Costco’s Weak Earnings Will Send Shares Lower

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Costco (NASDAQ:COST) on Thursday reported its second-quarter 2014 earnings, and it wasn’t a pretty picture. While the company’s sales rose from $24.3 billion to $25.8 billion, profits fell from $547 million to $463 million due to lower margins.  What’s worse is the fact that the company’s growth is slowing considerably. Year-over-year sales growth has slowed from 14 percent (2011 versus 2010) to 11 percent (2012 versus 2011) to 6 percent (2013 versus 2012). While it seems to have stabilized at 6 percent for now, shrinking margins really highlight the longer-term trend.

The fact of the matter is that Costco is getting larger and it is becoming harder for the company to grow. The company does a really good job as a retailer in that it fulfills a particular market niche and it does so better than any other company. Namely, it provides everyday consumers with the opportunity to buy bulk goods inexpensively. But clearly it is having trouble attracting new customers. While it grew its same-store sales in the United States by 4 percent year over year, same-store sales were flat internationally. A lot of this international weakness was due to a strong dollar, and Costco’s news release emphasizes this point.  Still, the company reported a bad quarter, and the stock fell 3 percent to reflect this fact.

There is no doubt that the company is struggling to grow its top-line figures, and its bottom line is shrinking. I think this says a lot about not just Costco but the retail environment in general. We are seeing weakness out of several retailers, from Wal-Mart (NYSE:WMT) to the struggling J.C. Penney (NYSE:JCP). Consumers have less disposable income, and companies like Costco are suffering the consequences.

Despite this fact, Costco trades at a rich valuation — 25 times earnings and 4.5 times book value. This is more or less in line with the S&P 500, but when we think of a company trading at 25-times earnings, we expect to see growth on both the top and bottom lines, and we aren’t seeing this. I think other investors are seeing this too, and they are selling off the shares.

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