Costco Wholesale Corporation: International Expansion Is The Key Growth Driver

| About: Costco Wholesale (COST)


Costco reported results for the second quarter of fiscal year 2014 and it missed analysts’ expectations in various metrics.

Costco delivered revenue growth but it could not be translated into earnings in the income statement.

Costco still has some key strength that keeps its business model intact and international expansion can bolster its growth.

Costco Wholesale Corporation (NASDAQ:COST) reported its quarterly results on March 6. Second quarter earnings lagged behind analysts' expectations since its profits fell by 15% and that was more than the anticipated fall. As a result the stock price also plunged by 2.8% and fell to $113.26 in afterhours trading. The company blamed deep discounting during the holiday season as the main culprit for profit decline. The purpose of this article is to explore its performance in the latest quarter and to see whether this stock has potential that outweighs the current profit plunge.

Revenue Growth

For the second quarter of fiscal year 2014, Costco delivered a 6% increase in net sales to $25.76 billion up from $ 24.34 billion last year. This figure also missed analysts' estimate of $26.65 billion compiled by Reuters. Comparable store sales for the second quarter and the first 6 months of fiscal year 2014 are shown in the tables below. The latter one excludes adverse impacts from gasoline price deflation and foreign exchange rates. Exclusion of the adverse impacts provides us with a rosier picture of the company's comparable sales.

Click to enlarge

Source: Costco Earnings Release

If we look at the company's comparable store sales in the last three months of December, January, and February we will discover that although the figures are positive the growth rate has been declining every month. US comparable sales remained flat in January and February after increasing from December's levels. However, internationally and in total comparable store sales surged in January but fell again during February. Despite the decrease in last month this metric is still above December's sales levels. The decline can be related to the worst weather during this February that may have hindered people from visiting the stores. However once the harsh weather is over then consumer traffic is anticipated to grow because people will visit the stores for renovating their houses and businesses affected by winter storms.

Source: Costco Earnings Releases

Comparatively, Costco performed better than its competitor Wal-Mart Stores Inc (NYSE:WMT) in terms of comparable store sales. Wal-Mart recorded a negative growth in its comparable store sales during the 14 weeks period ending January 31st 2014. On the other hand Costco's comparable store sales for the quarter ending February 16th maintained positive growth both in US and in total.

Source: Costco & Wal-Mart earnings release

Profit for the quarter stood at $463 million or $1.05 a share that is 15% below the previous year's profits of $547 million or $1.24 a share. However the prior year profits included a tax benefit of 14 cents per share but even excluding that tax benefit we will get EPS of $1.1 that is 5 cents higher than the current EPS.

Profit Contraction

Deep discounts offered by the company to lure customers during Christmas and New Year holidays caused the profit margins to heavily decline. And this is not the situation in just one quarter because over the whole year of 2013 the company's profit margin kept slowly and gradually declining. In February 2013, the profit margin stood at 2.2% while up until February of this year the margin has shrunk to below 1.80% as illustrated in the graph below.

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Source: Bloomberg

The operating profit for the second quarter was 2.7% down from 2.97% in the same period last year. This is because merchandise costs surged by almost 6% while selling, general, and administrative expenses increased by 7.2%. The net margin declined to 1.76% during the quarter from 2.2% last year. This decline was due to a low operating margin and a massive 38% increase in income tax provision during the quarter. On a comparative basis Costco is offering lower margins than both Wal-Mart and the industry.

Source: Reuters

Discount Stores: A Key Strength

Retail sales are mostly dependent on the economic environment but warehouse retail is a different business model and is more resilient because it has less to do with the sluggish economy. Attractive bargains offered by these warehouse clubs has been the major traction for consumers who are charged membership fees and in return get shopping discounts. Costco is considered a leader in this sector as it has the biggest market share of the $390 billion industry.

Source: L.E.K Consulting

Costco is enjoying robust member renewal rates of 90% in US and Canada and 875 in rest of the world. During first quarter of 2014 membership fee saw an uplift of 7% that shows the company's warehouse system popularity and resultant pricing power. New sign ups during the latest quarter rose by 13% mainly driven by new stores in Japan and Australia. This industry is anticipated to grow even further in the future because it has gotten more popular among consumer groups. During a robust economic environment sales at warehouses automatically get bolstered while during tough situations the discounts offered lure customers to buy in bulk for cost saving. Ongoing square footage growth will also act as the catalyst for the company's turnover. Costco operates just 460 stores in the USA where on the other hand Wal-Mart has a total of 4,203 in US. That identifies the room for Costco to grow as it is still far away from saturation point in US.

Source: Earnings Releases

On a comparative basis we can see that Costco is performing more efficiently than Wal-Mart in terms of generating higher revenue per square footage. Moreover, the company has successfully improved the key metric since the first quarter of fiscal year 2014.

The Road Ahead Leads to international Expansion

Costco is the 4th largest retailer in the US as well as in the whole world. The US acts as the key market for Costco since it operates 460 warehouses in the US out of its total 649 warehouses around the globe.

Source: Costco Earnings Release

The International market has just 28% of the company's warehouses and thus can offer huge room for the company to grow. Costco should not be obsessed with its expansion and revenues from the USA since one day this market will start cannibalizing its results as the company will move towards its saturation in the American market. Internationally, Costco can use India and China as its next big target markets due to their huge populations and the rising income levels in the two countries. Costco has left these countries untouched while on the other hand, Wal-Mart is ahead of it with 405 stores in China and 20 in India. Expansion into emerging markets will act as a catalyst for the company's growth.

Bottom Line

Costco remains a market leader in terms of its warehouse business model. International expansion can also open doors for the company to grow enormously. The company is offering a payout ratio of 174.13 which is huge when compared to the industry (35.75) and Wal-Mart (38.59). Yahoo Finance has set a higher price target for Costco of $132 and lower target of $120.23. This implies that at the current price level of $114.59 this stock has an upward potential of 15.2% at the higher end and almost 5% at the lower end. This scenario makes this stock desirable and makes me inclined to rate this stock as buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article.