10/4/2011
By Brian Sozzi, Research Analyst

Costco (COST) will report its 4Q11 earnings tomorrow.  Rather than provide your typical dry sell-side research earnings preview, let's wave our hands over a crystal ball and take a crack at predicting the report ahead of time.

What we Know Checklist:

4Q11

* Currency continued to be a tailwind to total sales.
* Existing members and newbies flocked to Costco to cut budget corners and undertake a mental escape from the August debt ceiling/stock market turmoil (average annual income for Costco member is $77,000 and as a result, has greater exposure to equities).
* Membership renewal rates and fee income strong.
* Gross margin benefit from decline in gasoline prices, with correlating unfavorability to operating expenses.
* Costco has found additional areas to trim operating expenses in the last three quarters.
* Inventories will not be an issue, opposite the case at many other retailers entering the holidays.

Overall

* A massive new share repurchase program was announced earlier in the year (surprise factor removed).
* The balance sheet is such that another strong dividend increase is likely in the cards (surprise factor removed).
* Upcoming new CEO will not try and reinvent the wheel (don't expect structural changes, such as a review of line item expenses, that immediately bolsters net income).
* Strong advance in the U.S. dollar from late August will cool international comparable club sales growth against weak dollar driven year earlier comparisons.
* On a P/E multiple basis, the stock is valued at a stark premium to a sector that is increasingly being pulled down by market volatility and at 21.7x forward earnings, trades in line with the nine-year mean multiple for Costco (strong earnings beat already factored in).
* The Street is dominated by uber Costco bulls, with EPS estimates on 4Q11 recently raised by a few firms.
* Costco shares were a significant outperformer to the S&P 500, Dow, and peer comparables in the third calendar quarter (+1.2% Costco; S&P 500 -15.5%; Dow -13.3%)

In case the tone was too subtle, we have been on the sidelines with respect to Costco in the lead up to its earnings announcement.  The risk reward remains unfavorable despite the stock's pullback from the 52-week high, seeing as: (1) expectations are elevated; (2) deployment of capital on further share repurchases may disappoint a shareholder base that has been demanding more action; and (3) the much talked about membership fee income increase may be an event for the middle of 2012 instead of tomorrow.

Brian Sozzi
Wall Street Strategies

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