Costco's quarterly results show why we're long-term investors, despite softer sales

Published Thu, Mar 2 20237:35 PM ESTUpdated Wed, Mar 8 20232:07 PM EST

Wholesale retailer Costco Wholesale (COST) on Thursday delivered solid earnings for its second quarter of fiscal year 2023, even as signs of weakening sales pushed shares lower in afterhours trading. But the results don't change the Club view that Costco is still the best-run retailer in the U.S. Revenue for the three months ended Feb. 12 increased 6.5% year-over-year, to $55.27 billion, missing analysts' expectations for $55.54 billion, according to estimates compiled by Refinitiv. Earnings Per Share (EPS) grew 13% year-over-year, to $3.30, ahead of analysts' forecasts for EPS of $3.21 a share, Refinitiv data showed. Shares of Costco dipped roughly 3% in afterhours trading, to around $471 apiece. Still, the new year has been kinder to this defensive name in retail compared to other big box stores like Walmart (WMT). After factoring in tonight's move lower, Costco shares have gained roughly 3.3% year-to-date, compared to a 3.7% increase in the S & P 500 . Bottom line Unsurprisingly, Costco delivered a steady quarter Thursday, a result of management's ability to execute in a difficult environment for retail. While it's a positive development to see Costco's margins expand from last year, it's also important to note that management doesn't run the business for profit margins. Costco is a members-only, volume-based company that prides itself on being the first retailer to lower prices, and the last to raise them. This customer-first philosophy has never failed it. The approach should continue to drive market-share gains and deliver dependable earnings streams for the foreseeable future, even amid challenging macroeconomic conditions. While shares slid in late trading, the stock has a history of trading lower on earnings reports because the company's monthly sales figures price in a lot of potential upside. A comparable sales slowdown in February and the stock's premium valuation keep us at a 2 rating for now — but Costco remains a defensive stock we want to own in the portfolio for the long term. Quarterly commentary Given sales figures are released on a monthly basis, the bigger question for the company when it comes to quarterly results – and really for all retailers in this inflationary environment – is how gross margins fared. Costco's gross margins, excluding membership fees (which flow directly into profits), proved a positive surprise, increasing eight basis points from last year, to 10.72%. And excluding gasoline inflation, gross margins would have been up nine basis points. On the post-earnings conference call with analysts and investors, Costco management broke down all the levers of the quarterly margin performance. Core merchandise was a six-basis-point drag on both a reported basis and excluding gas inflation. Margins continued to get squeezed in the retail part of the business, with most major departments down last year, especially fresh foods. Despite inflation pushing prices higher, Costco remained committed to holding, or dropping, prices when possible in order to beat out competitors. Costco's ancillary businesses — including gas stations, pharmacies, food courts, travel centers and hearing aid centers — provided a two-basis point tailwind on a reported basis, but a three-basis-point lift excluding gas inflation. Costco's discount gas prices, coupled with strong consumer demand for travel, helped those businesses pace the quarter, though were partially offset by e-commerce and pharmacy. Costco's 2% reward program was a two-basis-point headwind on both sides due to more sales coming from Costco's executive members. And last in, first out (LIFO) inventory accounting was a 14-basis point benefit because, unlike last year, the company did not have to pay out a $71 million inventory charge. Taken together, Costco saw an eight-basis-point improvement on a reported basis, mostly due to the lack of LIFO charges. Inflation has started to come down notably for Costco, with the company now seeing year-over-year price increases in the 5% to 6% range and even a little lower towards the end of the quarter. Back in August, Costco was experiencing annual inflation closer to 8%. One way management can improve margins in the future is by raising its membership fees. This is something the company traditionally has done every five-years-and-seven-months, and we're roughly at the anniversary. Those potential gains wouldn't flow directly to the bottom line because management would want to invest those extra dollars into keeping prices down, but any uplift would help the company's overall performance. Management did not give any indication that a fee hike was imminent, but CFO Richard Galanti reiterated Thursday that "it's a question of when, not if." The company remains hesitant to raise prices on its members during this period of high inflation, though increased churn is probably the last thing they have to worry about. Costco just finished the quarter with renewal rates at all-time highs. Meanwhile, Costco has paid a out a dividend four times in the past eight years, the last being in November 2020. Management has hinted in the past that another could be on the horizon, but did not offer any concrete commentary Wednesday. February sales Alongside its fiscal second-quarter results Wednesday, Costco provided comparable sales for the four-week period ended Feb 26. The numbers pointed to some softness in the business, with adjusted comparable sales (excluding foreign exchange and gas headwinds) increasing 3.5% in the U.S. That figure came in well below analysts' estimates of a 5.3% gain and was significantly lower than the 6.9% growth seen in January. In total, comparable sales increased by 3.5%, missing estimates of 4.7% and decelerating from the 7.4% gain in January. Food and sundries continued to be a source of strength, while nonfood categories fell by a single-digit percentage. This trend is a continuation of what we've seen in the post-Covid world, whereby consumers have continued to shop for essentials like food despite inflation, while sales of general merchandise have proven to be weaker, in part because the pandemic pulled forward a lot of demand. (Jim Cramer's Charitable Trust is long COST. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Shoppers wearing face masks leave a Costco wholesale store in Washington, D.C.

Ting Shen | Xinhua News Agency | Getty Images