Returns policy affects Costco’s bottom line

ISSAQUAH, WASH. —Costco reported another quarter of strong earnings but is still feeling the pinch from its former returns policy on consumer electronics. The company also reported a strong increase in same-store sales and said it expects to add 30 new stores for its fiscal year.

Costco reported earnings of $223.9 million for its third quarter ended May 13, a 5% drop from the same period last year. But those profits would have increased 14% to $254 if not for a $30.3 million charge to its sales return reserve, the result of an internal study prompted by rampant returns on high-ticket consumer electronics.

Costco evp and cfo Richard Galanti told analysts during a May 31 conference call that an internal study made by the company showed customers typically waited longer than expected to return product, which resulted in a greater rate of depreciation.

“The lag time was longer than we expected and that lowered the realized value of the returned product,” said Galanti, adding that the problem was “exacerbated by CE returns from the prior year.”

Costco adopted a new 90-day, money-back return policy in February to stem a trend in which customers took advantage of the previous, unlimited return window to trade up to better products. Costco was hit hardest by TV returns the past few years as plasma and LCD prices fell, but was also hit in other areas.

Galanti noted that Costco saw a rash of returns on iPods last year when Apple came out with the new and improved iPod Video. “That’s an extreme example but a good one,” said Galanti. Costco expects returns to still have some impact—since the unlimited return window is still good on products purchased before February—but said it should tail off the rest of the year.

The company also lowered its number of projected store openings for its current fiscal year, which ends in August. “We’re still looking at 30 net new locations for fiscal 2007 but that’s only because a few openings slated for August have slipped into fiscal 2008,” said Galanti.

Total revenues for the third quarter totaled $14.6 billion, up 10% from the same period last year, and Costco reported a 7% increase in same-store sales. JP Morgan Securities analyst Charles Grom expressed some concern about the hit Costco took on its returns but said the 7% increase in same-store sales was a good sign that “leads us to believe trends in the second half of the quarter improved, especially during the first half of May.”