Costco is bulking up its moat

Its loss-leader capabilities should drive unrivaled sales per square foot and excess returns.

Ken Perkins, CFA 8 March, 2014 | 4:01AM

  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.

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Ken Perkins, CFA

Ken Perkins, CFA  Ken Perkins, CFA, is an equity analyst for Morningstar.

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