• Costco (COST) reported a solid fiscal third quarter on Thursday last week (26 May). Total revenue increased 16% year over year to $52.596 billion and beat the consensus Street estimate of $51.55 billion. Earnings per share grew 10.5% to $3.04, in line with estimates, despite a one time 13 cents per share charge for incremental benefits awarded under a new employee agreement. 

• Over the full 12-week period, comparable sales in the United States increased 16.6% and 10.7% on an adjusted basis, which excludes the impact of gasoline prices and foreign exchange. In Canada, comparable sales increased 15.2% and 12.8% on an adjusted basis, while for the rest of international, comps increased 5.7% and 9.1% on an adjusted basis. E-commerce comparable sales increased 7.4% and 7.9% on an adjusted basis. For the total company, comparable sales increased 14.9% and 10.8% on an adjusted basis, higher than estimates of 11.5% and 9.37%, respectively. 

Synopsis

• Fear was building ahead of the Costco quarter that the retailer would suffer a margin crunch like Walmart (WMT) and Target (TGT). But that didn’t happen and once again Costco showed why it is the best run retailer on the planet and a market-share gainer no matter the macroeconomic environment. The stock is not cheap on any measure (forward P/E in the thirties vs the S&P 500's in high teens), but we believe the market is willing to give it a premium because of its dependable, forecastable earnings growth and excellent executional track record.

Membership stats

• Revenue from membership fees is a closely followed metric because it is subscription based and is where Costco earns the majority of its profits. Revenue from membership fees increased about 9.2% year over year to $984 million, beating estimates of $968 million. 

• Costco ended its quarter with 116.6 million total cardholders, an increase from 114.8 million total cardholders last quarter. Paid executive members ended the quarter at 27.9 million, up from 27.1 million last quarter. 

• Renewal rates in the U.S. and Canada were 92.3%. That’s up 0.3% from last quarter. The worldwide renewal rate hit 90% for the first time in company history, up 0.4% from last quarter. 

• Costco continues to see higher first-year member renewal rates than historical levels. People absolutely love being a Costco member. 

Margins

• Gross margins were lower by 99 basis points from last year, but excluding the impact of gas inflation it would have been lower by 53 basis points. 

• Company margins were pressured in the quarter by core merchandise, where margins fell 87 basis points on a reported basis and 46 basis points excluding gas inflation. Sales mix was the primary driver of the decline because higher gas prices pressure gross margins. 

• Within core merchandise, gross margins fell mostly due to free foods, which are lapping a very difficult comparison from last year when spoilage was low and productivity was high. 

• Ancillary and other businesses’ margins increased 6 basis points on a reported basis and 18 basis points excluding gas inflation. 

• Elsewhere, “2% reward” reported margins increased 8 basis points and 3 basis points without gas. 

• LIFO (last in, first out) margins fell 25 basis points on a reported basis and 27 basis points excluding gas. 

• Other margins fell 1 basis point both ways. 

 Other items

• The best-performing categories in the fiscal third quarter were candy, sundries, tires, toys, jewelry, kiosks, home furnishings, apparel, bakery and deli. Liquor, office, sporting goods, and hardware underperformed. 

• The global popularity of Costco means the company still has plenty of room for expansion. Management now expects to open a net total of 24 new warehouses this year. That’s four less than what they said last quarter but a push out in timing is always to be expected. Costco now expects to open the four delayed warehouses by the end of calendar November. 

• Costco’s warehouse in the Minhang District of Shanghai was closed for the last six weeks in the third quarter, negatively impacting sales by $35 million. Costco’s second building in Suzhou largely avoided lockdowns and restrictions. A third Shanghai building is expected in open in December, and four additional buildings are expected in China over the next few years. 

• The company estimated price inflation in the quarter was in the 7% range. That’s up from about 6% in the prior quarter and 4.5% to 5% two quarters ago. On a positive note, inflation in fresh foods was slightly lower compared to the prior quarter a year ago. 

• The company said it has not seen a lot of trade down by the consumer. Trade down is when consumers start buying more private label goods over brand name products as a way to keep costs in check.

• The company attributed the large volumes they do in a relatively low number of stock-keeping units (SKUs) as one reason why it has done an effective job mitigating price increases. 

Potential catalysts

• On the conference call, management immediately addressed membership pricing. Recall, that Costco historically has increased its membership fee every five to six years, and we are coming up on the fifth anniversary of the last hike. Although we were hoping to see management announce a price hike because those extra dollars typically fall right to the bottom line, they said they do not believe it’s the right time. Their reasoning was the current macro environment and how high inflation has put a burden on consumers. 

• There was zero talk about cash on the balance sheet and the potential for a special dividend, but we continue to believe an announcement is possible later this year. Costco has paid out a special dividend four times in the past eight years, the last being in November 2020.