Costco Wholesale Corporation — Q1 FY2010 Form 10-Q
Business context and reporting period. Costco operates membership warehouses offering a limited selection of merchandise at low prices. This unaudited filing covers the 12 weeks ended November 22, 2009; comparisons are with the 12 weeks ended November 23, 2008. At quarter-end, Costco operated 533 warehouses across the U.S. and several international markets, including Mexico through a 50%-owned joint venture. Financial amounts below are in millions except per-share data.
Key financial results
| Metric | Q1 FY2010 | Q1 FY2009 | Change / context |
|---|---|---|---|
| Net sales | $16,922 | $16,036 | Up 5.5%; comparable sales up 3% versus 1% |
| Membership fees | $377 | $359 | Up 5.2% |
| Total revenue | $17,299 | $16,395 | Up 5.5% |
| Gross margin | $1,841; 10.88% of sales | $1,760; 10.97% | Down 9 basis points |
| SG&A | $1,777; 10.50% of sales | $1,677; 10.46% | Rate up 4 basis points |
| Operating income | $428 | $422 | Up 1.4%; operating margin was about 2.5% versus 2.6% |
| Net income attributable to Costco | $266 | $263 | Up about 1%; diluted EPS was $0.60 in both periods |
| Operating cash flow | $751 | $(15) | Improved $766, substantially reflecting working-capital movements |
| Capital expenditures | $313 | $375 | Cash additions to property and equipment |
| Cash and short-term investments | $4,189 | $3,727 at FY2009 year-end | As of November 22, 2009 |
Financial position and cash flow
- Cash and cash equivalents were $3,617 and short-term investments were $572 at November 22, 2009. Total current assets were $11,627 and current liabilities were $10,285.
- Long-term debt, including its current portion, was $2,185; short-term borrowings were $30. The company reported compliance with restrictive covenants. It repaid Japanese promissory notes due in November and did not plan to refinance them.
- Operating cash flow improved from an outflow of $15 to an inflow of $751. Costco attributed the increase mainly to a $395 reduction in its net investment in inventory (inventory less accounts payable) and a $378 favorable change in other current operating assets and liabilities, including timing of prepaid health-insurance funding.
- Investing cash outflow was $296; financing cash outflow was $5. Cash increased $460 during the quarter. Costco paid a quarterly dividend of $0.18 per share, up $0.02 year over year; annualized, the rate was $0.72 per share.
Changes, drivers, and management commentary
- Net sales growth reflected a 3% increase in comparable sales and sales from 21 net new warehouses since the end of Q4 FY2008. Foreign-currency movements added approximately $203 to net sales, while gasoline price deflation reduced sales by approximately $160. Comparable sales benefited from increased shopping frequency, partly offset by slightly lower average spending after adjusting for gasoline and currency.
- Membership-fee growth was attributed primarily to sign-ups at new warehouses and greater penetration of Executive Memberships. Costco reported approximately 56 million cardholders, compared with 54 million, and an 87% renewal rate.
- Gross-margin rate pressure was primarily associated with warehouse ancillary businesses, especially gasoline. Core merchandise margin improved, partly offsetting that pressure. Higher healthcare and other employee-benefit costs contributed to SG&A deleverage.
- Costco said general economic conditions continued to weigh on sales and could continue to adversely affect member spending, while management believed its business model positioned it well to compete.
Outlook, risks, contingencies, and unusual items
- Costco planned approximately $1,300 of FY2010 spending on real estate, construction, remodeling, equipment, and related operations, funded from operating cash flow and existing liquid resources. It had spent approximately $313 through Q1, opened six warehouses, and intended to open up to 12 more during the remainder of the fiscal year, including one to two relocations. These plans were subject to change.
- The filing provides no specific earnings or sales guidance. Management identified risks including economic conditions, currency rates, competition, regulation, consumer spending and debt levels, financial-market uncertainty, real estate matters, vendor actions, employee costs, and geopolitical conditions.
- Contingencies include employment-related class actions, a gender-promotion case, membership-renewal and fuel-temperature cases, product-labeling claims, shareholder derivative litigation concerning historical stock-option grants, government inquiries regarding hazardous merchandise and environmental compliance, and state unclaimed-property examinations. Costco said it could not reasonably estimate possible losses for several matters; it did not expect pending matters, individually or in aggregate, to materially affect financial position, but an unfavorable outcome could materially affect an individual quarter.
- A California managers’ overtime case had a partial settlement requiring payment of up to $16, substantially paid in Q1. A proposed membership-renewal settlement had a $7 reserve for expected costs; final court approval was pending. A proposed fuel-temperature settlement required installation of temperature-correcting dispensers in specified states over five years, subject to final approval.
- Costco reported $7 remaining in the restricted-liquidity Columbia investment fund at quarter-end, down from $27 at FY2009 year-end. No impairment was recorded in Q1 FY2010, but management cautioned that uncertain markets could lead to further declines and losses. The prior-year quarter included a $6 impairment on these securities and a $28 charge related to employee life-insurance contract values; neither comparable charge recurred in Q1 FY2010.
- An $80 liability was recorded for a capital lease entered into in October 2009 for a future warehouse; aggregate future minimum lease payments were $162. Costco also reported no stock repurchases under its public program in Q1, versus $55 in the prior-year quarter.
Important facts for investors to verify
- Whether comparable-sales momentum and membership-fee growth persist, and how currency effects and gasoline prices affect reported sales.
- Whether gross-margin pressure and higher employee-benefit costs continue, and whether operating income converts into sustained net-income growth.
- How much of the $751 operating cash flow reflects recurring performance versus quarter-end working-capital timing.
- Execution, funding, and returns on the approximately $1,300 FY2010 capital-spending plan and planned warehouse openings.
- Developments in the disclosed litigation and government inquiries, including settlement approvals, potential penalties, and any losses that become estimable.
- Valuation and recovery of the remaining Columbia fund investments, as well as debt, liquidity, and future dividend decisions.