Costco Wholesale Corporation Stock Report

Costco Wholesale Corporation

The Chart shows that annual revenues and earnings per share for Costco have increased at a strong and very steady rate (with the exception of fiscal 2009 due to the recession at that time). The fact that the earnings line is so far below the revenue line is due to the thin net profit margins that are typical of retail (only 2.0% in the case of Costco, though that is by design as they focus on being a low price leader and it includes gasoline sales). Book value per share (the green line) has been stagnant and sometimes declining but this is not a cause for concern as it was due mostly to special dividends paid out, and also share buy-backs and the higher U.S. dollar which lowers the value of foreign stores. Per share figures were flatter in fiscal 2016 due to currency and gasoline price fluctuations.

Costco (COST, New York)
RESEARCH SUMMARY
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Aug ’17 Y.E. + Q1 ’18
Last updated: 20-Dec-17
Share Price At Date of Last Update:  $                            187.51
Currency: $ U.S.
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): (lower) Sell rated at $187.51
SUMMARY AND RATING:  As the graph illustrates, over the past eight years Costco has recorded good (specifically 5.3% average over the past five years)  growth in revenues per share and it would have been higher if gasoline prices had not declined and the U.S. dollar risen.  Earnings per share growth averaged 8.4% annually the past five years. Very importantly, Costco seems very predictable. It seems almost certain that it can keep growing earnings per share relatively steadily in the next ten and even 20 years. Costco does well on Buffett’s tenets (except, importantly Costco is not apparently selling at a bargain price) and has Buffett’s protégé Charlie Munger on the Board. The value ratios indicate that it is a strong company but is probably at least fully valued and could be rated Sell.  The very recent earnings trend is strong. Costco has very strong competitive advantages in its low-cost structure, recognized brand, and disciplined management systems.  We don’t think Amazon even after purchasing Whole Foods will be much of a threat to Costco given Costco’s low costs. Still, having a competitor that does not seem to care about profits is never a good thing. The insider trading signal is moderately negative.  The outlook appears to be for growth in the 8% to 10% range given same store revenue growth of about 4% to 6% and a 4% increase in the store count annually. And probably some additional earnings growth due to scale and additional debt leverage.  They could likely increase profits at will by raising the mark-ups but they favor a strategy of lower profits to boost the brand identity as a place for bargains. They could also easily increase the dividend. Overall we rate it a (lower) Sell at this time.  Canadian investors obviously face currency risk if the Canadian dollar rises after investing in this U.S. company. In summary, this is a business with exceptionally good economics and very strong and predicable prospects but which may be somewhat over-priced at this time. Given the possible jump in earnings due to lower income taxes and given the possibility of additional special dividends, it may reasonable to continue to hold these shares but we would be reluctant to Buy.
DESCRIPTION OF BUSINESS: (December 2017)  Costco operates large members-only warehouses based on the concept that offering members very low prices on a limited selection basis of nationally branded and selected private label brands in a wide range of merchandise categories will produce high sales volumes and rapid inventory turnover.  It describes its business model as “continually providing goods and services at the lowest prices”. It can be categorized as a retailer although some of its sales are truly wholesale as small retailers use it as their wholesale supplier. It is one of the largest “retailers” in the U.S. and the seventh largest is the world. The average Costco size is 144,000 square feet (about 380 feet by 380 feet). It has746 warehouses (stores) throughout the USA (518,  69%), Canada (98,  13%), Mexico (37, 5%), the United Kingdom (28,  4%), South Korea (13,  1.7%), Taiwan (13, which are only 55% owned, 1.7%), Japan (26, 3.5%), and  Australia (9, 1.2%), Spain 2 stores and Iceland and France with 1 store each.. It is interesting to note that there is only four stores in Europe outside of the U.K. and none in China or South America; they appear to concentrate in a limited number of countries. It also has 23 distribution depots that receive some shipments from manufacturers and then redistribute these usually within 24 hours to individuals Costco locations. Net income is only about 2.0% of the revenue amount. (Therefore the slightest change in margins has a large impact on earnings.) There are about 231,000 employees of which 42% are part-time and 7% are unionized. Costco owns virtually all of its own buildings and the great majority of the land as well. There are 49.4 million members most of whom pay $55 per year. (And an additional 41 million secondary member cards).  An average store does $163 million in revenue per year. With an enterprise value of $89.4 billion (at the recent share price of $187.51)  and with a recent 746 stores that is a value of $120 million per store. Their private label Kirkland products account for 28% of global sales.
ECONOMICS OF THE BUSINESS: Costco has very good and very stable economics. It is one of the largest retailers in the U.S. and the seventh largest in the world. It has significantly lower costs than key competitors including Walmart and Target. We suspect that its costs are lower than Amazon’s considering that Amazon incurs the cost of delivery to the customer. It has a cost structure that enables it to be highly profitable despite having the lowest prices. It continues to increases sales and profits per share by adding new stores and growth in same-store sales. Its advantages are likely to be enduring. It recently achieved an ROE on ending equity of 24% even though profits on sales were just 2.0%, The 2.0% was leveraged up by sales that were 3.37 times assets and assets that were 3.55 times the ending common equity level.
RISKS: The risk that currently (or at least periodically) worries the market is that Amazon’s purchase of Whole Foods and take market share from Costco. Please see annual report for additional risks. In our view, the major risks include competition, and general economic factors, and product liabilities . The fact that its net profit margin is a thin 2.0% of sales (this is in keeping with its strategy to be a low-price leader) adds to the risks. However, we think they could raise prices a certain amount at will. (They have left pricing power on the table in order to be a low price leader). Product liability and reputation is always a risk.
INSIDER TRADING / INSIDER HOLDING: As of December 19, 2017, Yahoo Finance shows that insiders sell regularly and with no apparent regard to price. Looking back, insiders were even selling at the low points in early 2009.  There were also direct sales by several insiders in the past few months and past year.  The data shows purchases by directors and officers on May 23 all at $173.01. However this appears to be stock compensation in reality and does not reflect anyone independently buying with their own money.  Overall, this is a moderately negative insider trading signal but it should be considered to be a weak signal.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is simple to understand (pass, warehouse retail concept with low costs), has favorable long-term economics due to cost advantages or superior brand power (pass, costs are low due to fast inventory turn over, warehouse style, control of theft by monitoring doors, low advertising, limited hours and limited acceptance of credit cards and it has brand value – seen as trusted for low prices), apparently able and trustworthy management (pass), a sensible price – below its intrinsic value (fail, selling above the upper-end of our value range), Other criteria that have been attributed to Buffett include: a low debt ratio (pass, modest debt), good recent profit history (pass) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass)
MOST RECENT EARNINGS AND SALES TREND: Adjusted earnings per share in the past four quarters starting with the most recent being Q1 fiscal 2018 which quarter ended November 26th 2017,  rose 17%, rose 12% (actually 18% but 12% considering the quarter had an extra week this year) rose 13%, and fell 6%. Revenues per share in the same quarters rose 13%, 9% (16% before adjusting down to account for the extra week this year) rose 8%, and rose 6%. Fiscal 2017 had earnings per share up 7% (9% before adjusting down to account for an extra week in 2017) and revenue up 7% (after the adjustment). Fiscal 2016 had earnings per share up 1% and revenues per share up 2.5%.  Fiscal 2015 had earnings per share up 13% and revenues per share up 3.1%.  Fiscal 2014 had earnings per share up 3.6% and revenues per share up 6.6%.   The recent earnings and revenue growth has been very strong boosted in part by a more favorable credit card deal.
COMPARABLE STORE SALES:  Same store sales growth (adjusted for currency and gasoline price fluctuations) in the past four quarters, starting with the most recent being Q1, ended November 26, 2017 were up 10% (There was no adjustment for currency and gasoline), up 6%, up 5%, and up 3%. In fiscal 2017 ended September 3, 2017, same store sales were up 4%, In fiscal 2016 ended August 28 same store sales were up 4%. In fiscal 2015 ended August 30 same store sales were up 7%.  In fiscal 2014 ended August 31 same store sales were up 6%. In fiscal 2013 ended September 1 2013, same store sales were up 6%. In fiscal 2012 ended August 2012, same store sales were up 6%. This is very strong  same store sales growth in the past four quarters.
Earnings Growth Scenario and Justifiable P/E: A P/E of 22 could be justified assuming 7% annual growth for 10 years and the current dividend pay-out ratio of about  33% followed by long-term growth of 4% and a higher dividend at 50% of earnings. The current 31 P/E can be justified at 11% growth for ten years with long-term growth at 4%. These calculations assume a 6.5% required return.
VALUE RATIOS: Analyzed at a price of $188. Price to book value ratio, in isolation, seems unattractively high at 7.5 however it’s not essential that this ratio be attractive if the earnings support the price.  The dividend yield is low at 1.1%, despite recent dividend increases. (This excludes occasional special dividends). The dividend payout ratio is 33%. The adjusted P/E seems unattractively high, even for this high quality company, at 31. Earnings per share have grown at an average 8.4% over the past five fiscal years (to August 2017), which is very good (and 8.7% annually over the past ten years). Revenues per share have grown at 5.3% annually on average in the past five years (to August  2017). The ROE in the last 12 months is very strong at 23%. We calculate an intrinsic value of just $104 based on 6% growth for five years and the P/E regressing to 16 (which may be quite a pessimistic view) and $152 with 8% growth a and a P/E regressing to 22.  And $167 with 10% growth and a final P/E of 22. possibly the P/E will stay well above 22, but that would be an aggressive assumption. The discount rate or required return used in these intrinsic value calculations is just 6.5% given today’s ultra low interest rates. Overall, these value ratios indicate a very strong company but which appears to be more than fully valued (absent very aggressive assumptions) and therefore indicating a rating of Sell despite being a very (very) strong company.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: COST, New York
Currency: $ U.S.
Contact: www.cost.com
Web-site: www.cost.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $132,735.0
Latest four quarters annual earnings $ millions: $2,774.0
P/E ratio based on latest four quarters earnings: 29.8
Latest four quarters annual earnings, adjusted, $ millions: $2,651.0
BASIS OR SOURCE OF ADJUSTED EARNINGS: Adjustments to earnings as identified by management have been very minor.
Quality of Earnings Measurement and Persistence: The persistence and quality of earnings is excellent with continuous annual earnings growth over the last nine years.  The earnings measurement is very straight forward with minimal estimated items.  The earnings appear to be somewhat conservatively calculated given the use of LIFO accounting and the expensing of pre-store-opening costs. The earnings may possibly be understated by the inclusion of depreciation expense on buildings that have in the past likely increased in value, but this last is not for certain going forward.
P/E ratio based on latest four quarters earnings, adjusted 31.2
Latest fiscal year annual earnings: $2,679.0
P/E ratio based on latest fiscal year earnings: 30.9
Fiscal earnings adjusted: $2,563.9
P/E ratio for fiscal earnings adjusted: 32.2
Latest four quarters profit as percent of sales 2.0%
Dividend Yield: 1.1%
Price / Sales Ratio 0.62
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         7.46
Balance Sheet: (Updated December 2016) Assets are composed as follows: 32% buildings, improvements, equipment and fixtures, 29% inventories (financed by accounts payable) 17% cash and short-term investments, 15% land, 4% receivables and 3% other. These assets are financed as follows: 33% by common equity, 30% by accounts payable (which finances all of the inventory), 14% by debt, 7% by accrued salaries, 6% by other current liabilities, 4% by deferred (unrecognised),membership fees), 3% other liabilities and 2% by accrued member rewards not yet claimed. About 51% of the equity is made up of retained earnings, 41% is made up of additional paid in capital (probably largely from stock options but perhaps some from the IPO or other share sales above par value as well) and 0.02% is made up from the original shareholder capital at par value in the company.  And this is despite substantial dividends paid out and share buy-backs. This attests to its history of profitability.
Quality of Net Assets and Book Value Measurement: The quality of the assets are high, which causes the measurement of the net equity or book value figure to be conservatively stated compared to market value. Current assets are high quality as the major component is inventory that can readily be exchanged for cash with rapid turnover.  Land, buildings and improvements are likely worth FAR more than the accounting values which are stated at the lower of cost or market value.  These assets would be highly attractive locations to competitors.   Intangibles and goodwill are a very small portion of assets. However, the shares trade at 7.5 times book value, which means that the company is valued for its earnings and not its assets.
Number of Diluted common shares in millions:                                 440.9
Controlling Shareholder: There are no controlling shareholders with the two co-founders holding relatively modest amounts of the outstanding shares (i.e. 3 million shares but there are 441 million shares outstanding) .  Institutions like pension and mutual funds own a high percentage of the shares.
Market Equity Capitalization (Value) $ millions: $82,664.0
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 28.1%
Interest-bearing debt as a percentage of common equity 61%
Current assets / current liabilities: 1.0
Liquidity and capital structure: It has very strong liquidity with relatively modest debt at a recent 61% of the equity level (and the equity is worth FAR more than book value).
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 23.0%
Latest fiscal year adjusted (if applicable) net income return on average equity: 22.4%
Adjusted (if applicable) latest four quarters return on market capitalization: 3.2%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 5.3%
Volatility of sales growth per share:  Strong reasonably steady growth
5 Years compounded growth in earnings/share 9.3%
5 years compounded growth in adjusted earnings per share 8.4%
Volatility of earnings growth:  Strong Steady growth
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 15.0%
More conservative estimate of compounded growth in earnings per share over the forecast period: 6.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 8.0%
OUTLOOK FOR BUSINESS:   The overall outlook for the business is positive.  Longer term, they appear set to continue to grow same-store sales and to open new stores. Same-store revenue growth has recently been in the 6% range. (That is a high level and may not be sustainable as one can only push so much merchandise through a given store, also there is lower inflation.) New store openings added 3.6% to the store count in fiscal 2017. Together this can result in profit growth of about 10% per year if maintained. A recent membership fee increase may have added one time approximate 10% increase to earnings. It appears that they could increase profits by charging higher margins but there is no indication that they plan to do so and in fact it would go against their philosophy to offer the lowest prices. They are also increasing profits due to increases economies of scale. And they increased profits in 2013 and again in early 2015 and mid 2017 by increasing financial leverage and could do more of that. A more lucrative credit card deal added a boost to profits in 2017 but that was a one-time increase in percentage terms. Overall it seems reasonable to forecast earnings per share growth of about 8% to 10% going forward. Possibly online sales growth will result in earnings growth higher than 10%. The U.S. corporate income tax reduction could generate a boost of as much as about 18% in profit but some of that may instead be passed onto customers in lower prices.
LONG TERM PREDICTABILITY: It seems highly certain that Costco will continue to grow and be more profitable in the next ten and twenty years.
Estimated present value per share: We calculate  $104 if adjusted earnings per share grow for 5 years at the more conservative rate of 6% annually and the shares can then be sold only at a much reduced P/E of 16 and $152 if adjusted earnings per share grow at the more optimistic rate of 8% for 5 years and the shares can then be sold at a lower but still relatively high P/E of 22. Both estimates use a 6.5% required rate of return.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Has barriers to entry (pass, as it is difficult to now develop the brand and scale of Costco). No issues with powerful suppliers (pass, suppliers are not concentrated). No issues with dependence on powerful customers (pass, dispersed consumers), No potential for substitute products (pass, Wal-Mart’s Sam’s Club and BJ Wholesalers are strong competitors but ultimately the broad range of products purchased will be purchased someplace) No tendency to compete ruinously on price (pass, particularly for Costco which is the low-cost leader). Overall this industry appears to have attractive characteristics for Costco as a large incumbent.
COMPETITIVE ADVANTAGE:  Warren Buffett has stated that a low-cost structure is a competitive advantage for Costco. Their gross margin (if we include membership fees as revenue) is only about 15% (versus Wal-Mart at about 25%) and this proves that they have a low cost structure to be profitable at such a low mark-up. The membership based approach may also be an advantage given that they have contact information for each of their customers. In fiscal 2017, membership fees were 2.2% of revenue and  were equal to 71% of pre-tax income. But we don’t think one can really say that 71% of profits “came from” membership fees given that those fees can’t exist without the rest of the business. The cost structure advantages identified by management include low shrinkage by monitoring the doors to allow in members-only and to check for cash register receipts on exit. Lack of working capital investment since goods are sold by the time vendors need to be paid, warehouse setup lowers product handling and building costs, limited product selection lowers costs, very limited spending on advertising, shorter hours of operation, only limited acceptance of credit cards, and the fact that revenue from memberships allows lower prices to be charged.
COMPETITIVE POSITION:  Its market share of the overall goods that it sells is unknown (it competes against many other categories of retail including notably grocery stores department stores).
RECENT EVENTS:  Online sales which accounted for 4% of sales in 2017 surged 43% in Q1 2018. Costco has made a small move into vertical integration for the first time, opening a meat plant in Illinois and a poultry plant in Nebraska. One of the two founders, who was Chair of the Board, passed away unexpectedly in August 2017. The other co-founder subsequently retired from the Board. However, the company retains very substantial continuity of long-serving management and Board members. Paid a special dividend of $7.00 per share in May 2017 and issued debt to fund this. Increased its annual membership fees by about 9%. Costco switched from exclusively accepting America Express cards to exclusively Visa in the U.S. in 2016 and switched to only MasterCard in Canada. With Visa, Costco got a lower merchant discount  fee AND on Costco-branded visa cards gets commission on the  non-Costco purchases AND a “bounty” on each new Costco-branded card that is issued. Opened a net of 26 new stores in fiscal 2017 ended September 3 which added  3.6% to the store count.  This included entering the countries of France and Iceland for the first time.. The company has been buying back shares at prices that averaged as high as $172 (May). Buybacks amounted to roughly 20% of net earnings in each of the past two fiscal years.
ACCOUNTING AND DISCLOSURE ISSUES: The annual report is written in a reader friendly format. The accounting appears to be somewhat conservative in that store pre-development costs are expensed (but this is a tiny impact)  and LIFO inventory accounting usually leads to slightly lower profit. In addition buildings are depreciated even though they may be increasing in market value.
COMMON SHARE STRUCTURE USED: Normal, one share one vote.
MANAGEMENT QUALITY: Excellent. Management has consistently stuck to an established way of operating that has worked very well.
Capital Allocation Skills: Management appears to have made good choices in investing its capital and in its financing. In particular it sticks to its established retail format and does not (to any material extent)  invest in alternative formats. In more recent years it added moderately to debt which allowed more leverage and a higher ROE and funded a special dividend on several occasions. It has done share buy backs but has been relatively conservative in doing so which seems wise as the stock was seldom demonstrably cheap.
EXECUTIVE COMPENSATION: From December 2016 proxy document. Total compensation ranged from $3.6 million to $6.6 million for the five named officers and relatively unchanged in the past three years.  For this large company with 2017 net earnings of $2,679 million this overall compensation is not a concern and does not seem unreasonable.
BOARD OF DIRECTORS: The board of directors is made up of 2 insiders, the CEO and the CFO.  The other eight members are well established including Charlie Munger of Berkshire Hathaway. We consider this to be a strong Board.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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