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The retail sector usually makes sense,or at least we can delude
ourselves that we can make sense of it all. There are obvious
macroeconomic trends filtering through into the results of the companies
in the sector. From the dollar stores to the high end, through the
specialty stores and the online based companies, there are discernible
patterns we can use to gauge future performance. And then there is Costco Wholesale (NASDAQ: COST).
Costco executes
I last looked at Costco in an article linked here and highlighted how well the company was doing but also inquired as to where the value was in the stock price. The
answer to my question was that it lies within its ongoing execution and
ability to service its customers with the goods they want. As
investors, we are more interested in its stock price potential rather
than its company performance per se, but in this case I think the
stock’s evaluation of 24x trailing earnings is at a level where the two
things are correlated.
This chart helps to outline how well the company has been doing over the last year:
Clearly gross margins have been expanding over the last five quarters
(note that the yearly comparisons are starting to get tougher too)
while comparable sales growth remains good too. Overall revenue growth
remains in the high single digits, and the company’s expansion program
(particularly internationally) remains on track. Indeed, Costco expects
to finish the year with 28 new openings as opposed to 16 last year. Of
the nine more expected for 2013, three are planned for the U.S. and the
other six are international.
What is Costco doing right?
And, more pertinently, can it continue to do these things right? I
have a five main points to discuss from its recent Q3 results.
Firstly, Costco’s traffic remains strong and it reported year to date
frequency up 4-5%. Costco cited the draw of its gas sales (30% of
people buying gas go on to shop at Costco), fresh food (which has seen
increased demand as the slow economy has reduced the demand for eating
out), and the ‘wow’ factor of many of its items.
Second, I think the psychological effect of inducing people to shop
at Costco after they have paid a membership fee is a sound one based on
many of the principles inherent in work on behavioral studies. I think a
membership fee is looked at as a sunk cost, but since people will ‘pay’
more to avoid a ‘loss’ they will shop at Costco in order to do this. Of
course if that cost increases (and Costco has hiked membership fees in
recent years) than the feeling of 'loss' will increase and customers may
be induced to shop more at Costco.
Third, membership fee increases have not encouraged churn. In fact
business renewal rates started and finished the quarter at an impressive
93.9%. New membership signups increased 19% with particular strength in
Asia. Membership fee income increased 12% to $531 million.
Fourth, Costco continues to generate growth where others can’t. In
particular I was struck by the strength within hard lines where it
recorded strong growth in lawn and garden and consumer electronics.
And lastly, Costco continues to reduce its stock keeping units (SKUs) in order to optimize inventory turns and profitability.
Costco is, of course, not alone in many of these activities but it
compares very well across the sector because it does all of them well.
For example Lowe’s Companies(NYSE: LOW)
has an ongoing plan to reset its product lineups in order to reduce
SKUs and ‘normalize inventory.’ While this may appear routine stuff,
Costco has been doing it well for years while Lowe’s has had to adjust
because it wasn’t doing it well. With that said, Lowe’s actually has some upside potential from successful execution of this plan.
Moreover, Lowe’s (and Home Depot for that matter)
both reported that outdoor and garden items were a bit soft in the last
quarter thanks to the late spring. In comparison Costco cited these
categories as being strong.
Whither Wal-Mart?
Costco isn’t alone in its membership fee model as BJ Wholesale and Wal-Mart’s(NYSE: WMT)
Sam’s Club also take membership. Wal-Mart is following Costco by
increasing its membership fee but its execution is nowhere near Costco.
For example its comparable sales growth (ex fuel) was only up .2% in the
last quarter with traffic up 1.3% compared to Costco’s 4.5%. In
addition its ticket value was down 1.1% while Costco’s was flat.
So while the economic environment is difficult and Wal-Mart on the
whole has been a bit disappointing (a net sales increase of only 1.8% in
the last quarter), Costco has outperformed, particularly against Sam’s
Club.
The bottom line
In conclusion, while something like Wal-Mart is largely a play on the
economic environment, Costco has demonstrated that its superior
performance can justify an evaluation premium over Wal-Mart. The problem
is that it will be pressured to continue this execution in order to be
rewarded by the market. Any slip-up and/or step-up in competition from Target or Wal-Mart and its current PE of 24x will start to get hard to justify.
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