Analysis: COST

Thursday night One-rated Costco Wholesale COST reported November quarter results that fell shy of the Wall Street consensus for both its top and (COST) lines. This follows what some called underwhelming November comp sales, particularly for the U.S., but as we correctly noted, Costco faced strong year-over-year comparisons for both November as well as the November quarter.

With that said, let's turn to the numbers.

Costco reported November quarter earnings per share of $3.10 on total revenue of $54.4 billion versus the consensus forecasts of $3.11 a share for EPS and $54.64 billion for revenue. Included in Costco's November quarter results was a $93 million pre-tax charge ($0.15 per share) primarily related to downsizing its charter shipping activities and a $53 million tax benefit ($0.12 per share) related to stock-based compensation. Factoring these items into the equation, Costco's bottom line results for the quarter were in line with consensus expectations, which explains the modest decline in the shares this morning versus what we've seen in recent weeks when a company missed consensus expectations.

Also impacting performance for the quarter, and something we expect to hear more about in the coming December quarter earnings season, was the dollar's strength, which hurt Costco's bottom line results in the quarter by about $0.12 per share.

Digging into Costco's adjusted comp sales for the quarter, the US rose 6.5% year over year, Canada was up 8.3% and Other International gained 9.1% while e-commerce slumped 2.0%, leading total company comp sales to rise 7.1% versus the November 2021 quarter. Again, we expect next week's November Retail Sales report to provide a favorable context for Costco's November and November quarter comp sales. From an investment thesis perspective, Costco shared its average transaction size in the US rose 6.9% during the quarter, well ahead of the 2.2% increase in traffic. This confirms that consumers are leaning toward Costco's ability to stretch their disposable spending dollars, something we expect to continue in the coming quarters.

One of the drivers of that move by consumers is the persistent level of inflation we are seeing. On that topic, Costco shared it has seen "some minor improvements in a few areas" and estimates the equivalent year-over-year inflation number in the range of 6%-7%, commenting that food and sundries are still up more than non-foods. With roughly 50% of the company's merchandise sales derived from Foods and Sundries and Fresh Foods, Costco remains well-positioned to tap into that consumer need as people need to eat. Also helping is Costco's efforts to continue to offer favorable prices to its members, which led to a modest decline in operating margins year over year for the November quarter despite the improved net sales and membership fee revenue.

Turning to the all-important membership fee revenue line, it rose to $1 billion from $946 million in the year-ago quarter, spurred on by a 7% increase in the number of cardholders, which hit 120.9 million exiting November. With 22 net new warehouse locations added over the last 12 months and plans to add another net new 24 units in the current fiscal year, prospects for this key line item remain very favorable. And on the subject of an anticipated membership fee price increase, on the earnings call Costco's CFO Richard Galanti shared "we feel that we're in a very strong competitive position right now. And if we have to wait a few months or several months, that's fine. And I'll be purposely coy on when that might be." That would suggest to us the odds of a membership fee price increase happening in 2023 are improving.

We continue to see Costco capturing consumer wallet share and growing its warehouse footprint in the coming quarters, driving continued gains in the high-margin membership fee revenue. However, given the likelihood of continued margin pressure in the merchandise business, we are reducing our price target to $575 from $620, which still offers ample upside ahead in COST shares. We expect others will do the same with their price targets, but we also suspect the eventual membership fee price increase that should foster a rebound in margins will also lead to another upward re-think on those price targets.

In keeping with our new rating categories, Costco remains a One or Buy Now position. Given today's hotter-than-expected November Producer Price Index report and the prospects of COST price targets moving lower, members are likely to pick COST shares up at modestly better prices in the coming days. We have some room in the portfolio to add more COST, and it's a move we're inclined to make as the dust settles.

At the time of publication, Action Alerts PLUS was long COST.