Is Costco's Dominance in Danger?

For decades, Costco Wholesale (NASDAQ:COST) has dominated the warehouse retail space. With millions of loyal members flocking to its stores and using its budding online e-commerce site, Costco has adapted to changing conditions in the retail industry while still being true to the core philosophy its customers embrace every day.

Yet some have wondered whether Costco is truly invulnerable to shifting consumer trends more broadly. Costco's fiscal fourth-quarter report showed the same level of solid, consistent growth that investors have come to rely on, but it also revealed some trouble spots that could prove problematic if they continue in the long run.

Costco puts up a solid quarter

Costco's fiscal fourth-quarter report looked a lot like what investors have seen over the past several periods. Revenue of $47.50 billion was up 7% from year-ago levels, slowing only slightly from its pace three months ago. Net income growth was considerably slower, but net income still rose 5% to $1.10 billion. After accounting for a pre-tax charge, adjusted earnings of $2.69 per share compared favorably to the consensus forecast among investors for $2.54 per share.

Is Costco's Dominance in Danger?
Image source: Costco Wholesale.

The comparable sales growth that Costco put up in the quarter closed a good fiscal year for the retailer. Fiscal fourth-quarter comps rose 5.1% across the company, with fairly uniform performance across the U.S., Canada, and other international markets when you adjust for currency and gasoline-price impacts. Costco kept making progress with its online shopping efforts, as e-commerce comps were up 21.9% on an adjusted basis. For the full fiscal year, overall comps growth of 6.1% and e-commerce comps gains of 23.3% kept Costco's forward momentum healthy.

Is there trouble ahead?

Yet there were still a few things that weren't optimal in Costco's report. First, membership fee revenue growth was slower than what the company got from retail sales, climbing just over 5%. That $1.05 billion is a vital part of what keeps Costco profitable, as the warehouse retailer typically slashes profit margin to extremely low levels in order to keep its members happy.

Also, some of Costco's costs rose more quickly than investors would've wanted. Merchandise cost increases stayed in check, climbing at a slightly slower pace than merchandise sales. However, overhead expenses were up nearly 10% year over year. It took lower income taxes and a more favorable interest profile to keep Costco's net income rising by more than the company's 1% gain in operating income.

China, e-commerce will power Costco's next phase of growth

CEO Richard Galanti went through some of his growth strategies in Costco's conference call. Costco has started to make enhancements to its app in order to support its e-commerce business, allowing members to use their smartphones and other devices as digital membership cards. The app also provides gas prices and membership reward information, along with tools to help members manage prescriptions at Costco's pharmacies. Galanti anticipates more features coming out soon.

At the same time, Costco acknowledged the success of its foray into China, and Galanti discussed future plans there. The CEO said that it expects a second store to open in early 2021, in Shanghai's Pudong neighborhood. With more than 200,000 members signed up from the first China store alone, Costco's excited about China's potential. In order to make up for sluggish growth in fee revenue, Costco has concentrated on keeping costs down, and those efforts have paid off. Cost of sales climbed 7.5% during the quarter compared to the fiscal third quarter of 2018, and overhead expenses were higher by just 6.8%. Those growth rates weren't all that far behind Costco's revenue growth, but they were enough less to widen margin figures slightly and to have a favorable impact on the bottom line.

Investors weren't entirely happy with the pace of Costco's growth to finish fiscal 2019, with the stock falling 1% to 2% in pre-market trading following the late-Thursday announcement. Cost concerns could continue to weigh on sentiment in the short run. However, Costco's success in building a world-renowned brand that resonates with shoppers in high-growth areas like China should help to give the warehouse retailer long-term strength to carry it forward for years to come.