Costco Earnings: Moderating Growth Pressures Margin, but Long-Term Bright; Shares Trade Fairly

Our $490 per share valuation of wide-moat Costco COST should not change significantly after it posted third-quarter earnings, with the impact of sluggish sales offset by a time value of money-related adjustment. With the lackluster sales growth attributable to transitory factors like pressure on discretionary spending from economic uncertainty and price inflation ebbing faster than we foresaw, our long-term forecast should not change much (mid- to high-single-digit annual percentage revenue growth, operating margins approaching 4%). We have a favorable view of Costco’s prospects, but with the shares trading near our valuation, we suggest investors seek a wider margin of safety.

Costco’s 3.5% adjusted comparable growth lagged our 5% forecast as consumers cut discretionary spending and as inflation slowed to a mid-single-digit rate from recent high-single-digit levels. With traffic up 5% worldwide, we believe Costco’s value proposition still resonates, and considering the firm’s history of pricing its assortment aggressively, we suspect it will be faster than most in adjusting pricing in consumers’ favor. With around 60% of operating income derived from a membership fee that we still believe will be increased soon in its domestic market, we believe Costco continues to be well-suited for a volatile environment. Its dynamic assortment, low-frills warehouses, membership model, and prodigious buying power should allow it to shift with demand easier than conventional retailers.

The slower growth led to cost deleverage, with Costco’s operating margin of 3.1% down from 3.4% in the same period last year and below our 3.6% estimate. Profitability was also affected by Costco’s decision to unwind charter freight contracts that were signed at the height of transoceanic transit disruptions last year. While this resulted in a nearly $300-million charge, we believe the decision was prudent, and do not fault the company for entering into the contracts to secure scarce capacity last year.