As Costco Goes, So Goes The Market

| About: Costco Wholesale (COST)

Even investors that do not own Costco Wholesale Corporation (NASDAQ:COST) may want to tune in for the earnings announcement on Wednesday. The shares have tracked the S&P500 index almost perfectly over the last two years and the health of the company may provide some clues to the health of the market. The shares may be able to outperform peers over the next few quarters if the company can continue its trend in margin growth and win market share.

Management outlook may mean more than just which way the stock will go

Costco is the second largest U.S. retailer by worldwide sales and the fourth largest retailer in the world. The majority of warehouses are still in the United States with 72% of 627 total stores, followed by Canada (14%), Mexico (5%), the United Kingdom (4%) and Japan (2%).

The correlation between shares of Costco and the S&P500 over the last two years is uncanny.

Costco and S&P500 Correlation
(Click to enlarge)

A big part of this correlation is the fact that consumer spending drives 70% of the economy, so you would expect the fate of retailers to follow the general market pretty quickly. Another factor is that 22% of the S&P500 is weighted to consumer discretionary and staples.

The financial trends at Costco have resembled that of most companies in the market as well. Costco has increased its operating margin since the recession on staffing and expense management. Operational efficiency increased to 3% last quarter from 2.5% in 2008. The company is seeing the same sales growth weakness as the rest of the market. Quarterly sales growth has averaged 10% over the last four quarters but slipped last quarter to growth of just 8% against the same period in the previous year.

Some notable comments in the last quarter conference call that could clue to the general market:

· In the third quarter, management pointed to flat average transactions. This could point to some weakness in the consumer going forward if it worsens.

· Dividend payout continues to be strong, up 13% recently to $0.31 per share on a quarterly basis and management projects $34 million in buybacks for the year. Companies still have a ton of cash on their balance sheets and the persistently slow revenue growth means they may continue to return money to shareholders rather than reinvest it.

· Inflation remains fairly benign though there is some fear of rising costs in meat products. The slow pace of inflation has baffled many in the market. Rising demand for protein may start to push up meat prices and push through to other products.

Costco may be able to outperform peers over the near-term

While a good case can be made for Costco and the general market to continue in lock-step, the warehouse chain may be able to outperform peers like Wal-Mart (NYSE:WMT) over the short run on better margins and market share.

The company is expected to post earnings of $ 1.46 per share on revenue of $32.85 billion this quarter. This represents a 5% growth in quarterly earnings against a 2% increase in sales.

The company beat expectations for earnings last quarter, posting $1.04 on estimates of $1.03 per share. Earnings per share jumped 18% last quarter over the prior year and earnings growth has averaged 16% over the last four quarters. The company has beat earnings expectations by an average of 3% over the last four quarters with stock performance the day of the release ranging from a loss of 0.9% to a gain of 2%.

Membership fee income has been strong with a 12% increase last quarter to $531 million. While the revenue from memberships only makes up about 2% of total revenue, its importance is as a gauge of membership satisfaction. Renewals for membership topped 90% in the United States and Canada over the last year despite an increase in fee rates in November 2011.

Wal-Mart has had issues with inventory management and restocking lately and could cede some market share to smaller rivals like Costco. A light workforce may also be showing through in customer satisfaction with longer checkout lines and fewer associates in key departments. Costco could be challenged to keep those new shoppers on the difference in product options compared to its larger peer. Costco carries an average of 4,000 stock keeping units (SKUs) per warehouse, which is less than 3% of the average 140,000 SKUs at most Wal-Mart stores.

Costco may also outperform Wal-Mart over the next few years if the minimum wage is increased nationally or across enough states. Wal-Mart associates typically start out at $10 an hour and make $12.50 after four years while Costco associates start at $11 an hour and make an average of $19.50 after four years. The lower wages means Wal-Mart has a higher operating margin at 5.9% but may see this advantage fade on higher minimum wage laws.

Shares of Costco trade for 24.8 times trailing earnings compared to a multiple of 14 times earnings on shares of Wal-Mart, and just over the company's five-year average of 23.0 times trailing earnings. While the shares may be slightly overvalued compared to the longer-term average, rising margins and the possibility of market share gains could help to push the stock higher.

Shares of Costco and the S&P500 have traded in unison for the last two years and investors may want to watch management's outlook during the earnings release for clues to the health of the general economy. Costco may be able to outperform peers over the short-term if it can continue margin trends and gain market share.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.