Costco Gets Bitten by Inflation

Higher commodity prices finally caught up with Costco (COST), as the Issaquah (Wash.)-based retailer announced that fourth-quarter earnings (for the period ending Aug. 31) would come in well below analyst expectations. But what sent the stock reeling—finishing down nearly 12% to 63.43 on July 23—was Costco's underlying message. With its costs rising, Costco could choose to please either investors by maintaining profit margins or its customers by keeping prices low. It chose its customers.

Most analysts agree that the giant retailer has a culture of putting its customers well above investors. That's how it has managed to continue opening new stores, growing membership, and driving sales. As the cost of goods rose over the last year, Costco has passed on only a small portion to customers and will continue to do so as long as possible.

Analysts expected Costco to earn $1 per share in the current quarter. While Costco refused to provide an earnings number, Chief Financial Officer Richard Galanti said on a conference call that it would be at least 5 below expectations.

"Some [of the shortfall] relates to us consciously holding some key price points on selected items to…help our customers," Galanti said. "We must and will maintain their confidence of what we stand for."

Shouldering the Burden of Rising Costs

So far, it seems to be working. Sales are up, as are renewal rates. But Costco left no doubt that rising commodity prices have finally infiltrated consumer goods. While Galanti refused to give numbers, he said that gas sales, which helped drive earnings during the fourth quarter of 2007, have become much less profitable. The cost of freight has gone up as well.

And while Costco's vendors had been raising prices by 2% to 4% during the earlier part of the year, they're now going up at a 5%-to-10% clip. Costco has tried to avoid sticker shock, but something will have to give. "Right now, they're eating the difference," says Edward Jones retail analyst Stephanie Hoff. "Ultimately, they'll have to pass that on to the customers."

The question is when. The big price clubs like Costco, Sam's Club (WMT), and BJ's Wholesale (BJ) watch each other closely to see what the others are charging, even sending shoppers into competitors' stores. They're playing a high-stakes game of chicken, and Galanti said he wants to be the last one to raise prices, on the belief that it will help Costco gain market share.

Sell the Stock? Not So Fast

But that also means it will take longer to pass costs through to customers. "The risk of not raising prices is your profits get squeezed and you have to make up for it with greater sales," said UBS (UBS) analyst Neil Currie.

Does that mean Costco's stock is a screaming sell? Not necessarily. In good times, Costco benefits because people are happy and want to spend. But during tough times, the same shoppers turn to Costco to save money. And if inflation is here to stay, it won't just be the usual bargain hunters heading for the stores. Middle- and upper-middle-class shoppers will be looking for value as well, says Piper Jaffray (PJC) analyst Mitchell Kaiser.

However, the stock isn't a buy, either. Before the July 23 earnings warning, Costco shares had been up 3.2% for the year. While other retailers had been trading at the low end of their multiples, Costco was trading at 23 times 2008 estimated earnings, and even after the July 23 haircut its price-earnings ratio is still above 20. "That's a pretty frothy multiple in this environment," Kaiser said.

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