Costco May Have Hit the Sweet Spot

 | Jul 13, 2013 | 1:30 PM EDT
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The retail sector got more complicated this past week.

Up until somewhat recently, when it came to the discounters, investors had considered them a "go." The U.S. economy had been in so-so condition, so a lot of consumers were looking to save a nickel anywhere they could -- and that certainly helped such companies as Family Dollar (FDO) and Dollar General (DG) and, of course, Wal-Mart (WMT).

Well, that thesis has taken a beating over the last 12 months, as all three of these names have sharply underperformed their retail peers. Shares of Dollar General have lost 0.4% in the past year, while Family Dollar and Wal-Mart have respectively gained just 1.1% and 9.9%.

Compare that with the 23.9% rise in Whole Foods Market (WFM), for example, and the 26.2% climb in Nordstrom (JWN). It turns out that, in a sluggish but very uneven recovery, well-heeled shoppers are a better bet than are the dollar-strapped.

But, judging by Family Dollar's fiscal third-quarter earnings, reported Wednesday, even that picture needs some complicating. The May-quarter numbers reflected a solid $0.03-per-share earnings beat above the Wall Street consensus of $1.02, as well as a 9% increase in revenue. Comparable-store sales climbed 2.9%.

Should this serve as confirmation of the original cash-strapped-consumer story? Well, not exactly, if you dig into what did and didn't sell. Revenue climbed for food, health and beauty aids and tobacco. Overall, consumables revenue was up 14.8% -- which made up for an 8.9% sales drop in apparel and a 0.5% slip in seasonal items and electronics.

The shift in sales mix wasn't good news for margins, which are smaller for consumables than for clothing or electronics. Gross margin came to 34.7% of net sales, down from 35.8% in the prior quarter. On Family Dollar's conference call, management told investors and analysts to expect flat margins for the fourth quarter, but you're entitled to a fair bit of skepticism on that projection.

The likelihood is that this margin pressure will persist as long as the economy is tottering along at its current pace. We're also liable to hear about such pressure from Wal-Mart and Dollar General in their reports, respectively scheduled for Aug. 15 and Sept. 5.

Still, it appears Costco (COST) -- one name that's frequently lumped in with the discounters -- could well escape this squeeze. In its fiscal third quarter (ended May) soft-line retail was the company's strongest category: A 10% rise in comparable-store sales was driven by small electronics, house wares, jewelry and apparel. June same-store sales were up 6%, well ahead of Wall Street projections for a 5.3% rise.

The standard story is that margins and sales are so strong at Costco because of the revenue stream provided by annual memberships. There's solid truth in that -- but something else may be going on here, too. Costco offers a mix of wholesale prices, as well as a selection of merchandise that aims to put those low prices on a slightly up-market mix -- for example, you might see Peter Luger creamed spinach and D'Artagnan sausage alongside the Kirkland house brand. As a result, Costco attracts bargain seekers from among the cash-strapped and the well-heeled, a customer mix that may be ideally suited to the current economy.

We'll have a better picture of that when Costco reports results for fiscal 2013, which ends in August.

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