Is Costcos' Shopping Cart Empty?

This morning, Costco COST announced earning, and while it was a mixed results, shares are not being hit as hard as one would believe, given the earnings miss. Despite the mixed results, investors have to ask if the shopping cart empty at Costco or are they going back to the store for seconds. The Issaquah, WA.-based company reported fourth quarter earnings of $1.08 per share on $28.18 billion in revenues. Wall Street had been expecting earnings of $1.10 per share on $27.78 billion in revenues. The company also announced that September U.S. same-store sales were up 11%, and it also announced something that was long considered inevitable. It announced it would be raising its membership fees by $5 per year. The company said that fee increases have historically shown little fall off, and also continue to talk about its $3.7 billion share buyback program. Given the earnings miss in a very volatile environment, shares would be expected to be down a lot more than the current two percent shares are falling as of the time of this writing. Some analysts had expected a strong report, and with the revenue beat, it does appear that Costco's earnings are being seen somewhat positively, despite the two cent per share earnings miss during the quarter. Yesterday, Brian Sozzi of Wall Street Strategies previewed the earnings report, and wrote, "In case the tone was too subtle, we have been on the sidelines with respect to Costco in the lead up to its earnings announcement. The risk reward remains unfavorable despite the stock's pullback from the 52-week high, seeing as: (1) expectations are elevated; (2) deployment of capital on further share repurchases may disappoint a shareholder base that has been demanding more action; and (3) the much talked about membership fee income increase may be an event for the middle of 2012 instead of tomorrow." Costco, whruns 592 warehouses, including 429 in the U.S. and Puerto Rico, 82 in Canada, 32 in Mexico, 22 in the U.K., nine in Japan, eight in Taiwan, seven in Korea and three in Australia. Today, Sozzi is out with some thoughts on the membership warehouse giant, and is particularly negative on the report, despite the strong sales in each month of the quarter. In his report, Sozzi wrote, "What we have this morning is the quintessential mixed bag SEC form 8-K. Decoding “mixed bag” in this case essentially means that Costco under-delivered its earnings story to shareholders (despite robust sales each month of the quarter) through a combination of a gross margin miss and continued reluctance to ramp up share repurchase activity, even though the company's balance sheet is arguably among the most liquid in the retail sector." He goes on to say that the company did something by raising the membership fees, which could increase earnings per share in 2012 by 20-30 cents per share. On the other hand, Sozzi is not particularly enthusiastic about the fee increase, and believes that some executive members may choose to trade down to basic plans, or potentially not renew their memberships in light of the increase. He does say that the fee increase should have been expected, in light of competitor increases at Sam's Club WMT and BJ's Wholesale Club BJ. Sozzi goes on to write, "If Costco had given us something in line on earnings against heightened expectations plus the fee increase news, buying on initial weakness would be the correct path to wander down. While the fee increase immediately bolsters the stream of future membership fee income, sending analysts hurriedly back to their spreadsheet models, 4Q11 was so lukewarm that we require greater insight as to the drivers, and therefore would not nibble at the open." Costco is one of the best run businesses in the country, but with the recent retirement of CEO and co-founder Jim Sinegal and the membership fee increase, Costco not be as attractive as it was earlier in the year. Shares have returned 11.3% year-to-date, far better than the return on the S&P 500 or the Dow Jones Industrial Average. Factoring in some fundamental changes, such as the membership fee increase, higher inventories, and the earnings miss despite the strong revenue performance, to go along with a premium valuation, Costco does not appear to be offering the value to shareholders currently that it does to its membership base. Members may still be buying two pound boxes of Goldfish, three dozen eggs, and gasoline at record paces, but if the company is not able to translate these sales into bottom line earnings, then perhaps Costco shares may go on sale at even better prices than some of their merchandise. ACTION ITEMS:

Bullish:
Traders who believe that Costco's fee increase and strong sales around the globe will lead to earnings beats down the line might want to consider the following trades:

• Shares are not exorbitantly valued, for a company growing revenues 16% year-over-year, but they are given a premium over competitors. If the company is able to add to 2012 EPS, then perhaps you may want to add or to initiate a position here.

Bearish:
Traders who believe that the economy is going to continue to worsen drastically may consider alternate positions:

• The average income for a Costco household is almost $80,000, so this is considered upper-middle class. If the economy gets materially worse than it already has, it may not be able to keep some members, and may lose them to Target TGT, or perhaps even lower stores, like Dollar General DG or Family Dollar FDO.
  
  

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