Business Context and Reporting Period
Company: Costco Wholesale Corporation
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: February 18, 2007 (Second Quarter of Fiscal 2007)
Operations: Membership warehouse clubs operating 504 locations globally (367 in the U.S., 70 in Canada, and others in the UK, Korea, Taiwan, Japan, and Mexico).
Key Financial Metrics
| Metric | 12 Weeks Ended Feb 18, 2007 | 24 Weeks Ended Feb 18, 2007 |
|---|---|---|
| Total Revenue | $15.11 billion | $29.26 billion |
| Net Sales | $14.80 billion | $28.66 billion |
| Net Income | $249.5 million | $486.4 million |
| Diluted EPS | $0.54 | $1.05 |
| Operating Cash Flow (YTD) | $725.9 million | |
| Cash & Equivalents | $1.57 billion | |
| Short-term Investments | $661.4 million | |
| Total Debt (Current + Long-term) | $629.1 million |
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 7.4% year-over-year (YoY) to $14.8 billion. Comparable warehouse sales grew 5%.
- Profitability Decline: Net income decreased 15.8% YoY to $249.5 million. Operating income dropped 16.2% to $361.3 million.
- Margin Compression: Gross margin percentage declined 28 basis points to 10.49%. SG&A expenses as a percentage of net sales increased 49 basis points to 10.05%.
- Stock Repurchases: The company repurchased 8.9 million shares in the quarter for $480.8 million, totaling $905.7 million for the first half of the fiscal year.
Unusual Items, Risks, and Outlook
Unusual Items Impacting Results
Management identified three significant non-recurring items that negatively impacted reported earnings by approximately $53.4 million (net of tax) in the quarter:
- Sales Return Reserve Adjustment: A change in accounting estimate regarding consumer electronics returns resulted in a $224.4 million reduction in net sales and a $48.1 million charge to gross margin.
- Stock Option Tax Consequences: A $46.2 million SG&A charge related to remedying adverse tax consequences for employees regarding historical stock option grants.
- Excise Tax Refund: A $10.1 million refund from the IRS provided a partial offset to the charges above.
Adjusted Performance: Excluding these items, adjusted net income was $302.9 million ($0.66 diluted EPS), representing a 6% increase over the prior year.
Subsequent Events and Risks
- New Debt Issuance: On February 20, 2007, the company issued $900 million of 5.30% Senior Notes (2012) and $1.1 billion of 5.50% Senior Notes (2017). This is expected to increase annual interest expense by approximately $108 million.
- Legal Proceedings: The company faces multiple class actions regarding overtime compensation, meal/rest breaks, and membership practices. A grand jury subpoena was received regarding hazardous merchandise handling, and a separate investigation into stock option granting practices was initiated by the U.S. Attorney's Office in March 2007.
- Expansion Plans: Capital expenditure plans for fiscal 2007 are estimated at $1.4 billion to $1.5 billion. The company intends to open 14-15 additional warehouses in the U.S. and Canada for the remainder of the fiscal year.
Investor Verification Checklist
- Adjusted Earnings: Verify the company's "adjusted" earnings metrics ($0.66 EPS) against reported GAAP figures ($0.54 EPS) to understand the true operational performance excluding one-time charges.
- Debt Service Capacity: Assess the impact of the new $2 billion debt issuance on future interest coverage ratios and cash flow, given the projected $108 million increase in annual interest expense.
- Legal Exposure: Monitor the status of the grand jury investigation into stock option practices and the outcome of the pending class action settlements (e.g., the $7.5 million tentative settlement in the Doty case).
- Inventory Valuation: Review the methodology changes to the sales return reserve, as this accounting estimate significantly altered revenue recognition in the current quarter.
- Share Count: Confirm the reduction in outstanding shares due to the aggressive $905.7 million buyback program in the first half of the year.