Risk Reward Balances Costco

Costco Wholesale Corporation (COST - Analyst Report) continues to be a dominant retail wholesaler based on the breadth and quality of merchandises it offers. The company’s strategy to sell products at heavily discounted prices has helped it maintain positive growth amid the beleaguered economic conditions as budget-conscious customers continue to see it as a viable option for low-cost necessities. Having delivered comparable-store sales growth consistently, Costco is well positioned in the warehouse club industry.

Riding on Positive Comps

The U.S. economy is still grappling with an uneven recovery, and companies are trying very hard to shield themselves from the financial turmoil. Amid this uncertain environment, Costco has almost successfully overcome the hurdles, keeping an upbeat note and sustaining momentum. The company, which exited 2011 strongly by registering an average comparable-store sales growth of approximately 10.6%, is all set to repeat the same performance in 2012 as evident from its comps data so far in the year.

From January to August, 2012, Costco has consistently registered comparable-store sales growth. In that period, comps growth touched a low of 3% and hit a high of 8%, thereby recording an average growth of approximately 5.5%.

In the first eight months of 2012, comps increased 8% in both January and February, 6% in March, 4% in both April and May, 3% in June, 5% in July and 6% in August.

The Company Counts Upon

A differentiated product range enables Costco to provide an upscale shopping experience to its members, resulting in market share gains and higher sales per square foot. Moreover, the company continues to maintain a healthy membership renewal rate. Costco also remains committed to opening new clubs in domestic and international markets. The company’s diversification strategy is a natural hedge against risks that may arise in specific markets.

Impressive Results

Consumers seeking discounts started flocking to warehouse clubs, leading to improved sales of discretionary items. Consequently, Costco witnessed high-single digit growth in the top line during the third quarter of 2012, which subsequently led to an increase in the bottom line.

Costco’s third quarter earnings of 88 cents a share beat the Zacks Consensus Estimate by a penny, and surged 20.5% from 73 cents earned in the prior-year period. In the second quarter of 2012, the company’s bottom line had augmented by 13.9%.

After registering a growth of 10% in the second quarter, the warehouse retailer’s total revenue, which includes net sales and membership fee, climbed 8.2% to $22,324 million from the prior-year quarter, and handily beat the Zacks Consensus Estimate of $22,072 million. Net sales jumped 8.2% to $21,849 million, whereas membership fee rose 9.2% to $475 million.

Costco’s comparable-store sales for the quarter rose 5%, reflecting a comparable sales increase of 5% both at its U.S. locations and international divisions. The results were favorably impacted by rising gasoline prices but adversely affected by foreign currencies fluctuation.

Excluding the effects of gasoline prices and foreign currencies, Costco’s comparable-store sales rose 5%, with U.S. comparable sales up 4%, while international comparable sales were up 8%.

Tough Economy and Stiff Competition

The economy is still not out of the woods, and whether 2012 will mark a complete turnaround is difficult to predict unless some concrete steps are taken. Cuts are deep and wounds not completely healed. Each and every company is vying to survive the downturn, and striving to reach the helm.

Costco faces stiff competition from Target Corporation (TGT - Analyst Report) and Sam’s Club, a division of Wal-Mart Stores Inc. (WMT - Analyst Report), which follows a similar business model that pushes through high volumes of merchandise at low prices in membership-only warehouse clubs. Thus, aggressive pricing to gain market share and drive traffic amid stiff competition, may depress sales and margins.

Moreover, the company’s customers are sensitive to macro-economic factors including interest rate hikes, increase in fuel and energy costs, a sluggish housing market, and high unemployment and household debt levels, which may affect their spending.

Let’s Conclude

Based on the pulse of the economy, we believe that budget-constrained consumers will remain watchful of their spending and look for discounts. Consequently, we could see competitive pricing, compelling products and innovative ways to attract shoppers.

Given the pros and cons, we maintain our long-term “Neutral” recommendation on the stock. Moreover, Costco holds a Zacks #3 Rank that translates into a short-term “Hold” rating.