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Five Things You Need to Know: Costco Offers Food for Thought


There is some evidence that Costco customers are beginning to push forward food purchases ahead of upcoming price increases.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. "A Liquidity Issue, Not A Credit Issue"

Despite the move today in equities, credit market issues are not going away. In fact, they may be worsening. Almost 70% of the auctions in the $330 billion Auction Rate Securities (ARS) market failed this week, according to Bloomberg.

There were 521 failed auctions in the market for the floating-rate securities yesterday, amounting to a rate of 66 percent, according to data compiled by Bloomberg. These are mostly municipal related bond issues and the failures are crimping states around the country. According to the article, the yields on the debt are average more than6.5%, compared to 3.6% in early January.

Goldman Sachs (GS) , Citigroup (C) and other brokers began allowing the auctions to fail last month, their refusal to step in to provide clearing bids effectively shutting down the market. The large banks apparently controlled the market both coming and going. During the good ol' days, back in 2006, before the widespread auction failures the SEC fined Citigroup, Goldman and 13 other banks $13 million after alleging they manipulated the market by giving some clients information about rival bids in the supposedly blind auctions.

For perspective's sake, between 1984 and 2006, only 13 auctions failed, according to Bloomberg. Meanwhile, one fixed income trader told Bloomberg that the risk is not that municipalities will default, but that the market has collapsed due to subprime mortgage market losses. "It's still a liquidity issue, not a credit issue,'' the trader said. Well, perhaps not yet.

2. Money Market Woes Redux

In another sign that ongoing credit markets issues imply cannot be wished away, money-market rates for euros and pounds climbed to the highest since mid-January, according to Bloomberg.

The three-month London interbank offered rate, or Libor, for euros advanced 1 basis point to 4.40% today, the highest since Jan. 18, the British Bankers' Association said. The rate for pounds gained half a basis point to 5.77%, the 12th straight daily increase and the highest level since Jan. 7, according to the BBA, Bloomberg reported.

In plain-speak, what this means is that the cost of funds is going up because the availability of funds is dwindling. This looks like a "liquidity crisis," but it's really a "debt crisis."

3. A Look Inside Costco

Costco Wholesale Corp. (COST) this morning said second-quarter profit rose 31% and revenue rose 12% to $16.6 billion. We listened to the call to get an idea of how the company is viewing customer behavior, especially in their foods category. In addition to selling in bulk to individuals, the company counts small restaurants and diners as a large percentage of their small business customers.

Related to weakness in the economy, the company says they have seen weakness where one would expect to see it; furniture, home furnishings, apparel, especially discretionary categories. "Even within strong categories like meat, which is 6% of sales, what we call meat is beef-poultry-pork and the like, we've seen a mix shift over the last be months from higher end beef to things like chicken," the company said on the call.

BJ's Wholesale Club (BJS), a Costco competitor in the warehouse retail space, made similar comments on their call this morning. Laura Sen, BJS COO said the company is seeing evidence of consumer tradedown in the meats segment. "We see that and depending on economic times, people will trade on their proteins say from beef to chicken or chicken to ground meat or whatever it is and that has been something we've seen in the last two months."

Of course, Costco is not immune from growing inflationary pressures. What is new is that the tipping point may finally have been reached where attempts at cost pass throughs from vendors are now showing up across a broad spectrum. Retailers have generally had the stronger hand related to pricing, Costco said. In other words, retailers have been able to force vendors to hold off on price increases due to competition among vendors for shelf space. That is changing. "We're seeing in recent months more and more vendors not talking to you, they're just announcing what the price increases are going to be because they've held onto it so long," the company said.

As well, echoing comments first heard from Del Monte Foods (DLM) last week, there is some evidence that Costco customers are beginning to push forward food purchases ahead of upcoming price increases.

4. But Wait, There's More...

While listening to the Costco (COST) call for food inflation reasons we got a little surprise about 45 minutes into the call.

The company took a $2.8 million charge due to impairment in some of their cash equivalents and investments. Of the $2 bln in cash on the balance sheet, about half was invested in enhanced money market funds.
That's in line with their (perhaps soon-to-be previous) investment policy, an amount they felt was conservative. The cash was spread between six separately managed funds, and they mentioned Bank of America (BAC) and UBS (UBS) specifically.
The company got a call in early December that redemptions were halted. Since then they've been able to redeem 800 million of the 1.15 bln and reinvested in government funds 20-40 basis points below the cash enhanced fund yield. The rest remaining in the funds have restricted redemptions and are in process of liquidation, but a process that will likely stretch into 2009.
"[A]t present the issue for us is one of liquidity and not credit quality," the company said.
On the bright side, at least they don't have any auction-rate securities.

5. Food for Thought

One more note on the Foods category. This is about the only industry with *some* pricing power, and they are passing through increased costs in agricultural commodities. The pass-through is not match-for-match and they are seeing margins come down as a result.

But part of the reason the pass through is not matching the increase is that ag commodities such as wheat and corn accelerated at an unprecedented pace in the second half. The companies simply couldn't raise prices fast enough.

Last week on their call Del Monte Foods (DLM) said they are seeing purchases by customers pushed forward due to anticipated pricing. This is something Costco is seeing anecdotally as well. This could be an important tipping point.

Meanwhile, Smuckers (SJM) and Heinz (HNZ) noted recently that they have not yet seen consumers shift from premium brands to private label, so consumers are apparently absorbing some of these cost increases without trading down, with the exception of proteins and meats as Costco and BJ's noted this morning.

But wait, there's more; more pricing to come, especially in the next eight weeks as another planned round of pricing for many of these companies takes effect.

What is interesting from our standpoint is what happens for these companies when agricultural commodities prices come down. These price increases won't be rolled back. Margins that are being compressed now may look entirely different a year from now.

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