(The following article was initially send to Action Alerts PLUS subscribers at 9:39 a.m. ET.)
Costco (COST) reported flat April same-store sales growth -- or roughly 3% excluding the negative impact of gas deflation and currency headwinds. The results came in below consensus by roughly 1%, or 100 basis points, and we expect shares to trade lower in today's session. We believe the market is struggling to reconcile the short-term weakness (which, to a large extent, is affected by transitory headwinds) against a flurry of tangible catalysts expected to take place in the second half of the year.
In last Friday's weekly roundup, we highlighted near-term risk around Costco, saying "we would not be surprised to see COST shares struggle short term, as traffic and average ticket growth may be subdued by its transition from American Express (AXP) cards to Visa (V) cards, with the transition taking place in mid-June." Prior to the roundup, we laid out the same concerns in our shopping list bulletin, noting "we would consider buying under $145."
We continue to view $145 as an appropriate trigger level, and while softer traffic/sales have raised the near-term risk profile -- particularly around competitive challenges from Amazon (AMZN) -- we continue to view Costco's differentiated value proposition (prices are lower than Amazon's on an aggregative and product-specific basis) and loyal membership model (marked by over 90% renewal rates) as quite durable in today's omnichannel world.
Costco's April results were weighed down by a variety of factors, including:
- Gas/currency headwinds (265 basis point drag)
- The decision to stop selling tobacco products (50 basis point drag)
- Food deflation (25 to 50 basis point drag)
Management did not quantify the potential sales disruption from the Amex/Visa card transition, but we expect these impacts to prove transitory. In fact, Costco Canada -- which ousted AmEx in late 2014 and issued a new, co-branded card in early 2015 -- serves as an excellent indicator of the expected comps cadence during the domestic
card transition. Although sales growth in Canada softened in the three months heading into the January 2015 card transition, they have since recovered in spectacular fashion, having delivered core same-store sales growth of more than 9% and more than 7% in March and April, respectively, vs. around 3% and 2%, respectively, in the U.S.
We expect the new Costco Anywhere Visa Card -- which not only comes at a lower fee to Costco (and is expected to benefit earnings by $0.25 a share annually), but also offers perks that are significantly greater than legacy AmEx perks -- to incentivize spending across all Costco locations, thereby driving average ticket growth. We believe Visa's added optionality (debit and credit) and ubiquity (as three times more households have a Visa card vs. an AmEx card) have the potential to benefit both traffic and ticket growth -- beginning in July and accelerating long term. Finally, easing year-on-year comparable sales in the second half of 2016, along with the likely fee increase in 2017, represent additional catalysts.
Bottom line: We expect near-term headwinds (including the AmEx/Visa transition) to weigh on shares in the short term, but we reiterate our long-term conviction of the strength of this name, given the confluence of tangible catalysts the should help drive a virtuous cycle of accelerating sales growth, operational leverage and earnings momentum, all of which give us reason to reiterate our long-term $175 price target, reflecting 28x consensus 2017 earnings per share.