Costco COST reported second-quarter results that were slightly below our expectations on the top line, and margins were also a bit weaker than we expected. However, a closer look at the results leaves us confident that Costco's bargaining power, highly efficient operations and loss-leader capabilities will allow the firm to outperform many retail peers, and we are maintaining our narrow Morningstar Economic Moat Rating with a positive trend, as well as our US$120 fair value estimate.
Comparable store sales increased 2% during the period, driven by a 3% increase in the U.S. and a 1% decline in international markets. However, U.S. and international segment comps were up a solid 4% and 5%, respectively, after adjusting for lower gas prices and exchange rates. These comps are much better than those posted by other retailers, again suggesting that Costco remains in a good position to leverage its cost advantage to strengthen its perceived cost leadership, which drives a brand intangible moat source by helping Costco raise membership fees and keep renewal rates in the mid to high 80s. On the basis of management's commentary, it appears that most of the underperformance occurred in the period leading up to the holidays. We aren't surprised that performance was weak during this period, given how competitive the holiday season was, and in the long term we are confident that Costco can sustain mid-single-digit comps.
The gross margin (excluding membership fees) contracted 10 basis points to 10.6%, while the operating margin (including fees) declined 20 basis points to 2.8%. We had expected both to remain flat with the prior year. Management said the gross margin was slightly lower than expected as a result of weak margins in certain general merchandise categories and fresh food. We suspect that weakness in general merchandise partially reflects intense holiday pricing, and we expect fresh food margins will improve over the long term, given strong consumer demand.
Pricing power over suppliers and customers
Costco pioneered the warehouse club retail model, which relies on bargaining power, a no-frills shopping environment, supply-chain efficiencies and customer-friendly average markups on branded products (in the low double digits, compared with the high teens at Wal-Mart WMT and the mid-20s at most grocery stores). With an average of 3,800 active stock-keeping units per club versus more than 60,000 at most mass-merchant superstores, Costco wields almost as much bargaining power as Wal-Mart and Kroger KR. The firm reduces handling costs by purchasing merchandise directly from manufacturers and storing merchandise on sales floors rather than in central warehouses. Self-service store formats and modest marketing requirements help to minimize operating costs, allowing Costco to deploy much of its assortment as a loss leader.
Because of its loss-leader strategy, Costco has become a relevant shopping destination for consumers across all income levels, as well as small businesses. This is important because Costco derives roughly 75% of its operating profits from membership fees. Member renewal and retention rates have not suffered much after membership fee increases, suggesting that Costco also wields meaningful pricing power over its customers. By selling several staples as loss leaders--fresh food and gas, in particular--Costco can preserve the market share it has already captured and fend off other discounters and online players like Amazon AMZN, in our opinion.
Margins are inherently low in Costco's business model. However, Costco offsets thin margins with massive sales volume and rapid inventory turnover, leading to exceptional unit productivity levels. In fiscal 2013, Costco generated about $162 million per club, compared with $80 million per unit at Sam's Club in its most recent fiscal year (all figures are in U.S. dollars). On a square footage basis, this translates into more than $1,100 net sales per square foot, a range normally reserved for high-end jewelers and fashion apparel retailers. Exceptional productivity also leads to strong returns on invested capital, which have consistently been in the low to mid-teens over the past five years, comfortably ahead of our 8.6% cost of capital assumption.
Price leadership digs a moat
We assign Costco a narrow economic moat, as the warehouse club business model gives the firm nearly unrivaled loss-leader capabilities and ever-increasing buying power. Membership fees are the main driver of operating profits, so Costco has the ability to sell virtually any consumer product at a wholesale rather than a retail price. This makes it very difficult for other retail concepts to compete with Costco on price. Costco's price leadership position is reinforced by the company's concentration on fewer and faster-turning stock-keeping units, which generates disproportionate purchasing power for its size. Additionally, the company does not advertise, and its austere warehouse format requires much lower maintenance capital expenditures. Therefore, the membership wholesale business model has a sustained cost advantage versus other retail operators that sell the same product categories.
Memberships keep cash flows consistent
We assign Costco a low uncertainty rating given that its scale and price leadership on inelastic consumer products have delivered some of the defensive sector's most consistent revenue and earnings growth. Because much of Costco's membership revenue is booked in advance, cash flow volatility is below average. The main risk to our fair value estimate is that membership growth turns negative and attrition rates increase. Membership renewal rates stand at about 90% in the U.S. and Canada, and they did not materially differ from this level during the Great Recession. On a global basis, renewal rates stand at about 86%, which indicates that attrition rates are much higher at the international operating segment. Therefore, as the mix of international warehouse increases, that could drag overall renewal rates lower. Still, the absolute level of members should continue to grow even with the addition of lower membership retention at international warehouse clubs.
Management is exemplary
From a capital-allocation perspective, we think Costco's management has been very disciplined. Although the company continues to roll out new stores, it has also been able to sustain excess returns on capital and generate ample free cash flow. Costco has a long growth runway, and we believe management will continue to prudently allocate capital over the years to come. As a result, we assign Costco an Exemplary Stewardship Rating.
Craig Jelinek assumed the CEO role in 2012, replacing cofounder and Morningstar's 2011 CEO of the Year James D. Sinegal. Jelinek has been with Costco for nearly 30 years. His previous positions had included president and COO since 2010 and executive vice president and COO of merchandising since 2004. The board is composed of founders Sinegal and Jeffrey Brotman, Jelinek, CFO Richard Galanti, and--also important--10 outside directors. The independent board members include Charles Munger, vice chairman of Berkshire Hathaway; William Gates Sr., father of Microsoft cofounder Bill Gates; and Hamilton James, president and COO of the Blackstone Group. Senior management compensation levels are well within industry norms, and the board evaluates the CEO annually.
