Costco Wholesale Corporation — Q2 FY2017 Form 10-Q
Reporting period: 12 weeks ended February 12, 2017; first-half comparisons cover 24 weeks ended February 12, 2017. Fiscal 2017 is a 53-week year. Amounts are in U.S. dollars unless noted.
Business and operating context
Costco operated 727 membership warehouses and online businesses in six countries. Its model emphasizes low prices, high sales volumes, rapid inventory turnover, and membership-fee revenue. Management identifies comparable-sales growth as a key profitability driver and notes that the business operates at low margins.
Financial performance
| Metric | Q2 FY2017 | Q2 FY2016 | First half FY2017 | First half FY2016 |
|---|---|---|---|---|
| Net sales | $29.130 billion | $27.567 billion | $56.599 billion | $54.194 billion |
| Total revenue, including membership fees | $29.766 billion | $28.170 billion | $57.865 billion | $55.390 billion |
| Operating income | $844 million | $856 million | $1.693 billion | $1.623 billion |
| Net income attributable to Costco | $515 million | $546 million | $1.060 billion | $1.026 billion |
| Diluted EPS | $1.17 | $1.24 | $2.41 | $2.32 |
| Gross margin percentage | 11.00% | 11.24% | 11.28% | 11.26% |
| SG&A as a percentage of net sales | 10.23% | 10.28% | 10.46% | 10.41% |
Q2 net sales rose 6%, including a 3% increase in comparable sales; comparable sales excluding currency and gasoline-price effects also increased 3%. For the first half, net sales rose 4% and comparable sales rose 2%; comparable sales excluding those effects rose 2%. Q2 sales benefited by approximately $244 million from higher gasoline prices, while currency changes reduced sales by approximately $20 million. First-half sales were affected by hardlines price deflation.
Membership-fee revenue increased 5% in Q2 to $636 million and 6% in the first half to $1.266 billion. At quarter-end, Costco reported 48.3 million paid members and renewal rates of 90% in the U.S. and Canada and 88% worldwide.
Q2 gross margin percentage fell 24 basis points, mainly due to lower margins in warehouse ancillary and other businesses, particularly gasoline. Core merchandise margin as a share of core merchandise sales rose seven basis points, but overall gross margin was also affected by business mix. First-half gross margin percentage rose two basis points; the company cited benefits from the U.S. co-branded credit-card arrangement and a non-recurring legal settlement, partly offset by weaker ancillary-business margins.
Cash flow, liquidity, and debt
- First-half operating cash flow was $3.286 billion, versus $1.602 billion a year earlier. Management attributed the increase primarily to approximately $1.7 billion of vendor payments accelerated into the final week of FY2016, ahead of an accounting-system change; therefore, the year-over-year increase is not solely an indicator of underlying operating improvement.
- First-half investing cash outflow was $1.052 billion, including $1.183 billion of property and equipment additions. Financing cash outflow was $825 million.
- At February 12, cash and cash equivalents were $4.744 billion and short-term investments were $1.221 billion, totaling $5.965 billion. Approximately $1.167 billion of cash and short-term investments was held by non-U.S. subsidiaries and considered indefinitely reinvested.
- Total debt carrying value was $5.072 billion, including $2.257 billion classified as current. Costco said it would pay approximately $1.1 billion, plus accrued interest, on its 5.5% Senior Notes on March 15, 2017, using existing cash and investments. No short-term borrowings were outstanding at quarter-end.
- The company declared a quarterly dividend of $0.45 per share, up from $0.40 a year earlier; it was paid February 24, 2017. First-half share repurchases totaled $188 million.
Material changes, outlook, and risks
- Quarterly net income declined 6% and diluted EPS fell from $1.24 to $1.17 despite higher sales. Management cited lower overall gross margin and foreign-currency transaction losses; SG&A as a share of net sales improved five basis points, though adjusted for gasoline-price effects it increased four basis points.
- Costco announced U.S. and Canada membership-fee increases effective June 1, 2017: most listed individual and business memberships rise by $5 to $60 annually, while Executive membership rises from $110 to $120. The maximum annual 2% reward rises from $750 to $1,000. Management did not expect a material impact on FY2017 results.
- Management expected up to 19 additional warehouse openings, including two relocations, for the remainder of FY2017, and approximately $2.7–$2.8 billion of capital expenditures for the full year. It expected funding from operations, cash, and short-term investments and stated that liquidity would be sufficient for foreseeable needs. No specific earnings or sales guidance was provided.
- Key stated risks include economic and consumer-spending conditions, competition, exchange rates, gasoline and commodity costs, employee costs, real-estate availability, regulation, and security or privacy breaches. Management reported no material changes to previously disclosed risk factors.
- Legal matters include fuel-temperature class actions, a California seating class action, unclaimed-property examinations, Canadian pharmacy-related inquiries, and Connecticut hazardous-waste notices. A January 2017 civil settlement concerning controlled-substance prescription practices requires a $12 million payment, previously accrued. Management said pending matters were not expected to have a material adverse effect on financial position, but an unfavorable outcome could materially affect an individual quarter.
- New lease accounting is expected to materially increase balance-sheet assets and liabilities, primarily through recognition of operating-lease right-of-use assets and obligations; management did not expect a material impact on results or cash flows. The company was also evaluating the revenue-recognition standard; its financial impact was not yet clear. Stock-compensation accounting changes were expected to potentially materially affect tax expense and EPS, with increased quarterly volatility.
Important facts for investors to verify
- How much of reported cash-flow growth reflects the prior-year vendor-payment timing shift versus recurring operating performance.
- Whether comparable-sales momentum persists after separating gasoline-price and foreign-exchange effects, and how new warehouse openings affect existing locations.
- Whether gross-margin pressure, especially in gasoline and ancillary businesses, improves or continues to weigh on earnings.
- The impact of membership-fee increases on renewals, membership growth, and fee revenue after their June 2017 effective date.
- Execution and funding of planned capital spending, near-term debt repayment, and the potential balance-sheet effect of lease accounting.
- Developments in the disclosed legal and regulatory matters, including any material changes to accruals or potential losses.