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Costco Wholesale (NASDAQ:COST) reported its third-quarter results before the market open on Thursday. Investors initially reacted favorably to the latest earnings release, but shares fell throughout the session to close with modest losses.

Despite excellent operational results, investors remain cautious. In recent years shares have rallied hard, leaving little value left for investors.

Third-Quarter Results

Costco generated third-quarter revenues of $23.55 billion, up 7.8% on the year. Revenue growth was driven by a solid 5% increase in comparable-store sales, as growth in the U.S. remained firm at 6% while international growth came in at 4%. Total revenues including membership fees came in at $24.08 billion, trialing consensus estimates of $24.21 billion.

Excluding the volatile gasoline prices and unfavorable exchange rate movements, comparable sales would have grown by 7%.

Net income rose by 18.9% to $459 million, coming in at $1.04 per diluted share. Earnings beat consensus estimates by a penny.

Looking Into The Results

Normal merchandise sales advanced by 7.8% to $23.55 billion, while lucrative membership fees rose by 11.8% to $531 million.

Costco managed to expand its gross margins by 12 basis points to 10.67% for the year. The company benefited from its strategy to reduce the number of stock keeping units (SKU), thereby boosting its negotiation position with suppliers.

At the same time the company managed to reduce selling, general and administrative expenses by 3 basis points to 9.82% of total revenues. Moderating healthcare expenses and an improvement in productivity following the decision to maintain fewer SKUs resulted in a decline in selling, general and administrative expenses.

The combination of revenue growth, expanding gross margins and tight cost control resulted in a solid 15.9% increase in operating income.

Valuation

Costco ended its third quarter with $6.51 billion in cash, equivalents and short-term investments. The company operates with $4.94 billion in short- and long-term debt, for a net cash position of $1.57 billion.

Total revenues for the first nine months of the year, including membership fees, rose by 8.6% to $72.7 billion. Net earnings for the period rose by 29.3% to $1.42 billion. At this rate, Costco is on track to generate annual revenues of around $106-$108 billion, on which the firm could earn around $2.0 billion.

Factoring in gains of 1% in Thursday's trading session, the market values Costco at $48.8 billion. This values operating assets of the firm at around $47.2 billion. As such operating assets of the firm are valued at 0.45 times expected annual revenues and 23-24 times annual earnings.

After the recent hike of its quarterly dividend towards $0.31 per share, Costco pays an annual dividend yield of 1.1%.

Some Historical Perspective

Long-term holders in Cosco have seen great returns. Shares have tripled over the past decade, rising from $30-$40 in 2003 toward $70 in 2007. Shares fell back toward $40 following the recession, to recover to all-time highs around $115 in recent weeks.

Shareholders have received a relative low dividend yield in the meantime as management decided to grow the business instead of paying fat regular dividends. Shareholder did receive a nice special dividend at the end of last year.

Between 2009 and 2013, Costco will is expected to expand its annual revenues by a cumulative 50% from $71.4 billion to $107 billion. Net earnings stand to almost double to $2 billion in the meantime.

Investment Thesis

Very competitive pricing has driven a lot of traffic toward Costco's warehouses in recent years. Relative high gasoline prices helped as well, as many people who filled up their tank at the company also went inside their warehouses to do some shopping.

The decent comparable-sales growth results, reported at 5%, shows the company is gaining terrain from competitors like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT), which both reported negative comparable-sales growth for the past quarter. Growth was almost entirely driven by an increase in traffic, not necessarily an increase in average spending.

Still Costco is seeing some modest headwinds as well, notably lower gasoline prices and a strong dollar, which shaved off a 1.5 percent point in reported comparable sales over the past quarter.

Besides growing operations in existing stores, Costco opened 5 new stores during the quarter, including 3 abroad. This brings the total store count to 627 stores. With another 9 planned openings in the current quarter, Costco is on track to open 28 stores for the year, up from 20 last year. The new openings will have some cannibalizing effects, shaving off an estimated 60 basis points from its total sales.

The major profit boost in recent years is Costco's membership program. The company hiked its fees in the U.S. and Canada last year, and it still benefiting from this. Total sign-ups increased by 19%, especially thanks to a strong performance in Japan. Despite a hike in membership fees, renewal rates remained relatively stable at high levels.

Despite the strong operational discipline, a solid balance sheet and gradual expansion plans, shares might not offer the greatest value at this point in time. Investors and Wall Street analysts are very impressed with a solid increase in comparable sales, international expansion plans and the membership fee model.

This has pushed the value of shares upward too much, trading at 23 times estimated earnings. With a lack of repurchasing activity taking place at the moment, despite a solid balance sheet, management indicates shares are valued a bit too rich as well.

While shopping at Costco might provide excellent value, investors should not shop for its stock at the moment.

Source: Costco - There Is More Value To Be Found In The Stores