Valuentum Exclusive Analysis for the Discerning Investor

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Image Shown: Shares of Costco Wholesale Corporation have been on an upswing over the past five years.

By Callum Turcan

The ongoing coronavirus (‘COVID-19’) pandemic has upended daily activities and encouraged households worldwide to stockpile consumer staples products. When Costco Wholesale Corporation (COST) reported its fourth quarter fiscal 2020 earnings (16-week period ended August 31, 2020) on September 24, management noted that Costco’s worldwide foot traffic was down ~1% year-over-year last fiscal quarter though its average basket size was up ~13% year-over-year during this period. Households are apparently making the most out of every shopping trip in order to socially distance.  

Costco’s ancillary businesses, like its in-store opticians and food courts operations, were hurt by temporary closures last fiscal quarter, though its core business held up very well. Costco’s gas business took a hit from reduced travel demand, though its membership renewal rates were broadly flat versus the same period a year ago last fiscal quarter.

Earnings Overview

During the fourth quarter of fiscal 2020, Costco reported that its adjusted (excludes the impact from changes in gasoline prices and foreign currency movements) same-store sales grew by 14.1% year-over-year company-wide. Costco reported that its e-commerce same-store sales surged by 91.3% year-over-year and that its US same-store sales were up 13.6% year-over-year during this period on an adjusted basis. The retailer’s Canadian and other international same-store sales also grew by impressive double-digits each on a year-over-year basis, highlighting the widespread strength in its financial and operation performance during these harrowing times. Management noted that Costco’s food (fresh and frozen), sundries, hardlines, softlines, and pharmacy sales all performed well last fiscal quarter.

Strong same-store sales growth combined with a moderate increase in revenue generated from membership fees led to Costco reporting a 12% jump in its GAAP revenues, a 32% surge in its GAAP operating income, and a 27% increase in its GAAP net income in the final quarter of fiscal 2020 on a year-over-year basis. Please note that as it relates to Costco’s GAAP revenues, significantly lower gasoline prices and sales by volume make year-over-year comparisons a trickier task though these dynamics put downward pressure on Costco’s merchandise costs.

Management noted during Costco’s latest earnings call that the firm’s core gross margins (a non-GAAP figure) improved significantly last fiscal quarter versus the same period the prior fiscal year (up ~70 basis points). This was made possible in part by the strong performance seen at Costco’s fresh food sales due to lower levels of product spoilage (as inventory moved out the door at a quicker rate due to surging demand for consumer staples products) and improvements in labor productivity. Costco’s retail-related gross margin rose by less than 20 basis points year-over-year last fiscal quarter when looking at just ‘net sales’ less ‘merchandise costs’ and not factoring in membership fee-related revenues and costs. Economies of scale played a key role in improving its GAAP operating margins, which rose by over 50 basis points year-over-year last fiscal quarter.

Costco had $13.3 billion in total cash, cash equivalents and short-term investments on hand at the end of August 2020 versus $0.1 billion in short-term debt and $7.5 billion in long-term debt. We strongly appreciate Costco’s net cash balance, though we caution the firm also had $2.6 billion in long-term operating lease liabilities on the books at the end of its fiscal fourth quarter. Even with that in mind, Costco still possesses a nice net cash cushion to ride out the storm while making major investments in its logistical operations.

Looking Ahead

Going forward, Costco is adjusting its inventory management habits to better match the needs of its consumers. Here is what management had to say on the issue during Costco’s latest earnings call:

“In terms of holiday merchandise planning; Halloween, a few – a small reduction in the amount of costumes. Some more basic candy items, as well as for Christmas going a little more basic in some areas and as well as looking at things, the needs and uses for the house.” --- Richard Galanti, CFO of Costco

Costco plans to keep expanding by opening new warehouses and relocating some of its existing warehousing operations. In fiscal 2020, Costco opened 13 warehousing units on a net basis and this fiscal year Costco plans to open 20 net new warehousing units according to management commentary. The company plans to spend $3.0 billion - $3.2 billion on capital expenditures this fiscal year, up from $2.8 billion in fiscal 2020, though please note this is according to management commentary and we will know more about Costco’s financials when the firm publishes its 10-K SEC filing (a cash flow statement was not included in Costco’s latest earnings press release).

At the end of the fourth quarter of fiscal 2020, Costco’s “total warehouse square footage stood at 116 million square feet” according to management. Some of Costco’s planned warehouse openings in fiscal 2021 are projects that were delayed from fiscal 2020 due to headwinds created by COVID-19.

Back in March 2020, Costco completed its acquisition of logistics firm Innovel Solutions for ~$1.0 billion in cash. Costco acquired Innovel Solutions from Transform Holdco, a privately-held firm owned by Eddie Lampert’s ESL Investments which operates some Sears (SHLDQ) and Kmart stores. Innovel Solutions’ operations caters to “big-and-bulky” logistics needs in the US and Puerto Rico, and Costco has been a customer of the firm since 2015. This deal added 11 distribution and fulfillment centers to Costco’s asset base along with 15 million square feet of warehouse space and over 100 final-mile cross-dock centers.

We like the deal as it supports Costco’s home-delivery and e-commerce growth ambitions, particularly as it relates to hardline products such as appliances and TVs. As mentioned previously, Costco’s e-commerce sales surged last fiscal quarter, aided by its same-day and two-day home delivery options. Here is what management had to say on Costco’s e-commerce performance during the firm’s latest earnings call (emphasis added):

“E-commerce: overall our e-commerce sales as you’ve seen each month have increased nicely. For the fourth quarter on a reported basis up 90.6% and ex-FX 91.3% increase during the fourth quarter. A few of the stronger deployments and there's several, health and beauty aids, food and sundries, appliances, TV's, computers and tablets, housewares and small electrics.

Total online grocery grew at a very strong rate in Q4, several 100%. This e-commerce comp if you will, the e-commerce numbers I just mentioned above follow our usual convention which we exclude the third party same day grocery program. If we included that third party same day our e-commerce comps result would have been approximately 120% up during the quarter.

Overall our e-com sites were relatively smoothly during the quarter despite the dramatic volume increases and we were able to improve our delivery times throughout - delivery times throughout the quarter as we adjusted to the ramped-up order volumes.” --- CFO of Costco

Costco’s e-commerce strength combined with the strength of its physical store operations highlights the resilience of its business model and indicates that its long-term growth outlook is steadily improving.

Concluding Thoughts

Our favorite retailer remains Dollar General Corporation (DG), which is included as a modest holding in our Best Ideas Newsletter portfolio, though we appreciate Costco’s impressive performance during the initial stages of the ongoing COVID-19 pandemic. When we update our models for the consumer staples sector, there is a decent chance we will increase our fair value estimate for Costco given its strong performance of late and improving long-term growth outlook.

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Dollar Store and Department Store Industries – KSS M JWN BIG DG DLTR PSMT

Specialty Retailers Industry – AAN BBBY BBY GME HD LOW LL ODP SHW TSCO WSM

Food Retailing Industry – CASY COST CVS KR SYY TGT WBA WMT

Related: AMZN, FDS, SHLDQ, SPY, VDC, IWM

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Callum Turcan does not own shares in any of the securities mentioned above. Dollar General Corporation (DG) is included in Valuentum’s simulated Best Ideas Newsletter portfolio. Vanguard Consumer Staples ETF (VDC) is included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.