Costco Wholesale Corporation _Costco_

Costco Wholesale Corporation (Costco) Investment Rating BUY Pricing Closing Price (10/11/05) $45.49 52-Week High $50.46 52-Week Low $39.48 Valuation FY 2003 2004 TTM 2005E EPS 5.35 6.57 7.18 ----P/E 17.2 11.3 12.5 11.8 I. Investment Highlights Company Profile Costco is a low cost/discount retailer that operates through 417 warehouse style retail stores, and through Costco.com. Access to Costco Warehouses is restricted to members who pay a small annual fee for access. Started primarily as a small business supply company, Costco’s inventory focus has grown to include high-end consumer goods including home electronics and luxury items. Costco has succeeded by focusing on the demands a specific customer group while continues to provided for other profitable customers. Growth Dynamics Costco’s quarterly sales growth is in tune with the rest of the industry at ~ 10%. This is a very sustainable growth rate and while not stellar, when combined with the lowest labor costs in the industry, results in an excellent return. Revenue Est. Avg. Estimate No. of An. Low Estimate High Estimate Year Ago Sales Sales Growth Current Quarter 12.78B 11 12.46B 13.07B 11.58B 10.4% Next Quarter 13.85B 11 13.39B 14.07B 12.66B 9.4% Current Year 58.7B 13 57.17B 60.53B N/A N/A Next Year 63.95B 11 61.13B 66.28B 58.74B 8.9% Profitability & Effectiveness (5 yr) ROA 5.99% ROE 12.51% Profit Margin 1.96% ROCI % Market Data Total Assets (000) Volume Market Cap (B) 21.87 Avg Vol (000) 3,017,520 EPS 2.07 P/E 22.07 Div & Yield 0.46(1.00%) Source: finance.yahoo.com Alex Arnote Ahae5d@mizzou.edu Since a great deal of Costco’s growth comes from new store openings, growth is somewhat limited by the availability of new markets. Costco’s management has recognized this and has already begun an extensive and successful overseas expansion plan while maintaining steady domestic growth. Growth in older stores is spurred by the addition of additional services included gas stations, pharmacy, and other service oriented enterprises. Earnings per share (MorningStar.com) 1 II. Executive Summary Costco is an international discount retailer with 415 retail locations in six countries and thirty seven states. Small business owners and professionals in the $100k salary range are the primary customers due to their disposable incomes and demand for high-end goods/services. The increased demand for designer goods has led to increased sales of designer home furnishings including furniture and accessories. Day to day office and home supplies, from paper to flour provide the economic saving of bulk buying and bring customers in who can then make high dollar impulse buys generating one of the highest dollars per square foot. Low volatility and consistent growth combined with excellent leadership and corporate policy make Costco an excellent stock for long term investing. Recommendation: BUY Costco is a buy for anyone who wants a low risk stock that will outperform the market and wants long term stability with excellent growth and consistent dividends. Target Price: ~ $45 the going market rate Pros -Highest sales/profit per square foot in the industry -Lowest labor costs in the industry -Steady/consistent growth -Low risk -Better than market returns -Everybody likes low prices Cons -Heavy economic link – luxury goods -Big name competition - Wal-Mart -Long-term growth limitations possible Critical Factors High dollar per square foot and low costs allow for some of the lowest prices in the industry. This combined with high quality and low cost creates high value customers that purchase large amount of high cost items, particularly impulse buys. 2 III. Company Description From the Costco website: Costco Wholesale Corporation operates an international chain of membership warehouses, mainly under the "Costco Wholesale" name, that carry quality, brand name merchandise at substantially lower prices than are typically found at conventional wholesale or retail sources. The warehouses are designed to help small-to-medium-sized businesses reduce costs in purchasing for resale and for everyday business use. Individuals may also purchase for their personal needs. Costco's warehouses present one of the largest and most exclusive product category selections to be found under a single roof. Categories include groceries, candy, appliances, television and media, automotive supplies, tires, toys, hardware, sporting goods, jewelry, watches, cameras, books, house wares, apparel, health and beauty aids, tobacco, furniture, office supplies and office equipment. Costco is known for carrying top quality national and regional brands, with 100% satisfaction guaranteed, at prices consistently below traditional wholesale or retail outlets. Members can also shop for private label Kirkland Signature products, designed to be of equal or better quality than national brands, including juice, cookies, coffee, tires, house wares, luggage, appliances, clothing and detergent. The Company also operates selfservice gasoline stations at a number of its U.S. and Canadian locations. Additionally, Costco Wholesale Industries, a division of the Company, operates manufacturing businesses, including special food packaging, optical laboratories, meat processing and jewelry distribution. These businesses have a common goal of providing members with high quality products at substantially lower prices. Leadership IV. Economic and Industry Environment Industry’s Relation to the Economy The discount retailer industry on a while is not very related to the economy. During poor economic times, discount retailers tend to do better since people have less money to spend. Costco is a high-end discount retailer, primarily serving small business owners who are susceptible to economic swings of the economy in general. Overall I would say there is a high correlation between Costco’s industry and the economy in general, unless Costco is able to shift is merchandise to follow the swinging economy. At a local level, Costco has done several things that have increased the value of each customer. Products are marked up a flat rate so customers know products are priced at a 3 very reasonable level. Products are high quality and the return policy is very customer friendly. Lastly, a great deal of the inventory at Costco has inconsistent availability. Products often sell out and may never be there again, this low availability combined with low prices and high quality dramatically increase impulse buying, particularly of high cost items. Competition Two major chains, Costco and Sam’s Club, a Wal-Mart Division, dominate the United States warehouse wholesale market. BJ’s Wholesale Club is a regional player, located only on the Atlantic seaboard of the US. Overseas there are many smaller competitors, but most are focused on food and not retail merchandise. DIRECT COMPETITOR COMPARISON Market Cap: Qtrly Rev Growth (yoy): Revenue (ttm): Gross Margin (ttm): EBITDA (ttm): Oper Margins (ttm): Net Income (ttm): Price/Book Value EPS (ttm): P/E (ttm): PEG (5 yr expected): P/S (ttm): COST 21.87B 10.10% 51.37B 1.96% 1.97B 2.89% 1.01B 2.47 2.07 22.07 1.61 0.43 WMT 185.57B 10.20% 298.46B 23.06% 22.39B 5.94% 10.72B 3.85 2.536 17.00 1.03 0.60 BJ 1.78B 9.8% 7.68B 1.55% 104.22M 2.52% 121.41M 1.91 1.71 15.2 1.05 0.23 Industry TGT 46.2B 291B 13.6% 10.0 49.57B NA 4.82% 3.4% 5.28B NA 7.92% NA 10.72B NA 3.45 3.4 2.536 2.66 19.62 18.4 1.03 291B 0.60 10.0 WMT = Wal-Mart Stores Inc. BJ = BJ’s Wholesale Club TGT = Target Industry = Discount Variety Stores V. Company Position Market Information Costco operates in 6 countries and 37 states. Regions with a large number of small business owners and/or higher income professionals with a demand for high-end goods are typical. 4 Product Development, R&D As a discount retailer, there few R&D costs associated with Costco’s operations. Costco does maintain its own Kirkland brand which sells high-quality products at lower prices. There are some costs associated with this development, but they are limited. Kirkland branded products cover most products Costco sells, particularly food and clothing. Demographics Costco primarily target independent small business owners who typically have $100,000 in personal income. Costco started by providing bulk sales of the items these business owners needed for day to day business operations, and then moved into supplying high end luxury merchandise that this customer group was demanding. It is the focus on this high-end demographic that differentiates Costco from other discount retailers, such as Sam’s Club. Threat of Substitution Costco’s demographics focus does limit the overall threat of substitutions. One common substitute, Sam’s Club sells bulk food and dry goods as well al a limited selection of high end merchandise. The increase in high-end sales has been a recent shift in an attempt to compete with Costco’s significantly higher dollar per square foot of $795 vs. $516 at Sam’s and $411 at BJ’s Wholesale Club. In fact, Costco received $13,647 in profit per employee last year, compared to $11,039 as Sam’s Club. This focus on high-end clients, mixed with low prices has created a loyal clientele that creates a significant barrier to entry. Image By having some of the best benefits in the industry, Costco has created a hard working and intensely loyal group of employees. The excellent treatment of employees has helped to create a very positive image among shareholders, customers, and suppliers that few of their competitors can match. Among its customers, Costco is seen as a high end/low cost store. Products are expected to be high quality and among the cheapest available. This image of low-cost/high-quality leads customers to make impulse purchases that would otherwise not occur. Sam’s Club, on the other hand, is associated with bulk buying cheap/low-quality goods and items. Management Quality Costco’s leadership has made excellent decision about store placement, expansion, target market, and product selection. Most promotions come from within and employees that generate exceptional results are rewarded and promoted within the firm. Management quality appears to be excellent and should be into the faceable future. One fact of interest is the significant shareholdings of the CEO, Chairman, Sr. VP, and Executive VP (see Other Considerations). It is preferential for high-level executives with 5 large stakes in the companies they run since it gives them a stake in the success of the company in the long run. VI. Financial Statement Analysis Financial Ratios Trend Analysis (Costco vs. S&P 500) Looking at the year to date chart for price changes we see that the S&P 500 has outperformed Costco. However, when looking at the 5 year chart below, we see a very different picture. Stock: Costco Wholesale Industry: Discount Stores 6 Index: S&P 500 Chart from www.morningstar.com DIRECT COMPETITOR COMPARISON Market Cap: Qtrly Rev Growth (yoy): Revenue (ttm): Gross Margin (ttm): EBITDA (ttm): Oper Margins (ttm): Net Income (ttm): Price/Book Value EPS (ttm): P/E (ttm): PEG (5 yr expected): P/S (ttm): COST 21.87B 10.10% 51.37B 1.96% 1.97B 2.89% 1.01B 2.47 2.07 22.07 1.61 0.43 WMT 185.57B 10.20% 298.46B 23.06% 22.39B 5.94% 10.72B 3.85 2.536 17.00 1.03 0.60 BJ 1.78B 9.8% 7.68B 1.55% 104.22M 2.52% 121.41M 1.91 1.71 15.2 1.05 0.23 Industry TGT 46.2B 291B 13.6% 10.0 49.57B NA 4.82% 3.4% 5.28B NA 7.92% NA 10.72B NA 3.45 3.4 2.536 2.66 19.62 18.4 1.03 1.15 0.60 0.94 WMT = Wal-Mart Stores Inc. BJ = BJ’s Wholesale Club TGT = Target Industry = Discount Stores As we see here, Costco is outperforming its competitors, its industry, and the market as a whole. VII. Financial Forecasts (from analysts) Avg. Revenue forecasts (from finance.yahoo.com) Earnings estimate (next quarter Feb. 2006) $0.60 7 Revenue estimate (next quarter Feb. 2006) Sales Growth estimate (current) EPS trends Earnings Trends Current Estimate 7 days ago 30 days ago 60 days ago 90 days ago Source: finance.yahoo.com Current Quarter $0.44 0.44 0.44 0.44 0.44 Next Quarter $0.60 0.61 0.61 0.61 0.61 $13.83B 9.5% Current Year $2.29 2.29 2.28 2.30 2.30 Next Year $2.59 2.62 2.62 2.65 2.65 There appears to be very little variation of the analyst’s opinions over the course of three month. This seems to indicative a level of stability and openness of the company. Growth Estimates and Trend Analysis Source: finance.yahoo.com Growth Estimates Current Qtr. Next Qtr. This Year Next Year Past 5 Years (per annum) Next 5 Years (per annum) Price/Earnings (avg. for comparison categories) COST 10.0% 11.1% 12.3% 13.1% 11.3% N/A 12.00% Industry 15.5% 14.6% 13.0% 15.9% N/A 14.72% S&P 500 17.90% 16.10% 14.50% 11.50% 10.58% 19.3 18.53 1.49 Currently Costco’s growth estimate for this quarter is 10.0%. Compared to the industry and the S&P 500, this is significantly lower. The estimate for next few years shows Costco increasing its growth rate to a level similar to the industry. It should also be noted that Costco’s “Industry” includes many companies that have very different business models, making comparison difficult. VIII. Analysis of Risk From an actual risk standpoint, Costco is not expected to have financial problems anytime in the near future. Morningstar has given it an A rating for financial health and I see few problems, barring a major collapse in the US economy, on the horizon. 8 Costco is traded on the NASDQ Stock Exchange as ticker symbol “COST.” During the last three months the average trading number of shares traded was 3,017,520 shares daily. During the last 12 months the low share price was $39.48 and the high was $50.46. The standard deviation, or relative risk, was measured at approximately 3.83 with a correlation of 0.627(see chart below). The Beta is 0.84 Marketability a. Trading Location – NASDQ b. Average Daily Volume (13 wk) – 3,017,520 Total Risk c. Range 52 week range $39.48 – $50.46 d. Standard Deviation: 3.83 Systematic Risk e. Correlation to market Date 1-Sep-05 1-Aug-05 1-Jul-05 1-Jun-05 2-May-05 1-Apr-05 1-Mar-05 1-Feb-05 3-Jan-05 1-Dec-04 Close 43.09 43.4 45.97 44.73 45.38 40.63 44.18 46.59 47.27 48.41 Market 1237.91 1220.33 1234.18 1191.33 1191.5 1156.85 1180.59 1203.6 1181.27 1211.92 9 1-Nov-04 1-Oct-04 1-Sep-04 2-Aug-04 1-Jul-04 1-Jun-04 3-May-04 1-Apr-04 1-Mar-04 2-Feb-04 2-Jan-04 Mean: StDev Mrkt. Corr. 48.6 47.94 41.51 41.17 40.71 41.18 37.9 37.5 37.61 38.86 36.94 42.83667 3.831115 0.627443 1173.82 1130.2 1114.58 1104.24 1101.72 1140.84 1120.68 1107.3 1126.21 1144.94 1131.13 1162.15 Beta with market .84 (MSN Money) IX. Fundamental Valuation Estimation of Required Rate of Return The required rate of return has been estimated from a series of data over the previous nine years. We use the assumption here that what has happened in the past has a reasonable change to continue in the future. The S&P 500 has been used as a proxy for the market. Also, we use historical rates on the 1-year T-bill as an estimation of the risk free rate of interest. For the periods 1995-2004 the historical equity premium on the market was 6.38%. This is a geometric mean average rate of return. The Capital Asset Pricing Model was used to compute the required rate of return for Costco: RE = R F+ β(Equity Risk Premium) RE = 4.3 + (.84) (6.38) = 9.6% Financial Summary A brief snapshot of financial performance and relevant ratios includes: (as of Oct. 11, 2005) Note: Information in table used for valuation, see page 1 for up-to-date figures. General Information Stock Price Market Capitilization Beta EPS DPS 45.49 21,810,000,000 0.84 7.180 0.46 10 P/E Dividend Yield Dividend Payout Ratio Required Rate of Return ROE Forecasted Growth Rate 22.01 1.00% 14% 9.6% 12.45% 8.30% Dividend Discount Model 0.46(1.06)/(0.096-0.06) = $13.54 Forecasted Growth Rate g = (1-p)*ROE = (1-0.01)*12.45 = 12.33% X. Other Considerations Top Individual Holdersª Holder SINEGAL, JAMES D. BROTMAN, JEFFREY H WALKER, THOMAS KIRK DICERCHIO, RICHARD D Relationship CEO Chairman Executive Vice Pres. Sr. Executive Vice Pres. Shares 655,674 162,475 152,902 107,408 Reported 6-June-05 11-Mar-05 26-apr-05 1-Nov-04 Top Institutional Holdersª Holder DAVIS SELECTED ADVISERS, LP BARCLAYS BANK PLC Shares 40,624,076 34,560,690 % Out 8.48 7.21 Value* $1,794,771,677 $1,526,891,284 Reported 31-Mar-05 31-Mar-05 Top Mutual Fund Holdersª Holder DAVIS NEW YORK VENTURE FUND VANGUARD/PRIMECAP FUND Shares 18,051,900 7,500,000 % Out 3.77 1.57 Value* $853,313,313 $363,075,000 Reported 31-Jan-05 31-Dec-04 ªSource: Major Holders – http://finance.yahoo.com *Value shown is computed using the security’s price on the report date given As for Benjamin Graham, it is a tough call. Given the current market, I would say that Costco’s low Price/Book ratio of 2.5 beats the industry average of 3.4 and the market average of 3.3 so it passes. XI. Conclusion 11 There are few unfavorable conclusions about Costco. The limitations on continued growth could be problems, but the overseas expansion and controlled domestic growth have reduced this risk. A major economic downturn would hurt the company since the demand for luxury goods would decline, but this could be offset by increased demand for low-cost bulk buying. The membership system not only an excellent source of income, but allows Costco to know what each customer buys and to tailor the marketing and product selection accordingly. Recommendation Buy. This stock will out perform the market and have a low level of risk due to the excellent management and a specific target market that Costco serves perfectly. Steady growth potential and success overseas will lead to excellent returns with very little actual risk. Disclaimer: This analysis does not necessarily reflect the beliefs of the University of Missouri-Columbia or the College of Business. The insights and opinions are of the students of Investment Funds Management and should not be used in personal investment decisions. The University of Missouri and the authors of this analysis take no responsibility for the validity of the valuation and analysis. 12 Financial Resources: Online Yahoo Finance (finance.yahoo.com) MSN Money (www.msn.com) Morningstar (www.morningstar.com) ADVFN (www.advfn.com) Databases Factiva ABI/Inform Fund Management Resources Citigroup Inc Analysis Report AutoZone Inc Analysis Report Portfolio Committee Spreadsheet 13