Costco's Earnings Preview: All Eyes On Margins

Following the widest earnings beat as far back as I can check, delivered in March of this year, Costco (COST) is now gearing up to report the results of its fiscal 3Q19. Consensus revenue of $34.67 billion would represent a 7% increase over year-ago levels, while EPS of $1.82 is projected to improve by just about the same rate.

Credit: Slickdeals

Given the February through April sales numbers, I expect comps to land at around 5.6%, pointing at slight growth deceleration following a fiscal 2018 that was one of the most robust years in Costco's recent history. The intra-quarter trend will likely prove favorable, as the colder- and wetter-than-usual month of February gave way to a March and April period whose comps approached healthy levels of 6% YOY.

Costco's revenue generation abilities continue to impress me, as the retailer produced quarterly comps of no less than +2% since fiscal 2013 at least. For reference, Walmart's (WMT) and Target's (TGT) metrics have fluctuated much more widely during the period, with the latter having experienced lows of -1.5% in early 2017. Costco's top-line stability is, in my view, a reflection of the company's enviable member base loyalty.

See historical comp chart below.

Source: DM Martins Research, using data from company reports

Even though I believe Costco will meet or beat expectations on the top line, I will be most interested in assessing the evolution of margins. Considering trade fears and the more pronounced growth of the e-commerce channel (which in turn tends to carry higher fulfillment costs), it was a surprise that the Issaquah-based company managed to expand both gross and op margins by 30 bps in fiscal 2Q19.

The feat was achieved primarily through a favorable revenue mix away from non-organic fresh foods and competent supply chain management, while SG&A relative to revenues remained under check. This time, I estimate that expectations are set between last quarter's unusual but welcome gross margin expansion and the typical 15-30 bps of contraction that is more consistent with longer-term historical trends. Any meaningful upside to earnings, I hypothesize, will highly depend on what gross margin might look like.

On the stock

I am not going to lie: COST continues to look pretty expensive. The current year P/E of 30.9x and long-term PEG of 3.0x seem oversized at first glance for a retailer whose op margin tends to hover around a dismal 3%. But there are a handful of reasons why I, who tends to favor a more conservative value investing approach, am not overly concerned about high multiples in this case.

Chart Data by YCharts

First, COST has traded at a premium to peers like WMT for as long as I can remember. In fact, the P/E gap between these two stocks is currently near a 12-month low, suggesting COST may in fact be cheaply valued relative to its key competitor.

Second, I believe COST's rich premium can be properly justified by the more predictable and less fragile subscription business model that is well supported by the company's loyal member base. I estimate that Costco produces somewhere between one-half and two-thirds of its total op profits through membership fees, which I believe makes the company better prepared to deal with headwinds that could range from lower prices to the consumer, higher cost of goods and reduced economic activity.

Lastly, in great part for the reason above, I think Costco is well equipped to engage in a more aggressive competitive battle with the "big wigs" in the big-box retail space - Amazon (AMZN) and Walmart, to name a couple. CFO Richard Galanti's reminder that Costco "drives its business by driving sales, and that usually means lowering prices" is a reflection, in my view, of the company's revenue model and continued focus on cost management that allow it to thrive even in environments that could be challenging for most other retailers in the space.

For the reasons above, I continue to think that COST is a "storm-resistant growth" stock worth considering.

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.

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