Membership-only discount retailer Costco (NASDAQ:COST) missed analysts' expectations in Q3 FY2023, with revenue up 2% year on year to $53.6 billion. Costco made a GAAP profit of $1.3 billion, down from its profit of $1.37 billion in the same quarter last year.
Costco (COST) Q3 FY2023 Highlights:
- Revenue: $53.6 billion vs analyst estimates of $54.6 billion (1.71% miss)
- EPS: $2.93 vs analyst expectations of $3.31 (11.6% miss)
- Free Cash Flow of $721 million, down 93.3% from the same quarter last year
- Gross Margin (GAAP): 12.6%, up from 11.9% in the same quarter last year
- Same-Store Sales were up 0.3% year on year
- Store Locations: 853 at quarter end, increasing by 23 over the last 12 months
Designed to be a one-stop shop for the suburban consumer, Costco (NASDAQ:COST) is a membership-only retail chain that sells groceries, apparel, toys, and household items, often in bulk quantities.
The company is well known for offering these products at lower prices than most of its competitors. Costco is able to offer low prices due to its lean operating model that prioritizes low overhead costs and high inventory turnover. If you walk into a Costco store, the products are presented in a warehouse format, stacked high and with many products still sitting in their original boxes and palettes, rather than neatly presented as individual packages on shelves. This reduces store labor costs.
Costco's core customer is the value-conscious suburban shopper who is willing to buy in bulk to save money. These customers must pay for an annual membership, as non-members are not allowed to enter Costco locations. On the other hand, consumers living in cities often do not frequent Costco because their smaller homes or apartments cannot accommodate that 64-roll package of toilet paper.
In addition to groceries, electronics, and apparel, Costco also offers other consumer services so their customers don’t have to go elsewhere. Pharmacies, photo centers, and vision services/eyeglass retailers are common in their roughly 150,000 square foot stores. Outside the majority of Costco stores, there is also a gas station for quick and convenient fill ups.
Big-box retailers operate large stores that sell groceries and general merchandise at highly competitive prices. Because of their scale and resulting purchasing power, these big-box retailers–with annual sales in the tens to hundreds of billions of dollars–are able to get attractive volume discounts and sell at often the lowest prices. While e-commerce is a threat, these retailers have been able to weather the storm by either providing a unique in-store shopping experience or by reinvesting their hefty profits into omnichannel investments.Competitors that offer groceries and/or other general merchandise in large-format stores include BJ’s Wholesale Club, Walmart (NYSE:WMT), and Kroger (NYSE:KR).
Costco is a behemoth in the consumer retail sector and benefits from economies of scale, an important advantage giving the business an edge in distribution and more negotiating power with suppliers.
As you can see below, the company's annualized revenue growth rate of 12% over the last four years (we compare to 2019 to normalize for COVID-19 impacts) was impressive as it opened new stores and grew sales at existing, established stores.
This quarter, Costco grew its revenue by 2% year on year, falling short of Wall Street's estimates. Looking ahead, the analysts covering the company expect sales to grow 7.27% over the next 12 months.
Number of Stores
When a retailer like Costco is opening new stores, it usually means that demand is greater than supply, and in turn, it's investing for growth. Costco's store count increased by 23 locations, or 2.77%, over the last 12 months to 853 total retail locations in the most recently reported quarter.
Over the last two years, the company has generally opened new stores and averaged 2.69% annual growth in its physical footprint, which is decent and on par with the broader sector. With an expanding store base and demand, revenue growth can come from multiple vectors: sales from new stores, sales from e-commerce, or increased foot traffic and higher sales per customer at existing stores.
Costco has generated solid demand for its products over the last two years. On average, the company's same-store sales have grown by a healthy 10.7% year on year. This performance suggests that its steady rollout of new stores could be beneficial for shareholders. When a company has strong demand, more locations should help it reach more customers seeking its products.
In the latest quarter, Costco's same-store sales rose 0.3% year on year. This performance was more or less in line with the same quarter last year.
Gross Margin & Pricing Power
Gross profit margins are an important measure of a retailer's pricing power, product differentiation, and negotiating leverage.
As you can see below, Costco has averaged a poor 12.3% gross margin over the last two years. However, when comparing its margin specifically to other non-discretionary retailers, it's actually pretty decent. That's because non-discretionary retailers have structurally lower gross margins as they compete to provide the lowest possible price, sell products easily found elsewhere, and have high transportation costs to move their goods. We believe the best metrics to assess these types of companies are free cash flow margin, operating leverage, and profit volatility, which take their scale advantages and non-cyclical demand characteristics into account.
In Q3, Costco's gross profit margin was 12.6%, relatively flat with the same quarter last year. This steady margin could stem from its efforts to keep prices consistently low or signal that it has stable input costs (such as freight expenses to transport goods).
Operating margin is an important measure of profitability for retailers as it accounts for all expenses that keep the lights on, including wages, rent, advertising, and other administrative costs.
This quarter, Costco generated an operating profit margin of 3.69%, up 0.3 percentage points year on year. This increase was solid and likely driven by stronger pricing power, as indicated by the company's larger rise in gross margin.From an operational perspective, Costco was profitable but held back because of its large expense base over the last two years. Its average operating margin of 3.57% has been paltry for a consumer retail business. However, Costco's margin has remained more or less the same, highlighting the consistency of its business.
Earnings growth is a critical metric to track, but for long-term shareholders, earnings per share (EPS) is more telling because it accounts for dilution and share repurchases.
In Q3, Costco reported EPS at $2.93, down from $3.04 in the same quarter a year ago. This print unfortunately missed Wall Street's estimates, but we care more about long-range EPS growth rather than short-term movements.
Between 2020 and 2023, Costco's adjusted diluted EPS grew 51.9%, translating into a solid 17.3% average annual growth rate. This EPS growth is materially higher than its revenue growth over the same period, indicating that Costco has excelled in managing its expenses (leading to higher profitability), bought back a healthy chunk of its outstanding shares (leading to higher PER share earnings), or did some combination of both.
Cash Is King
Although earnings are undoubtedly valuable for assessing company performance, we believe cash is king because you can't use accounting profits to pay the bills.
Costco's free cash flow came in at $721 million in Q3, up 93.3% year on year. This represents a 1.34% margin, in line with its free cash flow margin in the same period last year.
Over the last two years, Costco has shown decent cash profitability, giving it adequate opportunity to invest organically into its business, pay down debt, or return capital to shareholders. The company's free cash flow margin has averaged 2.19%, slightly better than the broader consumer retail sector. Furthermore, its margin has been flat, showing that the company's cash flows are relatively stable.
Return on Invested Capital (ROIC)
Costco has a strong competitive position and its management team has a stellar track record of successfully investing in profitable growth initiatives. Its five-year average return on invested capital (ROIC) is 32.3%, firmly placing it among the best consumer retail companies.
We like to track ROIC because it tells us about a company’s prospects for profitable growth and its management team's ability to achieve it through capital allocation decisions such as organic investments, acquisitions, and share buybacks. ROIC can also be used as a tool to benchmark a company's performance versus its peers, and just like how we focus on long-term investment returns, we care more about analyzing a company's long-term ROIC because short-term market volatility can distort results.
Key Takeaways from Costco's Q3 Results
Sporting a market capitalization of $241 billion, more than $13.7 billion in cash on hand, and positive free cash flow over the last 12 months, we believe that Costco is attractively positioned to invest in growth.
We struggled to find many strong positives in these results. Overall, they could have been better. The stock is flat after reporting and currently trades at $543 per share.
Is Now The Time?
When considering an investment in Costco, investors should take into account its valuation and business qualities as well as what happened in the latest quarter. We think Costco is a good business. We'd expect growth rates to moderate from here, but its revenue growth has been solid over the last three years. And while its gross margins make it more challenging to reach positive operating profits compared to other consumer retail businesses, the good news is its high ROIC suggests it is well run and in a strong position for profitable growth, and its above-average same-store sales performance has supported total revenue growth.
There are definitely a lot of things to like about Costco, and looking at the consumer retail landscape right now, it seems that it trades at a reasonable price point.
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