Risk-Reward Balances Costco - Analyst Blog

Costco Wholesale Corporation (COST) continues to be a dominant retail wholesaler based on the breadth and quality of merchandise it has to offer. The company's strategy to sell products at heavily discounted prices has helped it to remain on a positive growth track amid beleaguered economic conditions as cash-strapped customers continue to see it as a viable option for low-cost necessities. Having delivered consistent comparable-store sales growth, Costco is well positioned in the warehouse club industry.

Costco Wholesale Corporation recently posted healthy sales data for the four-week period ended August 28, 2011. The company has been able to maintain its sales momentum. After a 10% increase in July 2011, Costco's comparable-store sales for August rose 11%, reflecting comparable sales growth rates of 9% at its U.S. locations and 18% at its international divisions.

Earlier, the company had posted third-quarter 2011 results. The quarterly earnings of 73 cents a share fell short of the Zacks Consensus Estimate of 77 cents, but rose 7.4% from 68 cents earned in the prior-year quarter.

The high single-digit increase in the bottom line was buoyed by double-digit growth in the top line from improved sales of discretionary items, as consumers seeking discounts started flocking to warehouse clubs. The company's international operations have been the major drivers.

The warehouse retailer's total revenue climbed 16% to $20,623 million from the prior-year quarter, and handily beat the Zacks Consensus Estimate of $20,533 million. Costco's comparable-store sales for the quarter rose 12%, reflecting comparable sales growth rates of 10% at its U.S. locations and 18% at its international divisions. The results were favorably impacted by rising gasoline prices and a weaker U.S. dollar.

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 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.

Costco continues to make prudent use of its free cash flows through share repurchases and dividend payments. This underlines its efforts to maximize shareholder returns even under trying economic conditions. Moreover, the company's current cash resources are adequate to support expenditures associated with its ongoing expansion initiatives.

However, Costco faces stiff competition from BJ's Wholesale Club Inc. (BJ) and Sam's Club, a division of Wal-Mart Stores Inc. (WMT). These two rivals follow similar business models as they market 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 macroeconomic factors including interest rate hikes, increase in fuel and energy costs, sluggishness in the housing market, and high unemployment and household debt levels, which may affect their spending.

Costco currently operates 592 warehouses, which include 429 in the United States and Puerto Rico, 82 in Canada, 32 in Mexico, 22 in the United Kingdom, 9 in Japan, 7 in Korea, 8 in Taiwan and 3 in Australia.

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