BMO Bullish On Costco Wholesale Corp, Says Co. Less Exposed To Food Deflation

Costco Wholesale Corporation COST is less exposed to food deflation, which, according to BMO, is likely to remain a headwind for the sector in the second half of 2016 and possibly into the first half of 2017.

"Despite food deflation pressure, we believe Costco is less exposed compared with pure grocery peers given its smaller exposure (56 percent of sales) and higher exposure to international (28 percent of sales)," analyst Kelly Bania wrote in a note.

During August, food and sundries remains the weakest category, dragged down by -1 percent deflation and a 2 percent drag from weak tobacco comps, given ongoing SKU reductions. Despite ongoing meat deflation, the analyst noted that fresh comps were solid at low- to mid-single digit percent growth.

Related Link: Costco Shares Drop After Disappointing Q4 Sales

Moreover, Bania believes investors may be willing to look past food deflation challenges given Costco's upcoming catalysts such as credit card conversion to Visa Inc V and Citigroup Inc C as the bank; and the potential membership fee increase.

Bania reaffirmed its Outperform rating on Costco shares with a target price of $180, which implies a potential upside of 15 percent over the recent close.

Meanwhile, Costco reported modestly disappointing August comps. Customer traffic moderated to +2.3 percent in August versus 3 percent/3.25 percent in the prior two months. U.S. base comps (ex-gas) grew by 2 percent in August, slightly below consensus of 2.5 percent. International cannibalization weighed on total company comps by 60 bps.

Nevertheless, Bania sees the upcoming fourth quarter as "big" due to the benefit from the interchange fees, which could add $0.02 to $0.05 to fourth-quarter EPS and $0.16 to $0.32 on an annualized basis. Stronger-than-expected gas margins could also support EPS upside in the fourth quarter.

However, the analyst cut 2016 and 2017 EPS view on a weaker international comp outlook, offset by modestly less FX pressure. The analyst now expects EPS of $5.26 and $5.85 for 2016 and 2017, respectively. The prior estimate was $5.33 and $5.90, respectively.

At time of writing, shares of Costco rose 1.31 percent to $158.25.

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