Inflation is a problem for everyone
Retailers can’t always raise prices faster than costs when inflation is at a 40-year high. After Amazon’s (AMZN) disappointing first quarter results, Walmart (WMT) and Target (TGT) recently announced disappointing results with an uninspiring outlook that spooked investors who originally viewed these defensive names as ideal places to hide in today’s market. Clearly, no one is immune to the impact of inflation, as consumers are forced to pay more for food and watch their wallets shrink at the pumps.
Grocery prices jumped 9.4% in April 2022, the biggest increase in 41 years, for reasons ranging from poor crop yields due to bad weather to the Russian-Ukrainian crisis which drove up wheat prices. India has just banned food exports and a growth list of countries do the same thing. On 05/18, the price of regular gasoline in LA reached $6.08/gallon. According to AAA, the national average cost of regular gasoline is now $4.56/gallon compared to $3.04 a year ago. Combine these factors with last year’s government stimulus checks, retailers are facing a tough 2022 characterized by higher input costs, supply chain challenges, markdowns and lower margins.
Costco is no exception
Cosco (NASDAQ: COST) is a top name in the retail space. The members-only warehouse operator has 829 locations worldwide that provide shoppers with an incredible treasure hunting experience. Since the start of the pandemic, incomes and BPA have increased dramatically, with consumers shopping at warehouses around the world for food and toilet paper (see below).
In March and April 2022, the company’s total comparable sales remained healthy at 17.2% and 12.6%, respectively. Total earnings (excluding gas/FX) came in at 12.2% and 8.7%, while e-commerce growth naturally slowed from 8.9% to 5.7%. These are strong numbers compared to peers such as Walmart which saw US comps increase 3% and e-commerce sales increase 1% in the April quarter.
Despite strong results so far in 2022, Costco is not immune to inflation. While current quarter revenue will likely beat consensus as consumers take on higher food prices, margins may be at risk as Costco will likely have to absorb higher supply chain costs, like all retailers.
For perspective, here are the takeaways from Walmart, Target and Amazon’s first quarter earnings in the context of inflation:
|1Q22 results||Outlook 2022|
Discretionary consumer spending slows
Another investor takeaway from Walmart and Target earnings is that consumer spending on discretionary items is coming into question as food and gas prices rise. Walmart derives approximately 32% of its revenue from general merchandise (eg, electronics, durable goods, apparel). On the 1Q22 call, management cited lower sales in this category versus grocery as one of the reasons gross margin was hit (earnings analysis here).
On the other hand, Target has also witnessed a noticeable slowdown in big-ticket items such as TVs and kitchen appliances, which has forced the retailer to implement higher markdowns to eliminate inventory and make sales. place for food and basic necessities. With apparel, durable goods and home furnishings accounting for >50% of revenue, Target’s first quarter gross margin was 435 basis points lower than 2021 (analysis here).
While the slowdown in discretionary spending (due to inflation and last year’s government stimulus measures) can be viewed as an industry-wide trend rather than an industry-specific issue company, Costco management will likely make similar observations when the company releases its May quarter results on 5/26 postmarket. Similar to Walmart, Costco’s non-food segment (appliances, electronics, clothing, toys, etc.) accounts for about 30% of total revenue.
Additionally, since gasoline prices have risen significantly, Costco’s gross margin will likely come under pressure as gasoline sales are of a lower margin.
According to Street estimates, Costco’s EPS is expected to be $13.1 in FY22 and $14.3 in FY23 (ending August). In the past 3 months, there have only been 2 downgrades versus 13 upsides. Given the negative reading from industry peers, Costco’s EPS estimates will likely see further downward revisions following its May quarter results. In my opinion, it is too early to say that this impact has been fully integrated.
Despite falling more than 30% from its all-time high, Costco stock is still trading at a rather demanding multiple under the current interest rate regime. While relatively more justified given Costco’s differentiated model and stronger revenue and bottom line growth relative to its peers, investors should carefully weigh the prospects of paying 29 times earnings at term, even for a blue-chip company when valuations and consumer spending today are challenged by inflation at a 40-year high.