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Investors bulked up on

Costco Wholesale

Costco, based in the Seattle area, reported earnings of 83 cents a share for its fiscal fourth quarter ended Sept. 2, up 4.7% from a year ago, when it earned 75 cents. Excluding a charge for an accounting change to its membership fees, the company would have earned 91 cents a share, ahead of the average Wall Street estimate of 83 cents.

Quarterly same-store sales rose 5%, up from analysts' average estimate of 4.7%, despite weak results for August. Same store sales rose 7% in May, 6% in June, 7% in July and only 2% in August.

However, same-store sales rose 6% in September, better than analysts' expectations. Costco said the growing strength of the Canadian dollar drove cross-border sales and increased buying in Canada.

Revenue increased 3% in the quarter, reaching $20.48 billion, up from $19.88 billion a year ago, but short of the Street's estimate of $20.73 billion.

"It represented a nice comeback," Costco Chief Executive Richard Galanti said on a Wednesday morning conference call.

Improved margins and a 2.3% increase in membership fees gave earnings a boost for the quarter and fiscal 2007, when the $2.37 a share in profits marked a 3% increase from last year. Fiscal 2006 also included 53 weeks' worth of results, including an extra week in the fourth quarter.

"So while last year's fourth quarter had a higher reported book membership amount on all but sales, this year was back to normal," Galanti said. "So we're comparing normal to something that was unusually high."

The Analysis

Costco had already released its sales figures, so the enthusiastic reaction to its earnings is mostly a margin story.

Gross margin in the quarter rose by 38 basis points, to 10.74% from 10.36% a year ago, providing much of the earnings lift.

"That really drove the surprise," says Dan Geiman, an analyst at McAdams Wright Regan, a Seattle brokerage. "It seems there were some margin improvements, particularly in terms of gross margins, and management has been pursuing a number of initiatives to get those. They've been a little bit coy in terms of communicating them."

In a preview note published Monday, Wachovia Capital Markets analyst Peter Benedict wrote that changes to Costco's consumer electronics return policy, improved distribution and the absence of a meaningful stock-options hit would all be factors in the margin story, though he estimated it would only improve by 12 basis points.

CO Galanti said the margin improvement would likely carry over, but cautioned that guidance for fiscal 2008 was still somewhat flexible.

"At this point I'd probably give a range from the high $2.80s to $3 [a share] and hopefully we can do a little better than that. But it's early in the game," he said. "You don't know what's going to happen with the economy. We've got to improve our expenses a little. We think the margins will be fine."

Analysts polled by Thomson Financial, on average, expect earnings of $2.91 a share for fiscal 2008.

The Bottom Line

Costco pulled off better-than-expected results against a backdrop of looming economic worries. If the National Retail Federation, which last month warned that the holiday shopping season would hit a five-year low, is correct, Costco's product mix and customer base will be a big help.

"They sell a pretty high, pretty large amount of staple-type items that you need day in and day out," says Geiman. "Also, they're obviously a discount retailer and selling to reasonably affluent customers, and that's certainly a good chunk of why they would perform a little bit better than other retailers."

Many major retailers report earnings on Thursday.

The membership fee revenue increase indicates growing interest in Costco's model, which mixes flat-screen television sets in with the 24-packs of microwave burritos.

The renewal rates of 91.5% for businesses and about 85% for individual consumers indicate the kind of satisfaction that makes these shares a better bet for the shopping cart than many retail rivals.