Analysis: COST

Costco (COST) reported after the closing bell on Thursday mixed results for its fiscal second quarter. Net revenue of $43.89 billion (+14.7% YoY) edged consensus of $43.748 billion, and earnings per share of $2.14 (+2% YoY) missed estimates of $2.45.

Before we move on, we want to point out that net income was impacted by $246 million pretax, or $0.41 per share, due to costs primarily related to COVID-19 premium wages allocated toward manufacturing, production, and fulfillment operations. Of this $246 million figure, $60 million was a hit to margins while $186 million impacted selling general and administration expenses. But the $2 per hour premium Costco has been paying its employees throughout the pandemic ended in February. As a replacement, Costco permanently increased its starting wage and most wage steps above that by $1 an hour for employees in the United States and Canada. After these changes, along with the reduction and or elimination of about $200 million of pandemic-related expenses, Costco expects to see this roughly $1 billion total expense (over the past 12 months) reduced by a little over one half beginning in March.

In addition to the quarterly numbers, Costco provided comparable sales for the February period. Comparable sales in the four-week period on an adjusted basis (which excludes the impacts from changes in gas prices and foreign exchange) increased 10.3% in the United States, 15.7% in Canada, and 20.6% in other international, leading to a total company comp of 12.3%. It's a bit of a slowdown from January, but it comes with a caveat as this period starts the lapping of the "pandemic pantry loading" phase we saw one year ago. Interestingly, however, management said on the conference call that comps in that last week of February were "modestly positive," despite the tough comparison.

For the full quarter, adjusted comparable sales increased by a robust 12.6% in the United States, 10.6% in Canada, and 17.7% in other international, leading to a total company comp of 12.9%. E-commerce remained as more and more Costco club members elected to buy online during the pandemic, with comparable sales increasing 74.8% in the period on an adjusted basis.

The full quarter revenue results and comps numbers should not come as a surprise to investors, because Costco reports four weeks' worth of sales every month.

Membership fee income is an important number to watch, because this is a large source of profits from the company. Costco generated $881 million in fee income this quarter, representing about 8% growth YoY that topped estimates of $868.8 million.

Costco ended its quarter with 59.7 million cardholders, up from 59.1 million in the quarter 12 weeks ago. Total cardholders were 108.3 million, up from 107.1 million 12 weeks ago. And as of the second quarter, paid executive members were 23.8 million, up 506,000 from the end of the first quarter.

Renewal rates looked strong and consistent with levels from prior quarters with the U.S. and Canada ticking 0.1 percentage point up to 91%. Worldwide renewal was at 88.5%, also up 0.1 percentage point from the prior quarter.

On the margin front, gross margins largely held steady at 10.96%, down two basis points from the second quarter last year. Margins would have been 11 basis points lower excluding gas deflation. As a reminder, profitability tends to fall as gas prices rise. Breaking down margins further, core merchandise margin improved 71 basis points or plus 63 basis points ex-gas deflation, as strong sales in fresh foods continues to be efficient with gains in labor productivity and low spoilage. But that's not the only category experiencing margin gains as food and sundries, soft lines, and hardlines all had higher margins YoY. Ancillary business margins contracted 53 basis points or 55 basis points without gas. Margins are typically higher in this category, but remained pressured due to travel, hearing aids, pharmacy, and food court, though e-commerce contributed a small positive impact. Margins from 2% reward were down six basis points, or five basis points excluding gas, while "other" margins were 14 basis points lower in both sets.

Margin improvement from fresh won't last forever in the economic reopening, because turnover will go down, but the net effect of the reopening is a rebound in the ancillary business and this higher margin business should provide a positive offset.

Traffic or shipping frequency in Costco's warehouses inflected and increased 1% worldwide, while the United States grew 2.7% on a YoY basis. These are both decelerations from the prior quarter, but the decline in traffic is getting offset by strong growth in average transaction size, which grew 11.9% for the total company and 8.5% in the United States -- both higher compared to the prior quarter.

No new stores were opened in the quarter, consistent with prior guidance. For the second half of the fiscal year, Costco plans to open 13 more net new warehouses, five of which will be in the U.S. while three will be in Canada and five overseas. Capital expenditure guidance was unchanged at $3 billion to $3.2 billion.

On the e-commerce side, management touted how Costco Logistics (the Innovel acquisition) continues to fulfill a greater percentage of delivery items. Costco also continues to enhance its white glove service which includes assembly or complex installation. Notably, the white glove service has a positive impact on margins because of better efficiencies.

Inflation has been the general fear hurting many consumer-staple type stocks this year because higher input costs are a headwind to margins. Costco acknowledged that it is seeing some low-single-digit percentage increases in inflation, largely due to the container shortages that increasing freight costs as well as product shortages of high-demand items.

Overall, the quarter looks solid when excluding some of the COVID-19-related costs that will be cut in half going forward as the February comps numbers remain elevated and membership income continues to consistently increase. With inflation on everyone's mind, the value of a Costco membership will never be greater due to the company's goal of being the last to raise prices and the first ones to lower. Only a retailer of Costco's size, scale, and commitment to customers can do this.

Still, shares are dipping lower after-hours to around $312.50, extending the recent rout that has caused the stock to fall more than 15% year-to-date because it's viewed as out of favor in the "reopening trade" and because of broader pressures facing equities thanks to the quick rise in interest rates.

What is hard to believe is that COST now trades roughly 13% above its March 2020 lows, despite all the company has accomplished in terms of membership growth and sales over the past year. This seems wrong, but we must also respect how the broader market wants to go lower right now.

We upgraded our rating to a ONE recently because COST now trades at the cheapest relative price-to-earnings ratio it has been at in years. Yes, years. But given the volatile environment, we think long-term oriented buyers should only apply wide scales -- meaning small buys on increments lower -- if interested in building a position in this high-quality, permanent market share gaining retailer.

Action AlertsPLUS, which Cramer co-manages as a charitable trust, is long COST.