COSTCO WHOLESALE CORP quarterly report, Q2 FY2018

Business context and reporting period

Costco Wholesale Corporation operates membership warehouses and e-commerce sites selling a limited selection of merchandise at low prices. This Form 10-Q covers the 12 weeks ended February 18, 2018 (fiscal second quarter) and the 24 weeks ended that date (first half); comparisons are with the corresponding 2017 periods. Costco operated 747 warehouses worldwide at quarter-end.

Financial performance

MetricSecond quarter 2018Second quarter 2017First half 2018First half 2017
Total revenue$32.995 billion$29.766 billion$64.804 billion$57.865 billion
Net sales$32.279 billion$29.130 billion$63.396 billion$56.599 billion
Membership-fee revenue$716 million$636 million$1.408 billion$1.266 billion
Operating income$1.016 billion$844 million$1.967 billion$1.693 billion
Net income attributable to Costco$701 million$515 million$1.341 billion$1.060 billion
Diluted EPS$1.59$1.17$3.04$2.41
  • Growth: Second-quarter net sales rose 11%; comparable sales increased 8% (5% excluding foreign-exchange and gasoline-price effects). First-half net sales rose 12%; comparable sales increased 9% (7% excluding those effects). Quarterly comparable-sales growth reflected increased shopping frequency and average ticket, partly offset by cannibalization from new warehouses.
  • Margins: Gross margin was $3.546 billion, or 10.98% of net sales, in the quarter, down 2 basis points year over year. Excluding gasoline-price effects, adjusted gross margin percentage increased 11 basis points. SG&A was 10.02% of net sales, down 21 basis points. For the first half, gross margin percentage fell 17 basis points and SG&A percentage improved 27 basis points.
  • Taxes: The second-quarter effective tax rate was 27.7%, versus 35.6%, and the first-half rate was 29.0%, versus 35.0%. A net $74 million benefit from the 2017 Tax Act increased second-quarter earnings by approximately $0.17 per diluted share.
  • Cash flow: First-half operating cash flow was $2.115 billion, compared with $3.286 billion; management attributed the decline primarily to approximately $1.7 billion of accelerated vendor payments in the final week of fiscal 2016 that benefited the prior-year comparison. Capital expenditures were $1.328 billion.
  • Liquidity and debt: Cash and cash equivalents were $4.781 billion and short-term investments $1.049 billion, totaling $5.830 billion at February 18, 2018. Long-term debt, including its current portion, was $6.627 billion. Current assets were $18.899 billion versus current liabilities of $18.913 billion. No short-term bank-facility borrowings were outstanding; available borrowing capacity was $875 million.
  • Capital returns: The quarterly dividend was raised to $0.50 per share from $0.45 a year earlier. First-half cash dividends paid were $220 million; common-stock repurchases totaled $184 million in cash-flow reporting.

Material changes and management commentary

  • Membership fees increased 13% in the quarter and 11% in the first half, reflecting the prior-year fee increase and membership sign-ups. Renewal rates were 90% in the U.S. and Canada and 87% worldwide; paid members totaled 50.4 million.
  • Foreign-exchange movements added approximately $553 million to second-quarter net sales, and higher gasoline prices added approximately $384 million. Gasoline-price inflation increased reported sales but affected reported margin percentages.
  • Core-category gross margin improved on a per-category-sales basis in the quarter, while lower softlines and hardlines sales penetration and costs from new centralized return centers weighed on overall results. First-half margin comparisons also reflected a non-recurring legal settlement in the 2017 period.
  • Management says sales growth, especially comparable-sales growth, is central to profitability. The low-margin model is sensitive to merchandise costs and SG&A; competition, wage and benefit costs, utilities, energy and commodity prices, foreign exchange, and consumer spending can affect results.

Outlook, risks and unusual items

  • Costco expected to open 18 to 20 additional warehouses, including three relocations, during the remainder of fiscal 2018. Fiscal 2018 capital spending was estimated at approximately $2.5 billion to $2.7 billion. The filing provides no specific earnings or revenue guidance.
  • The Tax Act produced a provisional net $74 million quarterly benefit, comprising a $165 million deferred-tax remeasurement benefit partly offset by $152 million of estimated tax on deemed repatriation and $39 million for reduced foreign tax credits and other items. Management said estimates may be adjusted as its analysis continues. The repatriation tax was payable over eight years; $88 million was included in other liabilities.
  • Management expects adoption of the lease standard in fiscal 2020 to materially increase balance-sheet assets and lease obligations, with no expected material effect on income or cash flows. Revenue-standard adoption was planned for fiscal 2019; the company was still assessing impacts, including cash-card breakage recognition and certain revenue presentation matters.
  • Legal matters include a California employee seating class action, an Ontario request concerning drug-benefit anti-rebate compliance, and Connecticut notices regarding hazardous-waste practices. Costco recorded an immaterial accrual for one matter and said a material adverse effect on financial position, results or cash flows was not expected, while acknowledging a possible material charge in an individual quarter.
  • Other disclosed risks include competition, economic and consumer-spending conditions, foreign-exchange movements, information-security breaches, real-estate matters, vendor actions, and rising employee, health-care, energy and commodity costs. The filing reported no material change in risk factors from the prior annual report.

Important facts for investors to verify

  1. Whether comparable-sales momentum persists after separating foreign-exchange and gasoline-price impacts, and accounting for new-store cannibalization.
  2. How much of earnings growth is recurring operating performance versus the provisional Tax Act benefit, and whether tax estimates change.
  3. Whether margin trends, centralized return-center costs and SG&A leverage develop as management describes.
  4. Execution of the planned warehouse openings and $2.5 billion to $2.7 billion capital-spending plan, alongside operating cash flow and liquidity needs.
  5. Developments in the identified legal and regulatory matters and the expected balance-sheet effect of lease-standard adoption.