3/3/2010
By Brian Sozzi, Research Analyst

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This morning, Costco Wholesale Club Inc. (COST) announced its 2Q10 financial results.  We, in addition to the market, were expecting good news from the company on the earnings line.  Collectively, our views were not without a solid foundation as Costco had several earnings related catalysts in the quarter.  They included (1) increased leverage over operating expenses from positive currency translation, (2) strengthening sales in discretionary merchandise departments (which comprise about 30.0% of the business), favorable comparisons to year ago markdowns that ensued from a soft holiday season, (3) a turn in the California market (27% of sales), and (4) a fair amount of availability under a share repurchase program ($2.0 billion).  What is the old saying, when things seem to be too good to be true they usually are?

Costco reported total revenues (includes membership fees) of $18.74 billion (consensus: $18.56 billion) and ex. items EPS of $0.71 (consensus: $0.72).  The company's actual EPS was $0.68, which included a $0.03 P/S charge related to a change in employee compensation whereby employees will get paid for unused vacation.  This is no surprise as Costco has one of the most generous approaches to employee wages in the retail sector.

In breaking down the ex. items EPS miss, we see the following as causes:

* Gross margin of 10.67% versus 10.79% consensus; increased gasoline sales penetration and 2.0% Reward program perhaps trumped less markdown pressure in softlines.
* Share count increased, overcoming any share repurchases made in the quarter (however given a surge in cash to $4.1 billion we wonder if the company was in the market buying back shares at a reasonable clip).
* Operating expenses increased 12.42% y/y; even stripping out the $22.0 million employee charge this percentage change is high, especially since management said expense control was a focus in FY10.
* Elevated consensus estimates.
Other Points of Interest
* Merchandise inventory increased 7.4% y/y; we are interested if the increase is more inflation/currency translation as opposed to more units per club.
* Quarter ended February 14; storm activity may have impacted results.
* February comps were solid, continuing the positive trends in recent months.

Final Note
We are inclined to maintain our Buy rating on the stock (stock will open lower), believing that Costco is at a point where it's positioned to return a strong amount of cash to shareholders either through a dividend increase or a buyback increase, or both.  Moreover, the company's business at the core appears to be a share gainer in a still up and down global retail market, with that share gain not coming at the expense of margin erosion.

Brian Sozzi
Wall Street Strategies