Analysis: COST

Costco (COST) reported a top- and bottom-line beat with its fiscal third quarter results. Net revenue of $43.89 billion (+21.7% YoY) edged consensus of $43.65 billion, and earnings per share of $2.75 (+45.5% YoY) cleared estimates of $2.32.

It's worth noting that net income was negatively impacted by a pre-tax $57 million, or $0.09 per share, due to COVID-19-related costs, primarily from $2 per hour premium pay. This $57 million impact was roughly one-quarter of the $246 million COVID-19 related hit Costco experienced in the fiscal second quarter, so it is great to see that this headwind has abated.

Over the full 12-week period of the quarter, adjusted comparable sales, which exclude impacts from changes in gasoline prices and foreign exchange, increased by 15.2% in the United States, 16.7% in Canada, and 13.1% in other international, leading to a total company comp of 15.1%. E-commerce adjusted comparable sales grew by 38.2%.

Traffic or shipping frequency in Costco's warehouses inflected and increased 12.5% worldwide and 11.9% in the United States (keep in mind we are now lapping periods of COVID-19 restrictions). Costco's average transaction, or ticket, including gas inflation and foreign exchange, grew 7.3% worldwide and 5.7% in the United States. Adjusting for gas and FX, transaction was up 1.8% worldwide and 2.7% in the U.S.

Before going further, it is always worth mentioning that Costco's stock tends to barely react to the quarterly reports. It may be boring to some, but there is a good reason for this. Costco reports its sales every month, and this prices in a lot of the "news" ahead of time. Still, the quarterly reports are worth digging into as the numbers and management's commentary provide meaningful insights into the trends they are seeing, and that helps shape our views of the future.

Membership fee income is an important number to watch, because this is a large source of profits from the company. Costco generated $901 million in fee income this quarter, representing about 10.5% growth YoY that topped estimates of $871.1 million. Another thing to track is when management might raise the price of its membership fee next. Historically, Costco increases its membership cost every five years, and the five year anniversary of the previous fee hike was June 2017. When asked about this on the conference call, CFO Richard Galanti channeled his inner Fed speak when he said "I get to think about not thinking about it for several months" -- but this will be something to monitor for in the months going forward.

Costco ended its quarter with 109.8 million total cardholders, up from 108.3 million one quarter ago. And paid executive members ended the quarter at 24.68 million, representing an increase of 817,000 from the prior quarter.

Renewal rates were consistent with levels from the second quarter, with U.S. and Canada at 91%. The worldwide renewal was at 88.4%, down 0.1 percentage point from the prior quarter, but this decline comes with a bit of a caveat, as CFO Galanti explained. This was the first quarter with China included in the renewal calculation, and as Galanti pointed out, first-year renewal rates tend to lag those of later years. When backing out China for the worldwide calculation, Costco said its renewable rate would have improved by 1 percentage point from the prior quarter.

On the margin front, reported gross declined 35 basis points year-over-year to 11.18%. Margins would have been 11 basis points lower excluding gas inflation. Breaking down margins further, core merchandise margin declined 52 basis points or 29 basis points ex-gas inflation. The company said the driver of the decline was the shift in sales mix from core to ancillary, a reversal of the positive trend they saw last year when many ancillary services were closed due to COVID-19. Ancillary and other business reported a 2-basis point increase in margin, or 7 basis points ex-gas inflation. Meanwhile, 2% Reward margins improved by 1 basis point, but declined 2 basis points ex-gas inflation. And Other margins improved 14 basis points in both categories, a result of lower COVID-19 related costs.

In terms of core on core margin, Costco said margins were better by 27 basis points, with nonfood up significantly. Meanwhile, Food and sundries were flat YoY while fresh foods were down from last year (a result of lapping a tremendous period of labor productivity and low spoilage), but remained strong by historical standards. In ancillary, Costco said margins are improving in optical, food court, e-com and hearing aids.

The conference call also touched on how strong the pent-up demand for travel has been. Costco's travel bookings business had 10 of its top 15 days in history in the last month, said Galanti. Travel is a relatively small business for Costco, but the rebound in travel could be a solid tailwind to company margins.

Costco opened six new warehouses in the quarter, one in the United States, three in Canada, and two internationally. Consistent with prior guidance, Costco plans to open seven additional warehouses in the fiscal fourth quarter, five in the United States, and two internationally. This puts Costco on track to open 21 net new warehouses in fiscal 2021.

Looking ahead, management said it plans to open about 25 net new units in each of the next two fiscal years, and we believe this is higher than what analysts are estimating based on FactSet consensus numbers of 23 new opens in fiscal 2022 and 22 in fiscal 2023.

Costco also said it plans to open a second warehouse in China in fiscal 2022 or toward the end of calendar 2021. And management said it expects to open a third warehouse in early fiscal year 2023 or late calendar 2022. Costco's warehouses have been a huge hit with the China consumer and we continue to see international expansion, specifically in China, as a great long-term growth opportunity for the retailer.

On the e-commerce side, management continued to praise its acquisition of Innovel, which it now calls Costco Logistics. This business has been a driver of big and bulky sales online, with e-com sales for these items up 53% in the quarter. In total, Costco Logistics fulfilled about 70% of all big and bulky orders in the United States and has helped improve delivery time on many items from up to two weeks to as fast as five to seven days.

Inflation is also hitting Costco. Inflation impacts prices (ex-gasoline) by 2.5% to 3.5% on average, said Galanti. That's higher than what he estimated back in the prior quarter of 1% to 1.5%. Costco is passing some of these costs over through higher pricing, while some prices are unchanged.

And in news that any Costco member would be thrilled to hear, management said it is beginning a phase return to full sampling over the next few weeks.

Overall, it was another solid quarter from Costco with comps elevated (as expected) and COVID-19 related costs representing less of a drag to the bottom line. With renewal rates still consistently high, it's clear that Costco is keeping the new members it picked up during the pandemic. And with the value proposition of a Costco membership and the best prices on the best quality goods and services is resonating with consumers of all ages -- even the younger ones as management spoke about on the call -- Costco should continue to enjoy share gains through the reopening.

Shares are down less than 1% after hours, despite the top and bottom-line beat, but we've come to expect muted reactions to the Costco quarters, because the monthly sales results are typically when the good news starts to get priced in. Even so, we continue to believe Costco should be appreciated as one of the most consistent and defensive names in all of retail.

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