Costco (COST-NASDAQ, $144.50); Substantial Earnings Headwinds Ahead?

Costco has long reported abnormally high profits from the Canadian division. With 90 stores located in Canada, or roughly 13% of the total store count, the Canadian operations are the single largest foreign source of revenue for Costco, outside of the United States.

Since inception, Costco was built on a simple and compelling business model. Customers purchase an annual membership and in return, Costco would endeavor to sell members all of the merchandise for a markup so low, that any merchandising profits, more or less, simply cover overhead. The primary source of income for Costco would, accordingly, come from the membership fees, not merchandise margins. Unfortunately, for those members of Costco’s largest single foreign division, Canada, that compelling business model DOES NOT apply. In Canada, there is a lack of meaningful warehouse competition (Sams Club and BJS Warehouse don’t exist in Canada). Accordingly, Costco Canada members pay an annual fee for the privilege of being able to buy merchandise at markups quite comparable to traditional American retailers. Canadian EBITDA margins have averaged about 5.1% vs 3.7% in the United States. Furthermore, service at Costco stores in Canada, in my personal experience, is sorely lacking, when compared to that enjoyed by US members in America. Furthermore some US merchandise under the Kirkland brand name is sold to Costco Canada by the parent for a markup. This increases EBITDA for the parent while artificially depressing margins at the Canadian division. If the merchandise was actually passed through at cost, adjusted Canadian EBITDA margins would be higher than fiscal reports indicate. Finally, Costco Canada capex on property and equipment was less than .8% of divisional revenues vs the US divisional capex of about 1.9%. Based upon an analysis of publicly available financial reports, there appears to be a meaningful corporate difference between the Canadian division and the US parent. The Canadian division has historically been a high profit center, serves as a source of funds for the US parent and subsidizes Costco USA on Kirkland brand imported merchandise.

It is my view that the halcyon days of abnormally high profits for Costco Canada are coming to an end. Due to the size of the Canadian division, this has important implications on the consolidated fiscal reports for the parent company. A whopping 90, of the 698 total Costco locations world-wide, are located in Canada. Each Canadian Costco location is roughly 2X as profitable as a comparable US location. This implies a grossly disproportionate percentage of consolidated parent company earnings derived from the Canadian division. With a total of 15 stores (16.6% of all Canadian stores) located in the hard-hit oil patch that is Alberta, sales will likely be flatlining in Canada for a while. Put another way, based upon the proportionate margins earned in Canada, those 15 Alberta stores accounted for more than 4% of Costco’s consolidated net profits. Outside of Alberta, the heavily resource based Canadian economy faces retail headwinds. Additionally, a Canadian currency that roughly moves in the same direction as petroleum prices has created pricing headwinds on imported merchandise and produce. What WAS the most profitable foreign division of Costco now looks to be an average performer for the parent. That suggests future earnings beats, at the consolidated level, may not be so readily come by.

Personal observations leads me to conclude that management at Costco Canada is under significant pressure to cut costs further. The highly touted “treasure-hunts” of limited supply items are not as readily available as in prior years. Cashiers continually pester customers for donations to meretricious causes and occasionally become sullen when the customer response is “no, thank you”. Most importantly, price inflation, partially led by the weak domestic currency and a reliance upon US suppliers for Canadian SKUs, has become evident to all and sundry.

Of late, the penny pinching has become extreme, to the point of getting ridiculous. Formerly SIMPLE service orders at Costco Canada, such as refilling a BBQ tank with propane, are now arduous events to be endured. Previously one could get a ticket for a tank refill while shopping and refill the tank on your way out of the store. It was seamless and quickly freed up a parking stall for another customer. Now, one must drop off their tank, get it weighed, then get it filled, then get a ticket for payment and a claim check for your tank, then go inside to pay, then go back outside and finally queue up in line AGAIN, for an attendant to take your ticket when he/she is not filling other tanks. Only then can you reclaim your tank…..and IS it your tank that you are picking up? This half an hour + process is an idiotic bottleneck (40 minutes of total time spent, by my watch). The change appears driven entirely by a goal of earning a few more pennies on each tank and if customers have to wait an extra 30 minutes for a formerly 5 minute service, well, so be it. What the penny pinchers have failed to take into account is the fact that a customer who is WAITING is a customer who is not BUYING. Moreover, that customer is also tying up a badly needed parking stall and preventing someone from parking to shop at Costco Canada. For the purpose of earning a few extra cents, two potential streams of revenue are now being minimized.

As a result of a cyclical profit setback in Canada, it appears that the entire Costco Canadian division has been infiltrated by ruthless cost-cutters and bean-counters, determined to offset a well understood reality of retail (you cannot earn more money when your customer base earns less). I greatly admire efficient retailers. Efficiency means that things are done quickly and correctly. However, there is always a risk to being overly efficient; overzealous cost-cutters, on occasion, have transformed many well-run corporations into tightfisted profiteers. When does the line get crossed? Frankly, it is no longer fun to be a Canadian customer of Costco. Making customers pay for a membership and then requiring customers to queue up for interminable timeframes, on ordinary purchases, is less a membership based benefit system and more like a prison-yard outing. At Costco Canada, my shopping experience begins with a hassle for a parking spot while I wait for propane tank customers to leave. Then, I pray that a strong wind won’t occur while in the store to prevent rolling shopping carts from damaging my vehicle. When inside, I endure slow and spotty checkout service with clerks spending as much time asking for donations as they do running through my order. Finally, as one who spends considerable time abroad, I must continually try to rationalize the fact that in Canada I’m paying more for, and receiving smaller portions of, products sold by the US locations of Costco. And for this, I PAY to be a member? The cost-benefit bureaucrats at Costco Canada certainly must assume that a customer’s time is FREE; it most assuredly is not.

Peer retailers also note the change in the Canadian economy. Loblaws, the largest retailer in Canada, recently reported that price competition caught that retailer napping for the prior quarter; they indicated a competitive response would be rolled out throughout the balance of 2016. Costco Canada margins will almost certainly suffer, in the quarters to come.

Finally, anecdotal conversations lead me to conclude that the Capital One MasterCard isn’t working out for Costco Canada as forecast. I understand that a survey was recently commissioned, to ascertain why the Capital One Costco Card was not enjoying a faster take up from Costco Canada members. A survey is not needed; the explanation is self-evident. The rewards from Capital One are NOT industry leading, in comparison to the United States Visa co-brand. Also, Capital One is, well, Capital One. It was likely a mistake for Costco to co-brand a MasterCard in Canada, while the parent co-branded with Visa, in the USA. Once again, American members of Costco are offered industry leading rewards whereas Canadian customers appear to be taken for granted, with an offering of a vastly inferior product.

There are those that will take strong issue with my view. Long time shareholders treat Costco with the same rock-star appeal as they do Warren Buffett. Analysts fawn over Costco management and seldom engage with critical questions. As a result, the Canadian issues are largely glossed over. Most assume that the struggles of a Canadian division will not have any impact upon the profits of the American parent. They might be correct. However, Costco is, to the investment world, a GROWTH story; the shares sell for a growth premium. Should it become evident that Costco is not immune to cyclical downturns in their largest subsidiary, the growth premium could surely shrink. More importantly, should Costco Canada be forced to adopt more customer-centric policies, which will permanently reduce Canadian margins, then the historic abnormally high profitability in Canada will come to an end. Should the penny pinching of Costco Canada continue unabated, a larger customer backlash might ensue, which will be profit limiting. In either case, a reversion to market rates of growth for Costco could spell bad news, for those, who believe that an ordinary retailer should fetch a premium valuation, in the equity markets.

Should an earnings misstep occur, a logical misdirection, by management, will be to lay blame at the feet of Alberta forest fires. I will not be so easily fooled.

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