Will Costco's trailing twelve-month gross margin fall below 12.5% by end of FY2026?

Q2 FY2026 data substantially resolves the prior prediction's key uncertainty: how would gross margin hold through the first major tariff quarter. The answer is: it expanded. Core-on-core margin improvement of 22bps is broad-based across nonfoods, food & sundries, and fresh — this is not a one-category fluke. The LIFO charge was only $12M, far below Q3 FY2025's $130M that the committee identified as the critical tail-risk scenario. Revenue grew 9.1% despite IEEPA disruption, demonstrating demand resilience that enables favorable pass-through dynamics. The TTM buffer above 12.5% is almost certainly wider than 35bps at this point. For the TTM to breach 12.5% by October 2026, Q3 and Q4 FY2026 would need to show catastrophic compression reversing both the Q1 and Q2 gains — no evidence in the current data supports this scenario.

The prior batch's unresolved debate was tariff pass-through capacity — Q2 FY2026 data provides partial resolution. Management's 'offensive approach' was not just rhetoric: the company was first to lower prices on egg/produce/dairy deflation, which is margin-accretive behavior. The 30 new Kirkland Signature items signal accelerating private label penetration, which structurally lifts gross margin since KS carries higher margins than national brands. The remaining downside scenarios are (1) IEEPA-replacement 150-day tariffs escalate significantly in H2 FY2026 and (2) LIFO charges spike as they did in Q3 FY2025. Both are possible but the trajectory from Q2 data argues against them being the base case. The legal settlement +5bps is nonrecurring and correctly excluded from the trend assessment. Net: probability falls from 17% to approximately 11-12%.

Quantitative update: The prior batch's Sonnet Run 3 established that ~$1B gross profit shortfall would be needed to breach 12.5% TTM. With Q2 FY2026 showing core-on-core expansion, the TTM buffer has likely widened, making that $1B threshold even harder to reach. LIFO charges in Q2 were $12M (-4bps impact), negligible compared to the FY2025 run-rate ($173M total). Even if LIFO charges return to $100M/quarter in Q3-Q4 FY2026 (a severe assumption), the annual LIFO burden would be approximately $224M ($12M Q1 + $0 Q2 credit-vs-charge + $100M + $100M), implying ~8bps annual impact on a $270B+ revenue base — still insufficient to breach 12.5% from a now-wider buffer. The Stress Scanner's 145-215bp worst-case is a 3-year cumulative figure; concentration in a single year is the true tail risk, and Q2 data argues against that concentration.

Q2 FY2026 is now the first full quarter with IEEPA/150-day tariff exposure, and gross margin expanded on a core-on-core basis. This is the critical data point. The prior prediction at 17% reflected uncertainty about whether the tariff regime would compress margins — that uncertainty has been substantially resolved in the NO direction. Revenue grew 9.1%, confirming demand strength that underpins Costco's ability to pass through costs selectively. The LIFO charge of $12M is trivially small relative to the $173M FY2025 burden and the ~$35B gross profit base. Good inventory position means the company isn't sitting on elevated-cost inventory that would drag future LIFO charges. The TTM metric (4-quarter average) now has two quarters of clean data (Q1 LIFO credit + Q2 minimal charge) and two remaining quarters in FY2026 to show further expansion. Breach below 12.5% requires a scenario with no current supporting evidence.

The 5bps legal settlement benefit is nonrecurring and should be excluded from the trend assessment — doing so, core-on-core expansion is approximately 17bps net of the settlement. Still positive. The LIFO 8bp swing (-4bps charge vs +4bps credit prior year) is also minor. The remaining risk is the new 150-day global tariff regime replacing IEEPA — this is an ongoing external variable. However, management's response (first to lower prices on deflated categories) suggests they are operating from a position of margin confidence, not compression stress. The egg/produce/dairy deflation that creates pricing opportunities also helps on the input cost side for food categories. Supply chain stability and good inventory position mean the company enters Q3 FY2026 without the inventory overhang that could force margin-negative markdowns. Net probability: approximately 10-11%.

The upgrade trigger from the prediction context was: 'Gross margin expands above 13.0%; LIFO charges remain minimal; tariff mitigation demonstrably effective in Q2+ FY2026.' Two of three upgrade criteria are met: LIFO charges are minimal ($12M) and tariff mitigation is demonstrably effective (core-on-core +22bps, revenue +9.1% through disruption). The 13.0% TTM expansion threshold is not yet confirmed but is no longer implausible. The downgrade triggers — gross margin below 12.5%, LIFO charges exceeding $100M/quarter — show no evidence of materializing. The monitoring trigger being tested by this market is in the process of NOT triggering. At 17% previously, the committee assigned 83% confidence to NO; the Q2 data should shift that to approximately 90%, implying YES probability of ~10%.

Q2 FY2026 core-on-core margin expansion of 22bps is directly the opposite of what would need to happen for this market to resolve YES. LIFO charges at $12M are minimal. Revenue +9.1% through tariff disruption. TTM buffer above 12.5% likely widened. Breach below 12.5% by October 2026 is a low-probability tail event.

The Q2 FY2026 data substantially lowers the probability. Core margins expanded broad-based. KS penetration growing (30 new items). Supply chain stable. Tariff disruption navigated with revenue growth. LIFO charge trivial. No scenario visible in the data that would compress TTM below 12.5% in the remaining 7 months. Even a $100M+ LIFO charge in Q3 or Q4 would be insufficient given the expanded buffer and positive trajectory established in Q1 and Q2.

Slightly higher than the prior two haiku runs to account for the ongoing tariff regime uncertainty. The 150-day global tariff window replacing IEEPA could escalate — tariff policy has been unpredictable. If the 150-day period results in punitive tariffs exceeding 20-25% on key import categories, Costco's mitigation strategies may face stress they haven't yet encountered. However, the Q2 data shows those strategies are working at current tariff levels. The base case remains solidly NO, but the tail risk of policy escalation in the remaining months warrants a slightly higher probability than models with high confidence would assign. Net: 11%, primarily reflecting residual tariff policy uncertainty.