Costco Earnings Point to Growth Struggles Ahead

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Costco (NASDAQ: COST) recently closed the books on a mixed 2017 fiscal year. On the plus side, the warehouse retailer extended its streak of above-average sales growth even as membership fees powered a solid boost in profits.

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Yet Costco's results also included several weak spots that suggest the company might be entering a period of sub-par growth. Let's take a closer look at the operating trends that stood out over the past quarter and fiscal year.

Sales growth

Costco's sales growth pace is strong and improving. Its 5.7% increase in comparable-store sales this quarter marked a slight acceleration over the prior-quarter's result and likely kept the company ahead of its major retailing peers. Both Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) last reported a 2% comps gain, and Kroger (NYSE: KR) struggled to stay in just slightly positive territory.

Costco's growth was powered by healthy customer traffic trends, too, with transaction frequency rising by over 4% during the quarter. That's about double the most recent result for Wal-Mart and Target.

Zoom out, though, and it's also clear that Costco isn't growing as quickly as it used to. Comps for the full fiscal year were just below 4% to mark no improvement over the prior year's relatively weak result.

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Profit gains

Net income marched higher by 14% over the last 12 months to $2.7 billion. The warehouse retailer stands out against competitors on this trend, too. Wal-Mart, Target, and Kroger have all seen their profits slip as they invest more heavily in their businesses, including by cutting prices. Kroger is projecting lower earnings this year as it aims to match rivals in their promotions.

Costco already prices its products at close to break-even, so there isn't as much danger in its gross profitability declining while it fights for market share. Its growing membership base, meanwhile, provides a steadily rising stream of income that accounts for most of the warehouse club's profits.

A small part of this year's fee bounce was related to the membership rate hike Costco recently announced. However, most of the benefit from that increase will start in fiscal 2018 as more of its subscriber base renews at the higher annual rate.

Membership trends

Costco gained 1.4 million cardholders last quarter thanks to help from an additional 26 warehouses in the store base this year. The company also benefited from healthy demand for its executive level membership. That segment ticked up to about 38% of the membership base and is responsible for two-thirds of sales. 

Overall renewal rates declined, though, dipping to 90% in the core U.S. segment from 90.1% in the prior quarter. Costco executives said in a conference call with investors that they're not worried about the slip because they believe it's a residual effect of last year's co-branded credit card switchover. Membership rates might continue trending lower over the next quarter or two, they warned, before beginning to rebound back toward the 91% that the company managed in the two years prior to fiscal 2016.

Looking ahead

As for the e-commerce threat that's disrupting the retailing industry, management says they don't see it hurting customer traffic or membership trends right now. To back up that claim, they can point to the company's speeding comps gains that continued into the new start of the new fiscal year.

Still, Costco appears to be taking the digital threat more seriously. It is expanding its e-commerce fulfillment network and recently launched a few new online delivery offerings, including one that promises to bring non-perishable grocery shipments to members' homes within 2 days of ordering. That's a significant step for a retailer that considers its physical warehouses, not its online sales channel, to be its main competitive advantage.

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Demitrios Kalogeropoulos owns shares of Costco Wholesale. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.