions. However, Target´s numbers for the quarter ended on May 3 were really uninspiring. Total sales increased by 2.1% to $17.1 billion, while comparable-store sales in the U.S. declined 0.3% year over year.

Costco was hurt by rising operating expenses during the last quarter, but the company is still doing remarkably well on the sales front, while clearly outperforming competitors such as Wal-Mart and Target. In such a stable and mature industry like discount retail, gaining market share versus the competition is of the utmost importance, since one company's gains are usually the other one's loses.

The future
Customer loyalty is a crucial factor to consider when analyzing a position in Costco. The economy will always have its ups and downs, and Costco will need to increase spending from time to time in order to consolidate its competitive strengths and position itself for growth.

As long as the company is gaining market share versus its peers, investors in Costco will benefit from solid returns in the long term, regardless of the short-term volatility in profit margins.

Fortunately for investors, Costco is actually stronger than ever on that area. The renewal rate was 87.3% during the last quarter on a global basis, while big markets like the U.S. and Canada were even better, with a renewal rate of 90.6% during the period.  

Customers love Costco because of its amazingly low prices and high-quality service. According to data from the American Customer Satisfaction Index, Costco has a score of 84, the highest one in its industry group, and considerably above the score of 80 obtained by Wal-Mart's Sam's Club, perhaps the company´s most direct competitor.

As long as demand remains strong and customers are still loyal to Costco, the company has abundant room for expansion, both in the U.S. and abroad. The rate of growth may vary on a year to year basis, but Costco is still on its way to continue making both customers and shareholders happy over years to come.

Foolish takeaway
Costco's numbers for the last quarter were a bit light on the profitability side, but the company is still doing much better than competitors such as Wal-Mart and Target, which shows that Costco is a superior player among discount retailers. The company's fundamentals are as strong as ever judging by customer loyalty and overall demand, so any dip in Costco as a reaction to earnings could be considered a buying opportunity for investors.