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Summary

  • COST saw strong April and May '14 comps.
  • Retailer has missed three consecutive quarters of EPS and revenue estimates.
  • Valuation has always scared me into short-term trading rather than longer-term positions.

Costco (NASDAQ:COST) reports their fiscal q3 14 financial results before the opening bell on Thursday, May 29th.

Analyst consensus is expecting $29.7 billion in revenue to generate $1.09 in earnings per share (EPS) for expected year-over-year (y/y) growth of 7% and 5%, respectively.

The consensus estimates have remained stable since the February '14 financial results were released.

March and April '14 comps were very strong and better-than-expected. With winter weather, the Easter shift, ex-gas, and ex-forex, it looks like core comps were in the 5% neighborhood, better than the 3.5% expected, and core merchandise comps were 6.5%.

Common size P/L8/14 q45/14 q32/14 q211/13 q18/13 q45/13 q32/13 q211/12 q18/12 q44/12 q31/12 q210/11 q17/11 q44/11 q31/11 q211/10 q18/10 q45/10 q32/10 q2
Net salesn/an/a98%98%98%98%98%98%98%98%98%98%98%98%98%98%98%98%98%
Membership fees and othern/an/a2.09%2.19%2.20%2.20%2.12%2.15%2.15%2.13%2.00%2.07%2.09%2.11%2.04%2.16%2.21%2.22%2.06%
Total revenuesn/an/a100%100%100%100%100%100%100%100%100%100%100%100%100%100%100%100%100%
Operating expenses:
*Merchandise costsn/an/a87.60%87.24%87.47%87.36%87.52%87.40%87.56%87.54%87.69%87.53%87.59%87.61%87.35%87.10%87.15%87.14%87.48%
*SG&An/an/a9.62%10.00%9.54%9.60%9.49%9.83%9.45%9.64%9.47%9.92%9.62%9.65%9.76%10.09%9.95%10.06%9.99%
*preopening expensesn/an/a0.03%0.10%0.05%0.04%0.02%0.08%0.05%0.03%0.03%0.05%0.08%0.04%0.02%0.06%0.04%0.02%0.02%
*Provision for impaired assets & warehouse costsn/an/a0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.00%0.01%0.00%0.01%0.00%0.01%0.02%0.01%0.02%0.00%
Total operating expensesn/an/a97.25%97.33%97.06%97.00%97.03%97.31%97.05%97.21%97.20%97.49%97.30%97.30%97.14%97.27%97.15%97.24%97.49%
Operating incomen/an/a2.75%2.67%2.94%3.00%2.97%2.69%2.95%2.79%2.80%2.51%2.70%2.70%2.86%2.73%2.85%2.76%2.51%
Other income expense
*Interest expensen/an/a0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%
*Interest income and othern/an/a0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%
IBIT & cumulative effect of account changen/an/a3%3%3%3%3%3%3%3%3%3%3%3%3%3%3%3%3%
Provision for income taxesn/an/a1%1%1%1%1%1%1%1%1%1%1%1%1%1%1%1%1%
Income before cumulative effect of account changen/an/a2%2%2%2%2%2%2%2%2%2%2%2%2%2%2%2%2%
Cumulative effect of account changen/an/a0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%0%
Net incomen/an/a1.76%1.70%1.90%1.91%2.20%1.75%1.89%1.73%1.72%1.48%1.70%1.57%1.67%1.62%1.79%1.72%1.60%

* Source - internal spreadsheet

We have been out of COST since the mid $80's for one primary reason: we've always worried about the razor-thin margins with which the company operates, and the low margin for error such margins tolerate.

The above "common-size" P/L shows readers just how thin the gross and operating margins for COST.

Yoy. growth rates8/14 q45/14 q32/14 q211/13 q18/13 vq45/13 q32/13 q211/12 q18/12 q44/12 q31/12 q210/11 q17/11 q44/11 q31/11 q211/10 q18/10 q45/10 q3
Net salesn/an/a6%5%1%8%8%10%14%8%10%13%17%16%11%11%8%12%
Membership fees and othern/an/a4%7%3%12%15%14%18%9%8%7%11%10%10%10%9%11%
Total revenuesn/a7%6%5%1%8%8%10%14%8%10%12%17%16%11%11%8%12%
Operating expenses:
*Merchandise costsn/an/a6%5%1%8%8%9%14%8%10%13%17%17%11%11%8%12%
*SG&An/an/a7%7%2%8%9%9%12%8%7%11%13%11%9%9%7%9%
*preopening expensesn/an/a33%33%13%67%0%80%-32%-25%50%-17%144%167%33%9%-25%-68%
*Provision for impaired assets & warehouse costs100%50%-55%
Total operating expensesn/an/a6%6%1%8%8%9%14%8%10%13%17%16%11%11%8%12%
Operating incomen/an/a-2%5%1%16%15%18%25%12%8%3%11%13%27%23%15%25%
Other income expense
*Interest expensen/an/a4%108%64%32%-7%-52%-39%-30%0%4%6%0%4%8%3%7%
*Interest income and othern/an/a15%-10%-5%-17%160%-46%-17%260%150%640%53%-50%-87%-72%100%138%
IBIT & cumulative effect of account changen/an/a-1%2%-1%14%18%17%25%16%9%10%13%13%21%19%18%27%
Provision for income taxesn/an/a38%1%-3%14%-14%0%26%12%5%31%10%18%21%13%20%15%
Income before cumulative effect of account changen/an/a-15%2%0%15%34%28%24%19%12%-1%14%10%21%23%17%35%
Cumulative effect of account change
Net incomen/an/a-15%2%1%19%39%30%27%19%13%3%11%6%16%17%16%33%
# of share O/S (Diluted)n/an/a1%1%1%0%0%0%-1%-1%-1%0%0%-1%-1%-1%1%2%
EPS (diluted)n/a5%-5%1%1%18%22%19%29%21%14%13%11%11%13%18%14%27%

* Source: internal spreadsheet

Here is another aspect I worry about regarding COST, i.e. slowing growth. Note the steady decline in operating income. I won't declare it is anything close to being permanent, but it is noticeable.

COST has missed consensus revenue and EPS estimates for 3 quarters in a row, despite the fact that comps have averaged between 5% and 7% for those three quarters.

A wise man once told me, "Comps are not earnings."

Several positive points around COST:

1.) In the Comp blend between "traffic" and "ticket," COST's traffic trends are some of the best in retail, at least in terms of the retailers I cover. COST has averaged 3.5%-4% "traffic" as a mix of the "comp" blend. Compare this to Wal-Mart (NYSE:WMT), which has seen 6 straight quarters of negative traffic growth;

2.) COST is expected to start repurchasing shares in this 3rd quarter which will be reported Thursday morning. However, with a free-cash-flow yield of just 3%, there is not an excess of free-cash to make a big dent in that share count right now, particularly with COST continuing their store growth;

3.) We are huge fans of Wal-Mart, both the management and the stock price, but I do think COST is giving Sam's a huge run for their money. Someday I need to do a head-to-head comparison Sam's revenue and operating income growth relative to COST, just to satisfy my own curiosity. In my little corner of the world in Lincoln Park, just north of downtown Chicago, there used to be a Sam's less than a mile from my house, but it was closed in the late 1990's and then COST opened a warehouse on Clybourn, just northwest of the same location, which is consistently packed, and where we shop regularly.

Our issue with COST, which relates to the margins and the business is that currently the stock trades at 25(x) expected 2014 EPS, which EPS is only expected to grow 3% this year. Over the next 4 years current analyst consensus per Thomson Reuters is expecting COST to "average" 10% EPS growth and 8% revenue growth. While that is pretty decent growth, a stock trading at 25(x) earnings, 14(x) cash-flow and 36(x) free-cash-flow is a stock where I want to wait for some bad news to discount the valuation.

Our internal intrinsic value model puts a perceived intrinsic value on COST near $130 per share, while Morningstar's value is $120. Average the two and you get roughly the $125 area, so with a $114 current stock price, we think there is not enough of a discount to intrinsic value to warrant a big position in the stock.

Technically, the stock looks a little wobbly. A trade below the early February '14 low of $109.50 and my guess is we are going to under $100. A trade back above $115-$116 on volume and I think you can trade the stock to the long side.

We'd become more interested in owning COST in size under $100 and even more interested at $90, but those price levels are a long way away.

Retail has been a very tough trade the last year. COST peaked in q4 '13 in the $125 area, and has been flagging ever since.

All of retail has labored in the past year, with a couple of notable exceptions. Is COST starting to be "Amazoned" and Wal-Mart'ed? Is the pressure of everyday, low-price taking a toll on the premier warehouse club operator, as they lap the membership fee increase?

At its current valuation, we prefer to wait on the stock, although that could mean it trades higher.

That is how we are playing COST into earnings. We could be wrong too.

Thanks for reading...

Disclosure: I am long COST, WMT, AMZN. 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.

Source: Costco Earnings Preview: Fabulous Operator, But Thin Margins And Valuation Has Limited Position

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