The Middle Class is also "Weakening," and is Costco facing headwinds?

Global Discount Retail King—$Costco Wholesale(COST.US) released its Q4 FY2025 financial report for the period ending in late August after the U.S. stock market closed on September 26. Overall, Costco's growth remains relatively stable, with both revenue and operating profit maintaining an 8%~9% growth rate, but some potential issues have been exposed. Specifically:

1. Nominal same-store growth appears stable, but customer traffic has significantly weakened: The most critical operating indicator, Costco's overall same-store sales growth rate for this quarter was 5.7%, unchanged from the previous quarter, still appearing stable. However, the growth in same-store customer traffic has significantly declined to just 3.7%, the lowest level in nearly three years.

This quarter's nominal same-store growth remains stable, mainly due to price factors. It has entered a structure of weak volume and increased prices, which is not a very healthy growth structure. Excluding oil and currency effects, the actual same-store sales growth rate has significantly slowed from 9.1% to 6.4% over the past three quarters.

2. Excluding oil and currency, the increase in average transaction value has not expanded: In terms of price factors, the nominal average transaction value growth appears to have risen significantly this quarter, with a year-on-year increase of 1.9% vs. 0.4% in the previous quarter. However, this is mainly due to the impact of oil prices and exchange rates, and after exclusion, the actual increase in average transaction value over the past three quarters has narrowed, with the peak of price impact having passed in FY1Q. However, while the trend is indeed narrowing, the absolute increase in average transaction value of 2.6%~3.2% over the past three quarters is still relatively high in recent years, reflecting the impact of inflation.

3. Online traffic grows against the trend: Compared to the weak customer traffic in offline stores, Costco's e-commerce sales grew by 13.6% year-on-year this quarter, showing a more stable performance. The reason is that this quarter, Costco's online site traffic increased by 27% year-on-year, accelerating significantly compared to 20% in the previous quarter. While offline store traffic growth weakens, online traffic has increased significantly, suggesting that consumers indeed have a tendency to shift towards more "affordable and low-priced" shopping channels.

4. Stores maintain a high expansion rate: The company net added 9 stores this quarter, bringing the total to 914, with the pace of store openings still relatively fast, slightly accelerating from 8 in the previous quarter. This partially offsets the impact of not very strong same-store growth, so this quarter, Costco's merchandise sales revenue still grew by 8% year-on-year, unchanged from the previous quarter.

5. Membership fee revenue accelerates but renewal rates decline: Membership fee revenue this quarter was approximately $1.7 billion, a significant year-on-year increase of 14%, clearly accelerating and exceeding expectations.

Among them, this quarter, paid members increased by 1.4 million quarter-on-quarter, a year-on-year growth of 6.3%, with a relatively stable growth momentum. Meanwhile, the average single-member payment price was $85 (annualized), a significant year-on-year increase of 7.3%, which is the core reason for the stronger-than-expected growth in membership fee revenue this quarter.

However, relatively, Costco's membership renewal rate has continued to decline for three consecutive quarters, with the global overall renewal rate falling below 90% for the first time since 1Q22. The company previously explained that the online memberships and discount memberships launched in early 2023 are now entering the renewal period, and the renewal willingness of these users is not high.

6. Inflation leads to increases in both gross and expense margins: Due to the decline in oil and gas prices and the rise in labor costs under inflation, Costco has entered a situation where both gross and expense margins are rising. First, the merchandise sales gross margin was 11.13%, a year-on-year increase of 13bps.

According to the company, the majority of the gross margin increase (10bps) came from the decline in oil and gas prices. In addition, the increase in the core retail business gross margin was offset by the decline in ancillary business gross margin and the rise in costs under the LIFO rule, contributing the remaining 3bps to the retail gross margin increase.

7. Expense margin expands faster and more persistently? Similarly, this quarter, the company's sales & management expenses as a percentage of revenue were 9.21%, a year-on-year increase of 17bps, higher than the gross margin expansion. According to the company's disclosure, excluding the impact of oil and gas prices, store expansion, rising labor costs, and increased operating hours contributed 9bps to the expense margin expansion. It seems that the expansion of the expense margin has more operational and persistent factors.

8. Expense expansion drags down profit growth: Due to the year-on-year expansion of the expense margin being higher than the gross margin expansion, the retail business's profit margin narrowed (due to the growth in membership fee revenue, the company's overall operating profit margin still increased). Therefore, this quarter, the company's operating profit was $3.34 billion, slightly below the expected $3.38 billion. The year-on-year growth rate also fell to a single-digit 9.8%, continuing to align with the revenue growth rate. The profit performance is undoubtedly not good.

In terms of net profit, due to the tax rate this quarter falling from 26.2% in the previous quarter to 25.6%, the net profit was $2.61 billion, with a year-on-year growth rate of 10.9%, slightly exceeding market expectations.

Dolphin Research View:

As per usual, one of Costco's greatest features is its stability and ability to grow through economic cycles. This financial report also shows that both revenue and profit maintain high single-digit percentage growth, with deviations from market expectations within a positive or negative 2%. It can be said that there are no truly bad signals.

However, from the marginal small changes or signals, the trends revealed in the past two quarters are indeed not so good. On one hand, although the conventional same-store sales growth rate remains stable, the underlying customer traffic growth rate has slowed for two consecutive quarters, especially evident this quarter. In commerce, volume growth is always more sustainable and healthier than price growth.

From this perspective, although Costco's average transaction value (excluding currency and oil) has not shown a significant upward trend in recent quarters, it still seems to reflect a consumer tendency to shift towards cheaper consumption driven by rising prices. This is also reflected in Costco's stronger online growth and weaker renewal rates.

Of course, considering that the company is currently in a relatively high store expansion period, it cannot be ruled out that the recent increase in new stores has dragged down the performance of single stores, which can be addressed by management's explanation. But logically, it should not be just the impact of new stores.

At the same time, from the perspective of costs and expenses, although Costco indeed has the ability to pass on the rising costs of goods to the supply chain or consumers on the sales side, its gross margin continues to rise. However, on the expense side, the rise in labor costs and the operating ramp-up period required for more new stores are expenses that the company needs to bear itself. This has affected the company's previous long-term excellent performance of profit outpacing revenue.

Overall, if U.S. inflation continues to be stubborn in the future, the negative impact on consumption and the rise in labor costs are likely to continue. Although this will not affect Costco's long-term certainty, in the medium to short term, Costco may face headwinds. Meanwhile, although the market seems to have accepted Costco's valuation of about 50x~60x PE, which is significantly higher than the average, and does not deny its rationality, it is still a relatively high valuation from an absolute perspective, and the potential risk of valuation correction should be cautiously considered.

Detailed Comments Below:

I. Customer Traffic Growth Significantly Slows, but Revenue Growth Remains Good with Oil Price, Currency, and Store Opening Benefits

1. Customer Traffic Growth Significantly Declines, Seemingly Stable Same-Store Growth Now Relies on Price Increases

The core operating indicator, Costco's overall same-store sales growth rate for this quarter was 5.7%, unchanged from the previous quarter, still appearing stable overall. However, in terms of price and volume drivers, same-store customer traffic growth this quarter significantly declined to just 3.7%, the lowest level in nearly three years.

Furthermore, excluding the impact of oil prices and exchange rates, the actual same-store sales growth rate has been continuously declining along with the slowdown in customer traffic growth. Meanwhile, the stability of the nominal same-store sales growth rate is more attributed to the combined impact of the decline in oil prices and favorable exchange rates.

In terms of price factors, the nominal average transaction value growth appears to have risen significantly this quarter, but after excluding oil and currency factors, the actual increase in average transaction value over the past few quarters has narrowed (although the absolute value of the growth rate is still relatively high).

2. By Market, Both U.S. and International Markets Show Significant Slowdown in Same-Store Customer Traffic Growth

By region, excluding the impact of exchange rates and oil prices, the same-store sales growth rate in international markets outside the U.S. and Canada also shows a significant downward trend, with growth rates narrowing by 1.9pct and 1.3pct respectively quarter-on-quarter. This is also due to the narrowing of same-store customer traffic growth in these two regions.

Similarly, the Canadian region, due to its already good customer traffic growth, did not see a significant decline in same-store sales growth.

In summary, the nominal sales growth rate reflected in the financial report remains stable due to the favorable impact of oil prices and exchange rates, but the more realistic customer traffic and adjusted single-store growth rates have narrowed for two consecutive quarters.

3. Online Traffic Grows Against the Trend

As a new growth driver in the post-pandemic era, Costco's e-commerce sales grew by 13.6% year-on-year this quarter, compared to store sales growth, showing a more stable performance. The reason is that this quarter, Costco's online site traffic increased by 27% year-on-year, accelerating significantly compared to 20% in the previous quarter.

In combination, while offline store traffic growth weakens, online traffic has increased significantly (but the online sales conversion rate is also declining), suggesting that consumers indeed have a tendency to shift towards more "affordable and low-priced" shopping channels.

4. Overall, as mentioned above, although the more "realistic" same-store sales are weakening, the nominal same-store growth remains stable. Additionally, 9 new stores were added this quarter, with the pace of store openings still relatively fast, contributing to revenue growth, so Costco's overall merchandise sales revenue still grew by 8% year-on-year, unchanged from the previous quarter.

II. Membership Fee Revenue Accelerates but Renewal Rates Decline

Although the absolute volume is not high, the membership fee revenue this quarter was approximately $1.7 billion, a significant year-on-year increase of 14%, clearly accelerating and exceeding expectations.

In terms of price and volume drivers, this quarter, paid members increased by 1.4 million quarter-on-quarter, a year-on-year growth of 6.3%, with a relatively stable growth momentum. In contrast, the average single-member payment price was $85 (annualized), a significant year-on-year increase of 7.3%, with price factors being the core reason for the stronger-than-expected growth in membership fee revenue this quarter.

Dolphin Research believes that, on one hand, the membership price increase implemented by the company in September last year, and the continuous increase in the proportion of high-level Executive members, are the reasons behind the rise in membership fees. Among the 1.4 million new members this quarter, 1.1 million were Executive level users.

However, relatively, the company's membership renewal rate has continued to decline for three consecutive quarters, both in the North American market and globally. Although the company explained that this is due to the online memberships and discount memberships launched in early 2023 entering the renewal period, and the renewal willingness of these users is not high.

But Dolphin Research speculates that the increase in membership fees, stricter checks on membership status, and the slowdown in customer traffic growth under inflationary pressure may also be factors contributing to the decline in renewal rates.

III. Inflation Leads to Increases in Both Gross and Expense Margins, but the Latter Has a Greater Impact, Dragging Down Profit Growth

1. In terms of financial indicators, this quarter, Costco achieved total revenue of $86.2 billion, a year-on-year increase of 8.1%, showing stable performance and meeting expectations.

2. In terms of gross profit and expense spending, which are more likely to create expectation differences, due to the recent decline in oil and gas prices and the rise in labor costs, Costco has entered a situation where both gross and expense margins are rising.

Specifically, this quarter's merchandise sales gross margin was 11.13%, a year-on-year increase of 13bps, resulting in merchandise gross profit of $9.4 billion, a year-on-year increase of 9.3%, outperforming revenue growth and slightly better than market expectations.

According to the company's explanation, the majority of the 13bps year-on-year increase in gross margin this quarter (10bps) came from the decline in oil and gas prices. In addition, the increase in the core business gross margin was largely offset by the decline in ancillary business gross margin and the rise in costs under the LIFO rule, contributing the remaining 3bps to the retail gross margin increase.

3. Similarly, this quarter, the company's sales & management expenses as a percentage of revenue were 9.21%, a year-on-year increase of 17bps, higher than the gross margin expansion. According to the company's disclosure, excluding the impact of oil and gas prices, store expansion, rising labor costs, and increased operating hours contributed 9bps to the expense margin expansion.

4. Therefore, overall, due to the year-on-year expansion of the expense margin being higher than the gross margin expansion, and the more long-term factors in expenses excluding oil and gas prices, this has led to short-term profit margins being dragged down (due to the growth in membership fee revenue, the company's overall operating profit margin still increased), and also causing market concerns about the company's mid-term profit margin outlook.

Specifically, this quarter, the company's operating profit was $3.34 billion, slightly below the expected $3.38 billion. Additionally, the year-on-year growth rate of operating profit fell to a single-digit 9.8%, no longer significantly outpacing revenue growth.