costco wholesale corporation - buy · costco wholesale corporation operates globally as a...
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CostcoWholesaleCorporation-BuyNYSE:COSTUSD187.82
TargetPriceUSD155
Author1–ChristopherAllanEquityAnalystB.Comm/B.IB–[email protected]
KeyFinancialData
MarketCap 80.46B
S&PCreditRating A1
DebttoEquityRatio 60.2
PricetoEarnings 27.17
EV/EBITDA 12.88
DividendYield 1.06
OperatingMargin 3.19
ReturnonAssets 7.71
RevenueGrowth–1yr 8.68
InsidethisReport
☑InitialResearch☐UpdatedResearch
☐PriceTargetChange
☐RatingChange
Tuesday,December5,2017
ResearchHighlights/InvestmentThesis• CompetitiveBusinessModel
Costco operatesmembershipwarehouses that offers itsmembers low pricesonbrandnameandprivatelabelproducts.Theselowpricesareenabledbytheoperatingefficienciesofvolumepurchasing,efficientdistributionandanofrills,self service environment that rapidly turns over its inventory of 3,700 SKU’s,much lower than the 60,000 SKU’s competitors hold on average. Theseoperatingefficienciesallowthecompanytohaveanaveragemarkupinthelowteen’svsotherlowpriceretailerssuchasWalmartthataverages20%markups.Costco is able to be the low cost provider due to the fact that the companymakesthemajorityofitsmoneyonmembershipfeeswhilesellingmerchandiseatvirtuallyzeroprofit.
• WideEconomicMoatCostco has a wide economic moat which is a result of its cost advantage,intangiblebrandassetsandtosomeextentnetworkeffects.Thecompanyhasboasteda90%renewalrateofmembersandhastheabilitytoraisepricesonitsmembershipfeeswithoutadropintherenewalrate.
• RichlyValuedWhilewearevery fondof thequalitativestoryof thecompany, itappearsasthough we are not alone in our admiration of the business model as thecompanyisrichlypriced.Weconductedascenarioanalysisandnotedthatthecurrentmarketpriceimplies6%revenuegrowthwithEBITDAmarginsof3.7%,which is on par with historical averages. While we do not think that this isunattainable,webelievethatthisimpliesthatupsidepotentialisdiminished..
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CompanyOutlook/OverviewCostcoWholesale Corporation operates globally as amembership-onlywarehouse club, catering to
businessandindividuals. In2017,Costco’smembershipbaseconsistedof36,600GoldMembersand
10,800BusinessMemberswith38%ofpaidmembershavingupgradedtoanExecutiveMembership.
Costco operates 741 warehouses across North America, United Kingdom, Japan, Australia, Spain,
FranceandIcelandwithlicensingagreementsinTaiwanandKorea.Costco’sdiverselineproductscan
becategorizedby:Foods,FreshFoods,Sundries,Hardlines,SoftlinesandOthers(ancillarybusinesses).
InFY2017,Costcohadnetsalesof$126.172Bwith87%beingderivedfromoperationsinCanadaand
the United States. Foods, contributing 21% of net sales, consist of dry foods, packaged foods and
groceries.Sundries,which includecandy,beveragesandcleaningsupplies,makeup20%ofthetotal
sales. The hardline category consisting ofmajor appliances, electronics and furniture accounted for
16% of sales. Fresh foods made up 14% of sales, while softlines which includes apparel and small
appliances made up 12% of sales. The last 17% of FY2017 net sales can be attributed to Costco’s
ancillary businesses which include gas stations, optical dispensing centers, food courts, hearing-aid
centersandpharmacies.
InFY2017,netsalesincreasedby9%withe-commercesalesgrowingby15%,accumulatingto4%of
totalsales.Witha lowgrossmarginof11.33%,Costcoreliesontheir90%membershiprenewalrate
andtheirmembershiprevenuewhichgrew4%,contributing$2.6Btototalrevenue.Thisiscompared
tonet incomeof$2.3B,evidencethatnearlyallofCostco’snet incomeisderivedfrommembership
fees.Costcoreinvested$2.65Bintothebusinessthroughexpansionofdistributionandtransportation
systems,newwarehouseopenings and$1.2B returned to shareholders through stock-buybacks and
dividends,producing$2.35Binnetincome.
Source:Bloomberg
Softlines12%
Foods21%
Hardlines16%
Sundries20%
FreshFoods14%
Ancillary17%
Figure1:SalesbyProductType
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MarketSize&Structure
Costcooperates intheretail industrywith5.1%ofmarketshare in2016forU.S. foodandbeverage
purchases.Withintheretailindustry,CostcoconductsbusinessthroughtheWarehouseClubssector,
facingcompetition fromSam’sClubandBJ’s.Overall,Costcohas43%fewerSKU’s instorethanBJ’s
and33%fewerSKU’sthanSam’sClubyetCostcodominatesthesector.Costcohas62%marketshare,
comparedto30%and8%marketsharefromSam’sClubandBJ’s,respectively.TheWarehouseclubs
sectorisestimatedtogenerateapproximately$191Binrevenuein2017.ThissectorgrewataCAGRof
7.2%between2001and2016intheU.S.whiletheinternationalsectorgrewat10.8%.U.S.retailsales
haveincreasedataCAGRof3.3%forthesametimeperiod.With87%ofsalesstemmingfromtheU.S.
andCanada, thisbriefoverviewwill focusonthesetwomarkets.Retail sales inCanadafromAugust
2016toAugust2017haveincreased6.9%whileretailsalesintheUnitedStateshaveincreased3.2%.
In comparison to thegrowth in retail sales, therehasbeena16.2%growth in grocerye-commerce
salescausedbytheAmazoneffect.TheAmazoneffectistheconsumershifttowardsshoppingonline.
Regardless of Amazon’s disruption efforts, only 8.9%of retail sales are conducted online,while the
remaining91.1%arestillconductedinstore.Adaptingtothesectortrends,Costcohasbeguntoshift
towardsmultichannelofferingswiththeironlinesalesgrowingby15%inFY2016.Evenwiththisshift,
Costco won’t be threatened by Amazon as they share a similar profit model of low margins/high
turnover.Despitebothcompaniesoperatinginretailwithmembershipservices,Costcofocusesonthe
shopping experience. Costco gives consumers the convenience of a one-stop shop providing extra
services tomake the shopping experience efficient. Customers can pick up groceries for theweek,
changetheirtires,filltheirprescriptionsandgetaneyeexamallinonetrip.Thehighcostassociated
with fulfilling online orders for Amazon is made up with their more expensice membership fee.
According toMorgan Stanley, 50% of Costcomembers also have an Amazon Primemembership. If
these two businesses were direct competitors, members would choose one membership over the
other.Lowercosts,easyreturns,shoppingasasocialactivityandbeingabletoseeandtouchproducts
Source:Bloomberg Source:Bloomberg
2%
98%
Figure2:RevenueBreakdown
MembershipFees Sales
72%
28%
Figure3:OperatingIncomeBreakdown
MembershipFees SalesProfits
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beforebuyingthemareallreasonswhyBrickandMortarstoresareheretostayfortheforeseeable
future.
ValueChain
Costco utilizes a low-cost leadership strategy, outputting high volumes with low margins, enabling
them to sell large quantities at competitive prices. Alongside this strategy, Costcohas been able to
implementanefficientsupplychaintoprovidecustomerswithhighqualityproductsatanaffordable
price. Selling, General and Administrative Expenses (SG&A)which consists of all operating costs for
Costcoin2017is10.1%comparedtoWalmartwhichis21.2%.Thecompanybelievesinkeepingonlya
limited number of products at their warehouses to ensure that every product meets the quality
standard Costco customers expect. Having fewer products to order, track and display means cost
savings forCostco.Carryinga smalleramountof SKU’sallowsCostco to increasepurchasingpower.
Less shelf space means more competitive bidding by suppliers, resulting in the acquisition of
merchandise at the best possible price. Costco buys products in bulk, directly frommanufacturers,
which then get delivered to one of their distribution centers, reducing material handling. Costco
utilizesacross-dockingtechniquetomoveproductsfromdepotstotheirwarehouses.Tothegreatest
extent, goods are handled in full pallets at the depot to reduce product handling. This process
increases handling efficiency and reduces storage costs associated with traditional multi-step
distribution channels. Merchandise is then displayed on the same industrial pallets on which it is
shipped,reducinglaborcosts.Warehousesoperateonanaverageof70hoursaweek(Walmart≈77
hrs.),which ismuch shorter thanother retailers, loweringoperating costs relative to the volumeof
sales. While most retailers spend large sums of money on marketing, Costco does not have an
advertisingbudget.ThecombinationofthesefactorsallowsCostcocustomerstopurchasehighquality
productsatabelowaveragecost.
Source:FungGlobalRetailandTechnology
Costco62%
BJ's8%
Sam'sClub30%
Figure4:U.S.WarehouseMarketShare
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Moat
LowCostLeader
Costcopurchasesproductsfrommanufacturersinbulkorderswhichallowtheirsupplychaintoexploit
economies of scale. Economies of scale results in reduction in fixed costs associatedwith ordering,
transportation and quantity discounts from suppliers. Costco’s warehouses are also cost efficient.
Operating costs are reduced through shorterweekly operating hours. Concrete floorsmanifest low
maintenance costs. Products displayed on shipment pallets reduce labor costs. Finally, warehouses
carryaround3,700SKU’scomparedtootherretailerswhocarryaround60,000SKU’s,enablingCostco
to increase inventory turnover and reduce costs associatedwith retaining excess inventory. Costco
then takes these cost savings andpasses it on to the consumer insteadof raisingmargins.Costco’s
efficientoperationmakesitdifficultforcompetitorstocompeteonprice.
BrandLoyalty
Costco‘s business model is a subscription business model, meaning that customers purchase
membershipswiththeexpectationoflowercoststomakeupfortheinitial investment.Costcohasa
self-reinforcing business model with a virtuous cycle. The cycle begins with their low prices on
merchandiseformembers.Competitorscannotcompetewiththeselowmarginsbeacsuetheyactually
needtoturnaprofitonthemerchandisetheysell.Whenmoremembersjointheclub,Costco’sscale
increases.ThisincreaseinscaleallowsCostcotospreadfixedcostsoveralargerbaseaswellasgives
themastrongerpositionwhennegotiatingwithsupplierswherethebenfefitsarepassedbacktotheir
members.With a renewal rate of 90% in Canada and U.S. and 87% internationally, it is clear that
customers consider the advantages of shopping at Costco well worth the membership fee. The
membershipfeeallowscustomerstofeelasiftheyarepartofanexclusiveclubofcustomers.Costco
alsooffersmembersdiscountsongasoline,insuranceandotherservices.Onceanindividualbecomes
amember,theythenfeelcompelledtoshopatCostcotojustifythepaidmembership.
IndustryAnalysis
Porter’sFiveForces
CompetitiveRivalry-High
The retail industry is highly saturated, meaning Costco faces intense competition. Costco faces
competitionfromavarietyofretailerswhospecializeandutilizetheiruniquecompetenciestoforma
competitive advantage. Besides Kirkland Signature brand, Costco sells a variety of homogeneous
products. This means that Costco sells products with a very low level of differentiation amongst
competitors. The retail industry approaches perfect competitionwhereby retailers are price takers.
Should a company raise the price of their product by the smallestmargin; consumerswill buy that
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product somewhere else due to the lack switching costs. Therefore, the Costco faces intense
competitionfromrivals.
ThreatofNewEntry-Low
Anynewcompanycanenterintotheretailorwarehouseclubindustry.Itwillhowever,bedifficult,if
notimpossible,foranewcompanytooperateonthesamesizeandscaleemployedbyCostco.Costco
hasbuiltbrandrecognitionand importantrelationshipswithsuppliersandcustomersovertheyears
that would be very difficult to replicate. Economies of scale, access to supplier and distribution
channels,andhighstartupcostswouldallbechallengesfacedbyanewcompany.Therefore,anew
entrantwouldfaceeconomicbarriersandlogisticalbarriers,reducingthethreatofnewentryintothe
industry.
ThreatofSubstitution–ModeratelyHigh
DuetoCostco’swideselectionofproducts,Costcofacesthethreatofsubstitutionfromawiderscope
ofretailersthanjustWarehouseclubs.Costcofacesthethreatofsubstitutionagainstretailspecialists
suchasBestBuy&Kohl’s,retailgeneralistssuchasWalmartorTargetandinternetretailerssuchas
Amazon. Costco has mildly reduced the threat through their unique private-label brand, Kirkland
Signature.Besidesstoreandprivate-labelbrands,thethreatofsubstitutionishighasmanysubstitutes
existintheindustry,althoughthethreatismitigatedbythepricesavingsofbuyinginbulkatCostco.
BuyerPower-Low
SwitchingcostsareeithernonexistentorverylowforCostcomembersandshouldn’tbeconsideredin
buyer power. There aren’t any switching costs associated with the membership fee as Costco will
refundtheentiremembershipatanytimeifthememberisdissatisfied.Thelowswitchingcostsmeans
that Costco customers can easily transfer to other retailers. In addition, members have many
substitutestochoosefrom,thusconsumerswillchoosearetailerwiththebestoffers.Onthecontrary,
buyer power is reduced through the psychological effect memberships have on members. Even
though members can choose to shop elsewhere, Costco members feel the need to justify their
membership and as a result spendmoremoney on average.Overall, buyers have a small influence
overthepricesatCostco.
SupplierPower-Low
Suppliers play a critical role in providing Costcowith commodities and products to sell. Due to the
large population of suppliers, retailers are not dependent on any one supplier. Since Costco sells
products in bulk, they are an attractive retailer to supplierswho are, in turn, able tomove a large
volumeofgoods.Sincesuppliersareabletosell largervolumesofgoodstoCostcocomparedtothe
averageretailer,supplierswill sell theirgoodsata lowermarkuptoretainbusiness. In2009,Costco
threatened to stop carrying Coca-Cola products due to a pricing dispute. Coca-Cola’s largemargins
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didn’tallowCostcotopassalongpricesavingstotheircustomers,thustheythreatenedtostopselling
theirproduct.Warehouseshavelimitedshelvingspacewhichmakesthebiddingprocessmuchmore
competitive, inturndrivingdowntheprice.Costcoreceivesa largesupplyof inventoryfromvarious
suppliers, which reduces any single suppliers bargaining power as their actions are unlikely to
significantlyimpactthetotalsupplyavailabletoCostco.
IndustryDynamics
E-commerce
New technologies continue to influence the retail industry through e-commerce platforms.With e-
commercesalesgrowingfasterthantotalretailsales(3.6%comparedto1.1%inthethirdquarterof
2017), businesses are beginning to adapt to the change in consumer behavior. E-commerce effects
pricing,productavailabilityandshoppingconvenience.Oneofthemajorplayersinfluencingthistrend
is Amazon.Millions of third-party sellers pay Amazon a fee to take advantage of their distribution
platformandconsumerreach.AccordingtotheU.SCensusBureau,E-commercesalesasapercentage
oftotalsaleshaveincreased4.1%overtheyear.E-commerceopenstheindustrytomorecompetition
aswell as growth opportunities for existing firms. Thedownsides to selling products online are the
logistics involved with delivering each product. Companies who deal directly in the e-commerce
industry have exceptionally low profit margins due to overhead costs. Costs associated with e-
commerceincludeshippingcosts,costsofhandlingreturnandwebsitemaintenancecosts.Thankstoa
pricestudydonebyBMO,lookingatabasketof54items,BMOconcludedthatCostcosellsitemsata
cheaperprice thanAmazon innearlyeverycategory.Evenwithcompetitivepricing,Costco’sannual
membershipfeeismuchcheaperthanAmazonPrime’smembershipfeeat$55and$99,respectively.
Althoughtheretailindustryismovingtowardse-commerce,customerslookingforthemostaffordable
priceswill continue to shop at CostcoWarehousees. Looking at Figure 6, we can see that Costco’s
same-store sales are not as influenced by the change in consumer behaviour compared to
competitors.
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ConfidentSpending
According to Deloitte, the labor market has continued to strengthen, with an average of 181,000
additional jobs intheUnitedStatesalone,permonth, in2016.Disposable incomehas increase3.4%
over the 2016FY alongside a steady increase in average hourly earnings. These factors have hiked
household income,ultimately increasing consumer confidence and consumer spending. Thanks to a
survey conducted by The Nielson Company, 63% of U.S. respondents expressed belief that their
economywasoutof therecession (up13%from2016)andof theremaining37%whobelievetheir
country is still in economic decline, 36% believe theywould be out of it in 2018. This is a positive
outlookfortheretailindustryasaconfidentconsumerwillbethedrivingforcebehindincreasedsales
asretailsalesareup2.5%since2016inNorthAmerica.
GrowthandRiskAnalysis
GrowthOutlook
Costco’ssuccessoriginatesfromafewkeyfactorswhichwilldrivegrowthifmanagedproperly.As72%
of net income is derived frommembership fees, Costco’s growth is dependent on expanding their
customerbasewhileensuringahighmembership renewal rate.Anopportunity forgrowthamongst
memberscanalsoberealizedfromincreasingthenumberofmemberswhoupgradetotheExecutive
Membership.Anaggressive internationalexpansionplanwas implemented in2013to increase their
customerreachbypenetratingnewmarkets.AsofJune2017,Costcooperatesover200warehouses
Source:BloombergBusinesswee
k
11%
63%
23% 22%
5%1.4% 1.6% -1.3%
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Costco Walmart BestBuy Target
Figure5:SalesGrowthComparison (2017)
E-CommerceSalesGrowth Same-StoreSalesGrowth
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outside of the U.S, with a current focus on expanding into Europe. Costco has recently opened
warehousesinParis,FranceandGarðabær,Iceland.DuetotheisolationofIceland,localretailchains
colludeinordertokeeppricesartificiallyinflated.IcelandershaveembracedtheAmericanwarehouse
wholesaler as one in four Icelanders (80,000) have already purchased a membership card to take
advantageofcostsavings.
Although 87% of revenue is driven from Canada and U.S., these markets are actually the least
profitable.InternationalmarketsallowCostcototakeadvantageofcheaperexpenseslikewagesand
benefits. There is also a greater opportunity for growth amongst international markets as the
warehouse club model is much less concentrated. Analysts believe Costco is preparing to expand
locations into the Chinese market as they recently launched an online store on the business-to-
consumersiteTmall.TmallGlobalhasbeenapopularapproachtotestinginternationalbrandsinthe
Chinesemarket.
Finally, Costcomust focus on the retention of existing customers. Costcomust provide its current
customers with reasons to return. Costco has permanently capped margins which allow for
consistently low prices in order formembers to justify themembership fee. Costco only sells high
quality products to ensure persistent customer satisfaction. Costco emphasizes their strong return
policy,whereeveryproductisguaranteed.Finally,Costcohassuchastrongbeliefinthevalueoftheir
membership;membersmayrefundthefullamountatanytimeiftheyaredissatisfied,somethingthat
increasesbrandequityandcustomerloyalty.
MajorRisks
InternationalExpansion
AsCostcolargelydependsontheircustomerbasetodriverevenue,internationalexpansionbecomes
anopportunityaswellasarisk.Costcomayfaceproblemsenteringintomarketswherethecultureis
verydifferent.Thiscanbeseenthroughtheslightly lower internationalmembershiprenewalrateof
87%comparedto90%inCanadaandU.S.Costcocarriesthesameproductsinalloftheirstores,thus
internationalcountrieswillbeexposedtoAmericanandCanadianproducts.Dependingonthemarket,
consumers may react negatively to the unfamiliar products. Costco’s international success may
differentiateduetohouseholdsizes,consumerneedsandeconomicconditions.
E-commerceandCostco’sBusinessModel
Withe-commercesalesgrowingfasterthanretailsales,Costcohasattemptedtobecomelessreliant
ontheirbrickandmortarstoresbyimprovingtheironlineplatform.EconomiesofscaleallowCostcoto
purchaselargevolumesofgoodsandsellthematrelativelylowprices.Onlineshoppingdoesnotalign
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wellwiththisbusinessmodel,astheadditionalcostofshippingoperationsandwebsitemaintenance
increases the price of each good. Additionally, purchasing bulk orders online make home delivery
options difficult. Alongside Costco’s bulk-sized goods is the ever-changing selection of general
merchandise. The unique assortment of items at each visit creates a treasure hunt experience for
customers. This experience is very difficult to replicate through an online platform. Overall, E-
commercehasthepotentialtodisruptorCostco’sbusiness,butthefactthatCostcoisthelowestcost
optionmeansthereisatangiblebenefittoshoppingatCostcoasopposedtoAmazonorotheronline
retailers.
GeographicConcentration
Operationshaveperformedexceptionallywell inCanadaandtheUnitedStateswith87%ofrevenue
stemmedfromthesemarkets.CostcoplacesahighdependencyontheNorthAmericaneconomyand
moreparticularly,California.Californiagenerates32%ofCostco’stotalrevenue.Costcofacestherisk
of being geographically concentrated. Any substantial slowing in the State of California could
significantlyhurtCostco’soverallresults.
Management
InsiderOwnership
Costco insiders have very little corporate control as they hold 0.70% ownership in the company.
Costco’smarketcap is$72.66B, thus0.70%ownershipaccumulates to$528M.Although insidersdo
nothavealargepercentageofownership,theyhaveasignificantamountoftheirownpersonalwealth
invested in Costcomeaning that they have a significant amount of skin in the game, aligning their
interestswithshareholders.
In the last 12months, Costco insiders’ have sold 178,762 (net activity) shares, yet in the last three
months,insidershavepurchased114,497shares(netactivity).ThisisapositiveoutlookforCostcoas
insidersellingisnotalwaysattributedtopoorcorporateattitude.Ontheotherhand,insiderbuyingis
apositivesignastheyareeitherpurchasingthem,whichisindicitiveofabeliefinthelong-termfuture
ofthecompanyorarebeinggrantedincreasedownership,increasingtheirskininthegame.
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TrackRecord
Costcohasaprovenrecordofincreasingvaluefortheirshareholdersthroughreturnsoncapitalabove
theircostofcapitalwithmodestreinvestmentrequirementswhichhasleftthecompanywithexcesss
cashtoeitherreinvestordistributetoshareholders.Wecommendmanagementonthefacttheythey
havechosentoreturnexcesscashaboveandbeyondtheirreinvestmentrequirementstoshareholders
intheformofdividendsandstockbuybacks insteadofreturningexcesscashback intothecompany
forprojectswithlowreturns.Infact,in2017,COSTissuedaspecialdividendof$7,returning$3.9Bto
shareholders.Costcohaspaidout specialdividends in thepastof$7 in2013and$5 in2015. Since
2012,Costcohasdeclared$8.3B inspecialdividends. InAprilof2017,Costcoannouncedadividend
increaseof$0.05 (to$0.50)andasharebuybackprogramof$4Bexpiring in2019. It’s important to
note that a similar buyback program commenced in 2011 but Costco only spent $1.5B of the $4B
budget which is indicitive of the fact that management acts like owners and are unwilling to
repurchasesharesthattheybelievearenottradingatadiscounttointrinsicvalue.Takentogether,itis
clearthatCostco’smanagementhascreatedaswellaspreservedshareholdervalue.
ExecutiveCompensation
Thecommitteeconsideredcompensationdatafromthefollowingpeercompanies:Wal-MartInc.,The
Home Depot., Target Corporation, The Kroger Company and Low’s Companies. The components of
Costco’s executive compensation programs include equity compensation, base salary, cash bonuses
andotherbenefits (healthplans and401(k)plan).According toproxy statements filed for the2016
fiscal year, President and CEO, Walter Craig Jelinek, made a salary of $700,000, a cash bonus of
$81,600, $5,563,064 of stock awards, $57,227 of deferred compensation earnings and $101,385 in
othercompensationforatotalof$6,503,276.In2016,hislong-termincentiveplanmadeup85.5%of
histotalcompensation.
Source:Bloomberg
InsiderOwnership,0.7%
InstitutionalHoldings,37.4%
MutualFundHolders,37.2%
Other,24.7%
Figure6:Ownership Breakdown
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Costco awards performance based RSU’s to their executive officers for management’s long-term
incentiveplan.TheseRSU’sareperformance-vestedforoneyear,timevestedoverfiveyearsandare
investedforlongservice,giventheexecutiveremainsanemployeeatthevestdate.Theperformance
goals consist of executives either achieving a 3% increase in total sales or a 1% increase in pre-tax
income.Managementsabilitytoincreasesalesorincomewillpositivleyimpactshareholdervalue.
Iftheexecutivehasnotbeenwiththecompanyfor25years,theRSUvestsfor20%followingthefirst
year of performance-vesting and an additional 20% for each of the following 4 years years. If the
executive achieved long service with Costco, RSUs are subject to accelerated vesting. Accelerated
vesting for long service consists of 33% fo executiveswith 25 years of, 66% vesting for 30 years of
experienceor100%vestingafter35years.Oncetime-vestingrequirementsaremet,RSU’sarepaidin
sharesofcommonstock.
FinancialStatementAnalysis
Profitability
Costco has realized relatively consistent economic and accounting profitability margins with an
incrementalupward trend.Costco’scompetitivepricingstrategycanbedemonstrated through their
lowprofitandoperatingmargins.Costcoprices itsgoodsatbelowaveragemarkupsaimingtomake
virtuallyzeroeconomicprofitonmerchandisesalesinordertoprovidememberswithconsistentlylow
prices, and intice them to renew theirmemberships. This is because Costco relies onmembership
revenue and not the proceeds from sales for the majority of its net income. Due to Costco’s
competitivepricing strategy, theirprofitabilitymargins trailbehindcompetitorsbut thishasallowed
for a steady increase in same-store-sales and attracting and retaining a loyal customer base. These
marginsarenotexpectedtoincreasemuchintheupcomingyearsastheirstrategyremainsthesame
astheyarenotaimingtomakeanymoneyonmerchandisesales.
Source:Bloomberg
CEO:W.CraigJelinek Amount %ofCompensationSalary 700,000$ 11%Bonus 81,600$ 1%StockAwards 5,563,064$ 86%DefferedCompensationEarnings 57,227$ 1%AllOtherCompensation 101,385$ 2%Total 6,503,276$
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2013A 2014A 2015A 2016A 2017AProfitabilityEBITDAMargin 3.8% 3.8% 4.1% 4.2% 4.3%OperatingMargin 2.9% 2.9% 3.1% 3.1% 3.2%ProfitMargin 1.9% 1.8% 2.1% 2.0% 2.1%ReturnonAssets 7.1% 6.5% 7.2% 7.1% 7.7%
ReturnonEquity 17.6% 17.8% 20.7% 20.7% 23.4%
ReturnOnInvestCapital 13.4% 12.5% 14.0% 14.0% 15.7%
Growth
SinceCostco generatesmostof its profits frommembership fees rather thanproductmarkups, the
company'searningsaremuchmorepredictable thanWalmart, forexample,which riseand fallwith
thelevelofpricecompetitionintheindustry.Membershiprenewalratesarecurrentlysittingat90%
comparedto88%in2010.Renewalratespeakedin2015at91%butthendroppedapercentagepoint
inthefollowingyearasmanagementblamesthedeclineonthecreditcardswitchover.Costcoended
their exclusive partnership of 16 years with American express to partner with Citi. This switchover
droppedCostco’ssharepriceby6%.Costcoislookingtomakeuptherevenueontheslightdeclinein
membershiprenewalratesbyincreasingtheirmembershipfeeforthefirsttimein6years.
Thedeclineinsalesgrowthin2016canalsobeattributedinparttothecreditcardswitchoveraswell
as the 29 new store openings which diluted the average sales per warehouse. Average sales get
diluted because new stores typically beginwith low annual sales compared to existingwarehouses
with a loyalmembership base. For example, first year sales for new locations averaged $87million
compared to $159 million for locations opened at least a decade. As Costco is looking towards
internationalexpansion,theforecastformembershipgrowthandnetincomearelookingpositive.
Source:Bloomberg
Source:Bloomberg
$146
$155
$160$164
$162$159
$167
135
140
145
150
155
160
165
170
2011 2012 2013 2014 2015 2016 2017
Figure7:AverageSalesPerWarehouse(inmillions)
AverageSales
SPROTTSTUDENTINVESTMENTFUND
13EQUITYRESEARCH–NYSE:COST
Solvency
In2017Costcorealizedrecordhighfinancial leverageratiosasCostcoappearstobeincreasingtheir
amountofdebtusedto fundtheirbusinessexpansionrelativetoequity.Withan increasingdebt to
equityratio,thismaybecomeproblematicinthefutureasitmaybecomeunsustainableforCostcoto
pay the increased interest costs. For the mean time investors should not be worried as Costco’s
interest rate coveragehasheld strong around30x suggesting the company is unlikely todefault on
their interest payments in thenear future. An increasing capex ratio is also insignificant due to the
wideswings inoperatingcashflowthatoccurasthecompanyinvests innon-cashworkingcapitalto
openstores.Insteadviewingcapitalinvestmentthroughadifferentlense,asapercentofrevenue,itis
verystableat2%ofrevenues.
Liquidity
Costcohasrelatively low liquidityastheirability topayshort termdebthasbeendeterioratingover
thepast fewyearsas thecurrent ratiodroppedbelow1.0 in2016.Foranormalbusiness, thismay
signifythatCostcomaynotbeabletopayitsliabilitiesinfullinthenearterm.Costcohastheabilityto
operate efficiently with a low current ratio since it is consistent with their strategy of maintaining
relatively small number of SKU’s and focusing on inventory turnover.With high inventory turnover,
Costcoisabletosuppliersaftertheyhavesoldthemerchandise.
Activity
The stable activity ratios indicate Costco’s operational efficiency. Costco’s high inventory turnover
allows for them to utilize supplier’s capital in order to finance inventory rather than capital gained
fromshareholders.Highinventoryturnover,whichisareflectionofoperatingwithalimitednumberof
2013A 2014A 2015A 2016A 2017ALiquidityCurrentRatio 1.19 1.22 1.01 0.98 0.99
CashRatio 0.46 0.51 0.39 0.30 0.33
2013A 2014A 2015A 2016A 2017AFinancialLeverageLong-TermDebttoAssets 16.5% 15.4% 14.7% 12.3% 18.1%Long-termDebttoEquity 45.4% 40.7% 44.8% 32.9% 59.3%DebttoEquity 45.8% 40.8% 56.7% 41.9% 60.2%FinancialLeverage 2.80 2.68 3.15 2.75 3.37InterestCoverage 31.82 29.29 30.06 28.21 31.14CapitalExpenditureRatio 1.65 2.00 1.79 1.24 2.69
Source:Bloomberg
Source:Bloomberg
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14EQUITYRESEARCH–NYSE:COST
SKU’s allows Costco to operate at lower gross margins through economies of scale. A/R and A/P
Turnoverhasbeenverystrongsuggestingthatmanagementhasbeenveryefficientincollectingand
payingdebt.ThisallowsCostcotomaintainstrongrelationshipswithsuppliersinthelong-term.
ShareholderRatios
While the underlying business performedwell, one of the key reasons for growth in EPS originates
fromCostco’ssharebuybackprograms.Aswasdetailedearlier,Costcoiscurrentlyundergoingashare
buybackprogramof$4Bthatissettoexpirein2019.Costco’shasbeenknownfordeliveringvalueto
theirshareholdersthroughincreasingdividendsandspecialdividendpayments.Costco’schieffinancial
officerattributesthespecialdividendanddividendincreasestoCostcohaving“astrongbalancesheet
andfavorableaccesstocreditmarkets”.
Valuation
DiscountedCashFlow
In order to value Costco, we opted to use a scenario based discounted cash flow approach. As a
warehouse club model, we based future revenue growth on growth in the membership base,
membership rate andmerchandise sales growth. For these variables,we included a bear, best and
worst-casescenario.Inthebasecase,revenuegrowthamountedto5%withthebestandworstcases
amounting to 8% and 4% respectively. In addition to revenue growth,we also sensitized operating
margins onmerchandise sales and terminal EBITDAMultiple. In regard to the operatingmargin on
merchandise sales the amounts range from 0.8% to 1.8% in line with historical estimates which
2013A 2014A 2015A 2016A 2017AActivityAccountsRecievableTurnover 94.44 95.90 97.98 95.90 96.14InventoryTurnover 12.27 12.04 11.64 11.51 11.90AccoutsPayableTurnover 12.22 12.10 11.60 12.39 13.09
CashConversion 3.75 3.94 3.61 6.03 6.70TotalAssetTurnover 3.40 3.34 3.40 3.50 3.47FixedAssetTurnover 7.41 7.43 7.38 6.81 6.95
2013A 2014A 2015A 2016A 2017AShareholderRatiosEPSpershare $1.40 $1.58 $1.73 $1.77 $2.09DividendPayout 17.46% 2.84% 12.05% 3.17% 14.57%
Source:Bloomberg
Source:Bloomberg
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15EQUITYRESEARCH–NYSE:COST
culminatedinEBITDAmarginsof2.9%-3.9%.Withrespecttotheterminalvalue,weoptedtousean
exitmultipleduetothefactthatitislesssensitivethanaperpetuityandthecompanyhashistorically
tradedwithin awell-defined rangeof 12X-15XEBITDA thereforewe canbe reasonably confident in
usingthesemultiplesinouranalysis. Inthebasecaseamultipleof13.75isused,withthedownside
andupsideamountingto12Xand14.5Xrespectively.Discountingthesevariablesatadiscountrateof
8%ascalculatedbyBloombergresultsinanimpliedpricepershareof$140inthebasecase,$218in
thebestcase,and$106intheworstcase.Fromtherewetookaweightedaveragepricepershareand
weightedthebasecase60%,bestcase25%andworstcase15%whichculminatedinanimpliedprice
pershareof$155,a10%discounttothecurrentstockprice.
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16EQUITYRESEARCH–NYSE:COST
RelativeValuationTherelativevalutationmodelreturnedanimpliedsharepriceof$119.86usingsimilarcompaniesthat
Costco’smanagementusedintheirpeergroupforexecutivecompensation.Thispeergroupconsisted
ofWal-MartStores,PriceSmartIncorporated,TargetCorporation,KrogerCompanyandLowe’s.These
companies were chosen as they operate in the global retail industry with the bulk of their profits
drivenfromtheCanadianandAmericanmarketwiththeexceptionofPriceSmartIncorporated.Price
SmartwaschosenastheyarethelargestoperatorofmembershipwarehousesinCentralAmericaand
theCarribean.Theproductmixforthesecompaniesarerelativelyhomogeneousinthatoneproduct
maybepurchasedatanyoneofthesecompanies.Themutliplesusedintherelativevaluationmodel
are justas importantas thechosenpeergroup.TheP/Emultiple is crucialas itgenerally takes into
accountpastperformanceandfuturegrowth.With increasingcompetition intheretail industry, it is
importanttorealizehowexpensiveorcheapthestockisincomparisontotheindustry.EV/EBITDAis
alsoextremelyimportantincompanieswithinthesameindustry.Thismultiplegivesinvestorsagood
ideaastohowprofitableabusiness inregardless if theyhavedifferentcapitalstructures. Iavoided
usingtheP/BmultipleasCostcoorretailersingeneralarenotverycapitalintensive.Whiletherelative
valuationimpliesthatCostcoisovervaluted,onemustnotethatwhencomparingCostcotoPricesmart
SPROTTSTUDENTINVESTMENTFUND
17EQUITYRESEARCH–NYSE:COST
Inc, the only other warehouse club included in the peer group that they are trading on par with
eachotherwiththerestfothegrouptrasingatadiscount.Thisislikelyduetothefactthatwarehouse
companies are much more attractive and have the benefit of an economic moat whereas other
retailers havemuch less insulation from competition. Therefore, on a relative basis Costcomay be
fairlyvaluedinrelationtosimilarwarehouseclubs,withtheirpremiumoverotherretailersinthepeer
groupmaybedeserved.
InvestmentRecommendation
Buy,PriceTarget$155
InvestmentPositives
Strong Economic Moat – Costco’s steady return of loyal members has set it apart from retail
competitors.ProvidingqualityproductsatthelowestpriceallowsCostcotoconsistentlyincreasestore
trafficwhileretaininga90%membershiprenewalrate. Theirmembeshiostructurehasledtobrand
loyaltywhichtranslatesintoincreasedsame-storesales.
Shareholder Value - Costco is a shareholder-friendly business. Shareholders benefit from capital
allocation policies in that excess cash gets returned to shareholders in the form of dividends and
special dividends. Rather than investing capital into projects with low rates of return, shareholders
reapthebeneiftsofoperationalsuccess.
InternationalExpansion–Costco’soperatingincomeislargelydependentonmembershiprevenue.In
2013,Costcoimplementedaninternationalexpansionplanwhichhasincreasedcustomerreach.With
recentwarehouseopeningsinIcelandandFrance,CostcolookstomoveoperationsintotheEuropean
PriceMultiples EVMultipleName P/E EV/EBITDACostcoWholesaleCorp. 27.17 12.88Wal-MartStoresInc. 15.45 7.42PriceSmartInc. 27.4 12.99TargetCorp. 12.73 6.33KrogerCompany 15.58 7.8Lowe's 18.37 10.6
Mean 19.45 9.67COSTImpliedShareVal. 118.8 120.9Weight 50% 50%
WeightedPrice 119.86$CurrentPrice 172.61$OvervaluedBy 44%
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18EQUITYRESEARCH–NYSE:COST
market.TheincreaseindomesticandinternationaloperationswillallowCostcotocontinueexhibiting
growth.
InvestmentNegatives
Valuation–TheDCFandrelativevaluationdemonstratedthatCOSTisextremelyovervalued.WhileI
believethereisstilltremendousroomforfuturegrowth,itisdifficulttoarguewiththesciencebehind
thevaluationofacompany
E-Commerce Influence – E-commerce has positively impacted retail sales for many organizations.
Unfortunately for Costco, the shift in consumer spending does not cope well with their Business
Model.Bulkitemsareexpensivetoshipandalsocauselogisticalproblemsintermsofdelivery.
CatalystforRecommendationChangeThekeydriverbehindCostco’ssuccessistheirmembers.IfCostcomembershiprenewalratesbeginto
tapper off or decrese dramatically, the companywill need to be reevaluated. A study organized by
MorganStanleysuggeststhat50%ofCostcomembersalsohaveanAmazonPrimeMembership.Once
online sales and in-store sales begin to converge, Costco members may be more influenced to
purchaseaPrimemembershipoverCostco.However,consideringthecorporationspotentialforfuture
growthanddownsidesofpossiblerisks,webelievethepositivesofinvestingrightnowoutweightthe
negativesofinvestingandthatiswhyourfinalrecommendationisaBuy.
DisclaimerThisreportwaswrittenbyastudentcurrentlyenrolledinaprogramattheSprottSchoolofBusiness.
The purpose of this report is to demonstrate the investment analysis skills of Sprott students. The
analyst isnotaregistered investmentadvisor,brokeroranofficially licensedfinancialprofes-sional.
Theinvestmentopinioncontainedinthisreportdoesnotrepresentanofferorsolicitationtobuyor
sell any securities. This report is written solely for the consideration of this student managed
investmentfundandshouldnotbeusedbyindividualstomakepersonalinvestmentdecisions.Unless
otherwise noted, facts and figures included in this report are from publicly available sources. We
cannotguaranteethattheinformationinthisreportis100percentaccurate,althoughwebelieveitto
befromreliablesources.Informationcontainedinthisreportisonlybelievedtobeaccurateasofthe
day it was published, and it is subject to changewithout notice. It cannot be guaranteed that the
facultyorstudentsdonothaveaninvestmentpositioninthesecuritiesmentionedinthisreport.
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19EQUITYRESEARCH–NYSE:COST
AppendixAPro-formaFinancialStatements FigureA1:IncomeStatementFigureA2:CommonSizeIncomeStatement
2015 2016 2017 2018E 2019E 2020E 2021E 2022E CVRevenues 116,199 118,719 129,025 138,148 147,920 158,385 169,595 181,602 194,463Expenses:CostofGoodsSold/Production 99,544 101,187 109,998 117,245 125,538 134,420 143,934 154,124 165,039SellingandAdministrative 11,445 12,068 12,950 13,496 14,450 15,473 16,568 17,741 18,997OtherExpenses 459 537 596 540 579 619 663 710 761EBITDA 4,751 4,927 5,481 6,867 7,353 7,873 8,430 9,027 9,666
DepreciationExpense 1,127 1,255 1,370 1,341 1,436 1,537 1,646 1,763 1,888EBIT 3,624 3,672 4,111 5,526 5,917 6,335 6,784 7,264 7,779
InterestExpense -124 -133 -134 -157.766 -137.4 -128.685 -107.314 -77.8925 -77.8925EBT(BeforeOtherItems) 3,500 3,539 3,977 5,368 5,779 6,207 6,676 7,186 7,701Non-OperatingItems:OtherItems 104 80 62 - - - - - -EBT(AfterOtherItems) 3,604 3,619 4,039 5,368 5,779 6,207 6,676 7,186 7,701
IncomeTaxExpense 1,227 1,269 1,360 1,833 1,970 2,114 2,271 2,442 2,614NetIncome 2,377 2,350 2,679 3,535 3,809 4,093 4,406 4,745 5,087
CostcoWholesaleCorporationIncomeStatement-USDMillions
2015 2016 2017 2018E 2019E 2020E 2021E 2022E CV
Revenues 100% 100% 100% 100% 100% 100% 100% 100% 100%Expenses:
CostofGoodsSold/Production 86% 85% 85% 85% 85% 85% 85% 85% 85%
SellingandAdministrative 10% 10% 10% 10% 10% 10% 10% 10% 10%
OtherExpenses 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%
EBITDA 3% 3% 3% 4% 4% 4% 4% 4% 4%
DepreciationExpense 1% 1% 1% 1% 1% 1% 1% 1% 1%
EBIT 3% 3% 3% 4% 4% 4% 4% 4% 4%
InterestExpense 0% 0% 0% 0% 0% 0% 0% 0% 0%
EBT(BeforeOtherItems) 3% 3% 3% 4% 4% 4% 4% 4% 4%Non-OperatingItems:
OtherItems 0% 0% 0% 0% 0% 0% 0% 0% 0%
EBT(AfterOtherItems) 3% 3% 3% 4% 4% 4% 4% 4% 4%
IncomeTaxExpense 1% 1% 1% 1% 1% 1% 1% 1% 1%
NetIncome 2% 2% 2% 3% 3% 3% 3% 3% 3%
CostcoWholesaleCorporation
CommonSizeIncomeStatement
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FigureA3:BalanceSheet
2015 2016 2017 2018E 2019E 2020E 2021E 2022E CVAssets:CashandEquivalents 4,801 3,379 4,546 6,773 11,289 15,321 20,665 26,675 31,772AccountsRecievable 1,224 1,252 1,432 1,500 1,500 1,500 1,500 1,500 1,500Inventories 8,908 8,969 9,834 10,000 10,500 11,000 11,500 12,000 12,500OtherCurrentAssets 228 268 272 272 272 272 272 272 272Short-TermInvestments 1,618 1,350 1,233 1,227 1,220 1,214 1,207 1,201 1,195CurrentAssets 16,779 15,218 17,317 19,771 24,781 29,307 35,144 41,648 47,238
Property,PlantandEquipment(Net) 15,401 17,043 18,161 19,583 20,745 22,058 22,956 23,917 24,946OtherAssets 837 902 869 869 869 869 869 869 869TotalAssets 33,017 33,163 36,347 40,223 46,395 52,234 58,969 66,434 73,054
LiabilitiesAccountsPayable 9,011 7,612 9,608 9,488 10,159 10,878 11,648 12,472 13,355AccruedLiabilities 4,550 4,860 5,162 5,162 5,162 5,162 5,162 5,162 5,162Other 1,695 2,003 2,639 2,639 2,639 2,639 2,639 2,639 2,639CurrentLiabilities 15,256 14,475 17,409 17,289 17,960 18,679 19,449 20,273 21,156
Long-TermDebt 6135 5161 6659 6659 5461 4963 3969 2679 2679OtherLiabilities 783 1195 1200 1200 1200 1200 1200 1200 1200TotalLiabilities 22,174 20,831 25,268 25,148 24,621 24,842 24,618 24,152 25,035
Equity:CommonStock 2 2 4 4 4 4 4 4 4RetainedEarnings 6,518 7,686 5,988 9,523 13,332 17,425 21,831 26,576 31,662AccumulatedOCI -1121 -1099 -1014 -1014 -1014 -1014 -1014 -1014 -1014OtherEquity 5218 5490 5800 5800 5800 5800 5800 5800 5800TotalEquity 10,617 12,079 10,778 14,313 18,122 22,215 26,621 31,366 36,452
Non-ControllingInterest 226 253 301 336 371 406 441 476 511TotalLiabilitiesandEquity 33,017 33,163 36,347 39,797 43,114 47,463 51,680 55,994 61,999
BalanceSheet-USDMillionsCostcoWholesaleCorporation
SPROTTSTUDENTINVESTMENTFUND
21EQUITYRESEARCH–NYSE:COST
2015 2016 2017 2018E 2019E 2020E 2021E 2022E CVAssets:CashandEquivalents 15% 10% 13% 17% 24% 29% 35% 40% 43%AccountsRecievable 4% 4% 4% 4% 3% 3% 3% 2% 2%Inventories 27% 27% 27% 25% 23% 21% 20% 18% 17%OtherCurrentAssets 1% 1% 1% 1% 1% 1% 0% 0% 0%Short-TermInvestments 5% 4% 3% 3% 3% 2% 2% 2% 2%CurrentAssets 51% 46% 48% 49% 53% 56% 60% 63% 65%
0% 0% 0% 0% 0% 0% 0% 0%Property,PlantandEquipment(Net) 47% 51% 50% 49% 45% 42% 39% 36% 34%OtherAssets 3% 3% 2% 2% 2% 2% 1% 1% 1%TotalAssets 100% 100% 100% 100% 100% 100% 100% 100% 100%
LiabilitiesAccountsPayable 27% 23% 26% 24% 24% 23% 23% 22% 22%AccruedLiabilities 14% 15% 14% 13% 12% 11% 10% 9% 8%Other 5% 6% 7% 7% 6% 6% ` 5% 4%CurrentLiabilities 46% 44% 48% 43% 42% 39% 38% 36% 34%
Long-TermDebt 19% 16% 18% 17% 13% 10% 8% 5% 4%OtherLiabilities 2% 4% 3% 3% 3% 3% 2% 2% 2%TotalLiabilities 67% 63% 70% 63% 57% 52% 48% 43% 40%
Equity:CommonStock 0% 0% 0% 0% 0% 0% 0% 0% 0%RetainedEarnings 20% 23% 16% 24% 31% 37% 42% 47% 51%AccumulatedOCI -3% -3% -3% -3% -2% -2% -2% -2% -2%OtherEquity 16% 17% 16% 15% 13% 12% 11% 10% 9%TotalEquity 32% 36% 30% 36% 42% 47% 52% 56% 59%
Non-ControllingInterest 1% 1% 1% 1% 1% 1% 1% 1% 1%TotalLiabilitiesandEquity 100% 100% 100% 100% 100% 100% 100% 100% 100%
CostcoWholesaleCorporationCommonSizeBalanceSheet
FigureA4:CommonSizeBalanceSheet