Costco's Fiscal Third Quarter: Not Too Shabby

Summary

• Costco's results were largely aligned with my expectations.
• Membership fees did not get the boost that I had hoped for, but margins looked much better than I anticipated.
• I doubt that Costco's fiscal 3Q20 results will turn bears into bulls, or vice versa. I remain bullish on this high-performing stock.
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Costco (NASDAQ:COST) reported fiscal 3Q20 results on May 28. The results were largely aligned with my expectations, although concerns over lower margins did not quite materialize.

Regarding the headline numbers, the company beat expectations on the top and bottom lines. Revenues of $37.3 billion came in ahead by nearly $600 million, and adjusted comps of 7.8% topped my projections by 30 bps. With op margins flat YOY, earnings per share of $1.89 surprisingly increased, albeit minimally.

All things considered, COST has remained a high-conviction bet (and one of the best performers so far) in my All-Equities SRG portfolio.

Credit: Supermarket News

A look at the results

As I had anticipated, revenue growth for the quarter looked ordinary in the aggregate. But the intra-quarter sales dynamic was nothing short of unusual. Looking strong were e-commerce and fresh produce. Much weaker were optical, hearing aids, photo and food court, businesses that remained closed for a portion of the twelve-week period. Traffic was down sharply, but increase in transaction size more than made up for the shortfall - an expected byproduct of the shelter-in-place orders.

I was curious to see whether the COVID-19 crisis would have boosted demand for Costco memberships. Unfortunately, I saw no definitive signs of it happening. Membership fees were up a modest 5% YOY, although the metric can be misleading due to revenue recognition guidelines. More importantly, total number of members increased by about 500,000 sequentially, just a little more than the company had in the comparable 2019 quarter.

Source: D.M. Martins Research, using data from multiple company reports

The better news of the quarter, in my view, was resilient profitability. The graph above clearly depicts an increase in gross margin in fiscal 3Q20, which I wasn't quite expecting. In fact, the 50-bp YOY improvement was the best that I recall seeing Costco deliver.

To be clear, the revenue mix shift to e-commerce and higher COVID-related wages, safety and sanitation costs played a role in dragging gross margins as projected. But gas price deflation helped to offset the headwinds, and so did scale and efficiency in fresh produce. Overarching these themes, Costco's trademark operational excellence has probably been a factor as well.

By far impacting the bottom line the most was SG&A. Combined with direct product costs, the COVID-19 crisis trimmed what would have been 47 extra cents in EPS - although without the pandemic, comps would have likely been lower as well.

Had the effective tax rate not been nearly two percentage points higher YOY, earnings per share could have landed five cents above where it did. See P&L below (fiscal 3Q19 is adjusted for the benefit of a non-recurring tax item).

Source: D.M. Martins Research, using data from earnings report

Bullishness intact

Following the earnings release, COST shares did not move much. The stock remains about 5% off the February peak, after it suffered a maximum drawdown of no more than 15% earlier this year.

Because the business fundamentals did not seem to have changed, and neither have the very rich valuations (see below), I doubt that Costco's fiscal 3Q20 results will turn bears into bulls, or vice versa. My interest in the stock continues to be supported by longer-term factors that, in my opinion, qualify shares as "storm-resistant growth." More specifically, I like that Costco's membership-based business model should provide some stability and predictability to revenues and earnings; and that the stock should continue to endure a period of global economic softness better than the broad market.

Data by YCharts

Analyst’s Disclosure: I am/we are long COST. 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.

Comments

[jimoc]

Was hoping for another chance to add under $300, hasn't come yet.

[gastank]

It probably won't, just saying.

[DM Martins Research]

Under $300 means a pullback of only $6 or $7, or 2%. You may get that on a single bad day. COST is volatile enough that it allows for that kind of movement easily.

But if you are willing to buy at those levels, why not $306?

[JDoe20]

@DM Martins Research, I’m betting on a trip to the low $90’s, could be low $80’s but not worth missing, and have a limit order in place.

As you say, it’s not far off these levels. Markets can’t just continue to climb to the sky - this ain’t no beanstalk!