Business Context and Reporting Period
Company: Costco Wholesale Corporation
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: May 13, 2007 (Third Quarter of Fiscal 2007)
Operations: Operates 510 membership warehouse clubs globally (372 in the U.S., 71 in Canada, and others in the U.K., Korea, Taiwan, Japan, and Mexico). The company focuses on low prices, limited selection, and high inventory turnover.
Key Financial Metrics
| Metric | 12 Weeks Ended May 13, 2007 | 36 Weeks Ended May 13, 2007 |
|---|---|---|
| Total Revenue | $14.66 billion | $43.92 billion |
| Net Sales | $14.34 billion | $43.00 billion |
| Membership Fees | $317.7 million | $924.4 million |
| Net Income | $224.0 million | $710.4 million |
| Diluted EPS | $0.49 | $1.54 |
| Operating Cash Flow (36 weeks) | $1.55 billion | |
| Cash & Equivalents (Ending) | $3.16 billion | |
| Long-Term Debt | $2.16 billion (excluding current portion) |
Margins: Gross margin was 10.21% of net sales for the quarter (10.42% for 36 weeks). SG&A expenses were 9.99% of net sales for the quarter (10.01% for 36 weeks).
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 10.3% year-over-year for the quarter and 8.9% for the 36-week period. Comparable warehouse sales grew 7% in the quarter and 6% for the 36-week period.
- Membership Fees: Increased 15.0% in the quarter, driven by new sign-ups, higher Executive Membership penetration, and a $5 fee increase implemented in the prior year.
- Profitability: Reported Net Income decreased 4.9% in the quarter and 5.0% for the 36-week period compared to the prior year. However, this decline is primarily due to non-recurring charges (see below).
- Debt Structure: On February 20, 2007, the company issued $2.0 billion in Senior Notes ($900M at 5.30% and $1.1B at 5.50%) to refinance maturing debt and fund share repurchases. This significantly increased interest expense compared to the prior year.
- Liquidity: Cash and cash equivalents increased from $1.51 billion to $3.16 billion, largely due to the debt issuance and strong operating cash flows.
Guidance, Outlook, and Unusual Items
Unusual Items Impacting Results
Management highlights that reported results were significantly impacted by the following non-recurring items:
- Sales Returns Reserve Adjustment: A $228.2 million increase in the estimated reserve for sales returns (related to consumer electronics policy changes) reduced net sales and gross margin. This resulted in a $47.2 million pre-tax charge in the quarter.
- Stock Option Tax Consequences: A $0.9 million charge in the quarter (and $47.3 million for the 36-week period) related to remedying adverse tax consequences for employees regarding historical stock option grants.
- Excise Tax Refund: A $10.1 million refund received in the 36-week period related to prior years.
Adjusted Performance: Excluding these unusual items, adjusted Net Income for the quarter would have been $254.3 million ($0.56 diluted EPS), representing a 14% increase over the prior year. For the 36-week period, adjusted Net Income would have been $793.8 million ($1.72 diluted EPS), an 11% increase.
Outlook and Capital Allocation
- Dividends: Quarterly dividend increased to $0.145 per share (annualized $0.58).
- Share Repurchases: Repurchased 11.3 million shares in the quarter for $614.5 million. Approximately $1.1 billion remains available under current authorizations.
- Expansion: Plans to spend $1.3 billion to $1.4 billion in fiscal 2007 on real estate and equipment. Intends to open 8-9 additional warehouses in the U.S. and Canada for the remainder of the fiscal year.
Risks and Contingencies
- Legal Proceedings: Multiple class actions pending regarding overtime compensation, meal/rest breaks, and membership practices in California. A $7.5 million settlement was approved for one case; others are in various stages of litigation or appeal.
- Regulatory Investigations: Cooperating with a U.S. Attorney's Office investigation into past stock option granting practices and a grand jury subpoena regarding hazardous merchandise returns.
- Market Risks: Exposure to interest rate and foreign exchange fluctuations, though hedging strategies are in place.
Investor Verification Checklist
- Sales Returns Reserve: Verify the methodology and long-term impact of the $228.2 million reserve adjustment on future gross margins.
- Debt Service: Confirm the impact of the new $2.0 billion Senior Notes on future interest expense and cash flow coverage.
- Legal Exposure: Monitor the status of the California labor class actions and the outcome of the stock option investigation.
- Comparable Sales: Assess the sustainability of the 7% comparable sales growth, noting the contribution from gasoline sales and foreign currency fluctuations.
- Capital Return: Track the pace of share repurchases against the remaining $1.1 billion authorization and dividend sustainability.