Business context and reporting period
Costco Wholesale Corporation operates membership warehouses and e-commerce businesses. This Form 10-Q covers the 12 weeks ended February 17, 2019 (fiscal 2019 second quarter) and the 24 weeks ended that date (first half); comparisons are to the corresponding periods in 2018. Amounts are in millions of dollars except per-share data, percentages, and where noted.
- Costco operated 769 warehouses worldwide and e-commerce websites in six countries. It reported U.S., Canadian, and Other International operations.
- Second-quarter net sales growth reflected 5% comparable-sales growth and sales from 22 net new warehouses opened since the prior-year quarter.
Financial performance and liquidity
| Metric | Q2 2019 | Q2 2018 | First half 2019 | First half 2018 |
|---|---|---|---|---|
| Net sales | $34,628 | $32,279 | $68,939 | $63,396 |
| Membership-fee revenue | $768 | $716 | $1,526 | $1,408 |
| Operating income | $1,203 | $1,016 | $2,152 | $1,967 |
| Net income attributable to Costco | $889 | $701 | $1,656 | $1,341 |
| Diluted EPS | $2.01 | $1.59 | $3.74 | $3.04 |
| Operating cash flow | Not separately reported | Not separately reported | $1,958 | $2,115 |
| Capital expenditures | Not separately reported | Not separately reported | $1,317 | $1,328 |
- Q2 net sales increased 7%; net income rose 27%. First-half net sales increased 9% and net income rose 23%.
- Q2 gross margin was $3,908, or 11.29% of net sales, versus $3,546, or 10.98%, a 31-basis-point increase. First-half gross margin percentage was 11.02%, down from 11.11%. Q2 operating margin was approximately 3.40%, compared with 3.15% a year earlier.
- Q2 SG&A was 10.00% of net sales versus 10.02%; first-half SG&A was 10.06% versus 10.19%. Interest expense declined to $34 in Q2 and $70 in the first half. Interest income and other, net, increased to $46 and $68, respectively.
- Effective tax rates were 25.8% for Q2 and 21.9% for the first half, compared with 27.7% and 29.0%. First-half results included $90 of discrete net tax benefits; excluding these, the rate was 26.1%.
- At February 17, 2019, cash and cash equivalents were $6,080 and short-term investments were $1,042, totaling $7,122. Current assets were $21,648 and current liabilities $22,450. Long-term debt was $6,492 in total, including $1,698 classified as current; total liabilities were $28,616.
- First-half operating cash flow fell to $1,958 from $2,115, primarily amid changes in inventory and accounts payable. Investing cash outflow was $1,171 and financing cash outflow was $749. Cash increased $25 from fiscal year-end to $6,080.
Material changes and notable items
- Comparable sales rose 5% in Q2 and 7% in the first half. Excluding currency and gasoline-price effects, comparable sales increased 7% in both periods. Reported sales were negatively affected by currency in both periods; Q2 was also affected by lower gasoline prices.
- Q2 gross-margin improvement was mainly attributed to ancillary businesses, especially gasoline. First-half gross margin percentage declined as reported, while the adjusted measure excluding gasoline-price and revenue-standard effects increased three basis points.
- Revenue-standard adoption (ASU 2014-09) added $179 to Q2 net sales and $519 to first-half net sales; the filing reports only a small gross-margin impact. The standard also changed presentation and timing for returns, cash-card breakage, and certain sales.
- Membership renewal rates were 91% in the U.S. and Canada and 88% worldwide. Paid members totaled 52.7 million, versus 50.4 million a year earlier; cardholders totaled 96.3 million, versus 92.2 million.
- Costco paid $501 in dividends during the first half. The quarterly dividend rate was raised to $0.57 per share from $0.50 in the prior-year quarter. First-half share repurchases were $151, compared with $178.
Outlook, risks, and contingencies
- Management planned approximately $2.8–$3.1 billion of fiscal 2019 capital expenditures and expected 17 additional warehouse openings, including two relocations, in the remainder of the year. It stated that cash and operating cash flows should meet foreseeable liquidity and capital needs.
- After quarter-end, Costco announced higher starting and supervisor wages and paid bonding leave for U.S. and Canadian hourly employees, effective March 2019; estimated annualized pretax cost is $50–$60.
- Management identified a material weakness in internal control over financial reporting; disclosure controls were therefore deemed ineffective as of February 17, 2019. Remediation was underway and expected before fiscal year-end, subject to controls operating effectively and successful testing.
- Risks highlighted include competition, economic and consumer-spending conditions, currency and commodity movements, employee and health-care costs, tariffs and geopolitical conditions, cybersecurity/privacy incidents, real estate and capital needs, and the ability to remediate control weaknesses. Management reported no material change to risk factors from its last Form 10-K.
- Legal matters include California employment-related claims, opioid litigation, shareholder securities and derivative actions tied to internal-control disclosures, and environmental matters. Costco said it did not expect pending matters to materially affect its financial position, results, or cash flows, but an unfavorable outcome could materially affect an individual quarter. A Canadian pharmacy subsidiary paid $5 million under an Ontario order; the amount had been accrued previously.
- Costco stated that adoption of the new lease-accounting standard was planned for fiscal 2020 and expected to materially increase balance-sheet assets and lease obligations, without a material income-statement or cash-flow effect.
Important facts for investors to verify
- Progress and timing of remediation of the material weakness, and any subsequent assessment of control effectiveness.
- Underlying comparable-sales and margin trends after separating currency, gasoline prices, and revenue-standard effects.
- Cash-flow conversion, working-capital movements, planned capital spending, and the schedule for debt classified as current.
- Whether the announced wage and leave changes, warehouse openings, and capital plans track management’s estimates.
- Developments in shareholder, employment, opioid, and environmental litigation and any resulting changes to accruals or exposure.