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Costco Wholesale (COST) is on the Hedgeye Consumer Staples Best Ideas list as a LONG.

 

HEDGEYE OPINION

COST reported 1Q17 earnings yesterday which missed slightly on the top and bottom line reporting revenue of $28.10bn versus FactSet $28.29bn and EPS ex-items of $1.17 versus FactSet $1.19. There were some items affecting comparability; stock based compensation was higher by $0.04 per share, gas profits were lower by $0.03 per share and additional IT expenses negatively impacted SG&A by about $0.025 per share. All-in-all deflation continues to be a headwind that has contributed to COST missing revenue expectations for the last four quarters, while missing two of the last four EPS estimates.

As deflation has persisted it has been harder for companies to grow the top line, even if traffic is increasing. For instance, on TV sales, dollar sales are up 2%, while unit sales are up 17%; it’s tough to make up for that sort of deflation. They are currently experiencing LSD deflation in food areas, but getting strong traffic performance from the category, particularly in produce and deli. From internal opinions on deflation at COST, they think the worst is now in, and expect a less bad period ahead and a trend towards minor inflation in mid-2017.

Many of the bears on this story were concerned about the switch from AMEX to Visa for their rewards card. We think after this quarter they can lay that to rest; this deal is not only working out very well for COST, but the members are enjoying it as well. Over 85% of the accounts that have been transferred from AMEX to Visa have been activated, which management believes to be a strong number. COST is also reaping benefits above expectations from the partnership with Citi on the Visa card, namely the revenue share on outside spend for the card is coming in higher than expected.

With Amazon going all-in on grocery and starting to build brick-and-mortar, there is a fair amount of skepticism on how COST will fair in that environment. We believe some skepticism is warranted but not to the degree people are thinking. Amazon tries a lot of things but they don’t execute well on everything. They are great at small pack sizes and fast shipping (something COST doesn’t have a huge desire to master) but they don’t do everything well. COST is a master at providing the highest quality goods at a very low price. Amazon’s self-checkout location is not going to have TV’s for sale, 40 packs of water, or enough Tide detergent to last someone an entire year. With that being said COST is improving its e-commerce platform, which has come a long way.

We continue to view COST as a top pick in the broader food/retail landscape, as their differentiated concept and strong consumer base will continue to be needed.

 

NOTABLE COMPANY THOUGHTS:

“Comp sales were negatively impacted by weaker FX relative to the U.S. dollar and slightly impacted by gas price deflation,” (Richard Galanti CEO).

HEDGEYEGas deflation was a key theme throughout the call, as it negatively impacted various line items.

“I’ll give you an example of deflation, which is impacting this department. In November, for example, TV sales were up 2% and units were up 17%. So quite a bit of deflation on big-ticket items, as well as some on the fresh food items…in recent months, we’ve seen the additional deflation overall in the low to mid-single-digit range in many food and fresh meat categories and a little more on some of the other nonfood areas,” (Richard Galanti CEO).

HEDGEYEDeflation was far reaching for COST, but not a surprise as this is a theme throughout the business.

When asked about their outlook for deflation and any signs for a potential upswing: “I think the feeling is given that the last few months have been a little more deflationary, the view is that it’s going to be another few months of that, but they all believe it will go back the other way,” (Richard Galanti CEO).

HEDGEYEThis was an educated guess by Galanti, but a similar sentiment has been expressed by others in the business.

When asked about whether they are concerned about their long-term traffic trends with the rise in Amazon: “You mentioned a number of mobile versus e-commerce sales; our numbers our lower than that mobile number, but they are improving quickly. And again, we recognize there are things we can and can’t do. We think we could and should do a lot more online, but we also want to get people into the warehouses,” (Richard Galanti CEO).

HEDGEYEIt is clear that COST is well behind Amazon with regard to mobile and e-commerce. This may be a race not worth running, as Amazon’s innovation and capacity is unparalleled.

QUICK COMPS:

  • U.S Comparable Sales: +1% (ex. Gas and FX: +1%)
  • Canada Comparable Sales: +4% (ex. Gas and FX: +5%)
  • Other Int’l Comparable Sales: 0% (ex. Gas and FX: +3%)
  • Revenue: $28.10B vs FactSet $28.29B
  • Membership fee income: $630M vs Consensus $630.5M
  • Gross Margin: 11.58% vs Consensus 11.41%
  • SG&A: 10.46% vs Consensus 10.37%
  • Operating Margin: 3.02% vs Consensus 2.90%
  • EPS: $1.17(ex-items) vs FactSet $1.19

Please call or e-mail with any questions.

Howard Penney

Managing Director

Shayne Laidlaw

Analyst