A Showdown at the Checkout for Costco

It's under fresh assault from a revived Sam's Club, which is tapping parent Wal-Mart's buying power to slash prices. Can Costco stay ahead?

By Amy Tsao

Over the past several years, while Sam's Club seemed an orphaned division of megastore-focused parent Wal-Mart, warehouse shopping club Costco proved itself the better investment. Sam's trailed Costco in earnings and same-store sales growth. Things are changing, though. Results are improving at Sam's, and Wal-Mart (WMT ) has turned to the warehouse concept as a growth vehicle. Sam's appears intent on becoming the low-cost price leader in warehouse stores. Many investors have a healthy respect -- some call it fear -- for what a dominant industry leader such as Wal-Mart can do to the competition when it commits to becoming No. 1.

FEELING THE HEAT.

  A revived Sam's is taking a toll on Costco (COST ) and its investors. On Aug. 5 , Issaquah (Wash.)-based Costco told investors in a sales update that price competition from Sam's are hurting margins, as are rising overheads. It warned that earnings per share for the quarter ending Aug. 31 would be closer to $0.46 to $0.48, down from its original projection of $0.54 to $0.56. In the two days following the lowered guidance, investors pushed Costco stock down by 21%, to $29. The stock now trades at around $31.

Costco chief executive, James Sinegal, downplays the increased pressure from Sam's. "The term 'price war' is a little overdramatic. There's been tightening of pricing, but that moderates from time to time," Sinegal says. "I'd say it's a sharpening of prices."

Sam's turnaround is impressive and may be gaining momentum, aided by a newly installed management team. Wal-Mart cited Sam's -- and the company's discount stores in foreign markets -- as the main drivers of its 21% earnings growth for the quarter ended July 31. The Sam's division, which accounted for about 7% of Wal-Mart earnings in 2002, reported a 12.8% jump in earnings, to $309 million for the quarter. With better marketing to its small-business customers and sharp cuts on merchandise prices, Sam's said it saw increases in both store traffic and the average amount each customer was spending.

READY FOR WAR.

  For now, Costco is still stronger on the top line than its rival. Same-store sales (those at stores open at least a year) rose 8% in July, while Sam's chalked up a 5.1% increase. The figure for Sam's represents a jump from a paltry 1.9% increase in the same month a year ago. And it's not inconceivable that Sam's, with $31.7 billion in 2002 sales, could overtake Costco, which had $38.8 billion in its fiscal 2002 year.

Sam's aggressive pricing could force Costco to respond in the same manner. Profit margins are already slim for both companies. And Wal-Mart has started to buy product from suppliers for both Sam's and Wal-Mart stores, allowing Sam's to lower prices while still making a nifty profit. In the quarter ended July 31, Sam's operating margin was about 3.6%. Analysts expect Costco's operating margin to be closer to 3% for its quarter ending Aug. 31.

A price war doesn't signal disaster, but investors would have an increasingly hard time justifying a premium for Costco's shares. "Costco believes it has faced the worst of price pressure from Sam's, but we're skeptical," says Standard & Poor's analyst Jason Asaeda (Asaeda doesn't own shares in either outfit and S&P performs no banking services.) He recommends avoiding the stock because Costco has yet to provide details on how it plans to improve merchandise margins.

UNHEALTHY TREND.

  Pricing pressure is unwelcome news for Costco, since its health-care and worker-compensation costs are surging. Jeff Tryka, analyst at Delafield Hambrecht, worries that Costco's plan for 8% to 10% earnings growth in fiscal 2004 could fall short if it continues "trying to compete on price with Sam's" and rising benefit costs don't come under control. "This price war has just begun. We could see it last well into [2004]," Tryka says. He has the only sell rating on the stock among Wall Street analysts, figuring the stock is worth $24 -- 23% below the current price. (Tryka doesn't own Costco shares.)

Worker compensation costs in California have been a problem special to Costco, which has 37% of its employees in that state. The occurrence of injuries isn't especially higher there, just the cost of paying for them. To help remedy that, CEO Sinegal is actively lobbying. "We're down here meeting with people right now," the CEO says. "We're trying to come up with some sort of solution that will alleviate that." Yet California is awash in political uncertainty amidst a tempestuous gubernatorial recall effort, and even Sinegal is doubtful that legislative change will take place soon, conceding that "it won't be anything rapid."

Costco is known for putting employee and customer interests first. It picks up much of the cost for employee health plans. And to the benefit of customers, it doesn't sell goods at more than 14% above the price it paid for them. While such efforts are popular, shareholders end up paying a price, says Tryka, in the form of lower profit margins. "Management is focused on consumers and employees to the detriment of shareholders. To me, why would I want to buy a stock like that?"

COSTLY CONCERN.

  Sinegal defends Costco's practices and insists some margin improvement will occur in 2004. "When your customers and employees are happy with you, you can't be going too far wrong," he says, noting that Costco has a long track record of earnings growth. Sinegal argues that higher labor costs to pay for employees who help unload carts at busy stores will show a return in the form of improved traffic flow. As for health-care expenses, Costco says it will provide details on efforts to reduce such costs on its next earnings call in October.

Many investors aren't giving up on Costco. Eric Jemetz, senior equity analyst at New Amsterdam Partners, says: "Costco has had a long history of [good] return on invested capital." It trades at a "reasonable multiple," Jemetz adds. Costco trades at a 2004 price-to-earnings ratio of 19, vs. a historical average p-e of 25. (Costco is a holding in New Amsterdam funds. Jemetz does not own the stock.)

Still, with Wal-Mart's industry heft behind Sam's efforts to take the top spot in this industry, Costco needs to focus on improving profit margins and keeping its shareholders happy.

Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column

Edited by Beth Belton

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