Costco is the dominant warehouse club in the world, with 487 stores in the United States and six other countries.  For the year now ending (9/3/06) revenues will approach $59 billion with net income of almost $1.1 billion.  Costco has a highly loyal membership base and extremely productive stores, with sales per square foot in excess of $900.  The company has never had a down same-store comp month and only one year of down earnings since the merger of the two companies in Fiscal 1994.  Over the last 10 years, revenues have compounded at 12% and EPS at 14% annually.  Operating margins are below levels attained during the late 1990’s and well below management’s long-term target.  The company has an immaculate balance sheet with roughly $2.5 billion of net cash and owns 75% of its warehouses outright.

 

Management is very focused on the creation of long-term value and delighting its customers.  In fact, many analysts believe that employees and customers are unduly rewarded to the detriment of shareholders.  This report will argue that, to the contrary, management’s obsession with delivering the best possible value and concern for employee loyalty enables Costco, over time, to build a wider and wider competitive moat. Costco should be able to widen its operating margins over the next several years driven by several factors detailed below. Equally as important, management has started to repurchase stock aggressively over the last year or so.  Since initiating a buyback in the summer of 2005, the company has repurchased $1.69 billion through mid-July, when the Board authorized an additional $2 billion (for a total of $2.8 billion) program at an average price of around $50/share.  This report will show that Costco can continue at approximately that rate--repurchasing over between $6-7 billion more over the next 4 years (about a 16% reduction in FD shares), and still have no net debt at the end of Fiscal 2010.  The combination of slightly higher margins and a smaller share base drives earnings growth of 16% annually--more than 2X what I expect S&P earnings growth to be for a company that, net of cash, sells at a market multiple on forward earnings. We also will use a real estate valuation approach that perhaps even more clearly demonstrates why Costco represents a great long-term opportunity.

 

 

Sol Price (a fantastic name for a merchant) opened the first Price Club 30 years ago in San Diego.  In so doing, he launched a retailing category that now does well over $100 billion in yearly sales:  Membership only shopping, exceptionally low margins, limited hours, cash and carry, and a focus on small businesses.  In 1983, Jim Sinegal, a Price Club executive and now CEO, teamed up with Jeff Brotman, now Chairman, to begin Costco in Seattle, using much the same formula as Price.  That same year, following a dinner that Sam Walton had with Sol Price, Wal-Mart opened the first Sam’s Club in Oklahoma.  Two other competitors, BJ’s Wholesale, an offshoot of Zayre’s, and Pace Membership Warehouse, followed soon after.

 

Costco went public late in 1985.  Over the next few years, Costco grew more rapidly and consistently than Price Club.  As Sol Price told a Fortune reporter a few years ago, “We [Price Club] were good at innovating, but when it came to expanding and controlling, we weren’t so good.” By the early 1990’s, the economics of the sector began to deteriorate as all five competitors were expanding too rapidly in a fight for market share.  Consolidation  came in 1993:  Price Club and Costco merged and Sam’s Club bought some struggling Pace units from K-Mart, which had bought Pace along the way.  Over the next several years Pace would close down and Wal-Mart acquired many of its units.

 

Returns quickly improved as the number of players was reduced from five to three.  Costco expanded largely on the two coasts and in Canada and Sam’s in the middle of the country.  By the end of the 1990’s, though, Costco became more aggressive--both sharply increasing its number of new stores and also entering traditional Sam’s markets such as Chicago and Atlanta.  Although this strategy produced somewhat reduced margins, it was a very important strategic initiative.  While the new markets take longer to reach maturation in profitability, they are uniformly successful--to the surprise of many analysts who believed that more direct competition with Sam’s would be suicidal--and will produce a much longer period of profitable gowth for the company.

 

Costco has 487 locations:  358 in the US and Puerto Rico, 68 in Canada, 18 in the United Kingdom, 5 in Korea, 5 in Japan, 4 in Taiwan, and 29 in Mexico (these are part of a JV and unconsolidated in the financials).  The average warehouse is 140,000 square feet and produces annual sales of roughly $130MM.  There are over 47MM cardholders and renewal rates run at 86%/year overall and over 90% for business members.  In May Costco raised the US membership fee for individuals and businesses to $50/year.  Historically, Costco has raised its fees every four years or so.  Since 2000, Costco has offered an Executive Membership card with a fee of $100 with a number of extra benefits, the most compelling of which is a 2% year-end rebate capped at $500 on most purchases (excluding tobacco, gas, food courts, and alcohol in most states).  Executive Members now represent 20% of the base and roughly 50% of all purchases, which cumulatively has produced an 80 basis point drag on gross margins:  Very meaningful as operating margins are now under 3%. This program has been an important contributor to the margin compression in recent years, but clearly has been a valuable investment for the company in terms of sales growth and membership loyalty.

 

Stores typically carry about 4000 SKUs, or less than 10% of the number handled by a typical supermarket or discount store.  Costco typically carries only one name brand product per category, giving it tremendous bargaining power with vendors (imagine the discussions with Duracell each year when both parties know that Energizer would kill for the business).  Over time, more and more vendors are willing to sell directly to Costco:  Recent examples include OshKosh, Sony, DeWalt, Henckels, and Fila.  Costco also has a very meaningful private label business (Kirkland Signature--now over 15% of sales and headed to 20%+ over the next five years), which further expands its leverage with manufacturers, bolsters gross margins, and adds to its customers’ savings (the goal is at least a 20% savings for comparable quality).  Gatorade, for instance, sells at Costco for $14.99/case while the Kirkland sports drink is $9.99.  Inventory turns 12X annually and over 85% of the inventory investment is covered by merchandise payables.  Other than fixed assets, Costco requires minimal capital.

 

Management fervently believes that underlying key to corporate success is what they refer to as,”Absolute pricing authority.”  What this means in practice is that, no matter how attractive a deal a buyer is able to negotiate,  marking an item up more than 14% requires a signoff from CEO Jim Sinegal.  Customers might be able to get an individual item for less at another store (although pricing surveys show that this seldom occurs), but can walk through the store knowing that anything they buy is an excellent price.  Adding to the customer experience is the treasure hunt atmosphere:  Exceptional deals that are in warehouses for a limited time period to encourage impulse buying and frequent store visits.

 

Costco pays employees very well by retail standards:  The average hourly wage is $17. Over 85% of employees are eligible for company benefits and, while the company made health benefits slightly less favorable about 3 years ago, they are still extremely attractive.

As a result, turnover is very low:  20% overall and only 6% after one year with the company. Executive cash compensation is extraordinarily low by current standards:  No employee had current income over $600,000 last year.  Option grants have ranged between 8-10MM shares in recent years, or roughly 2% of shares outstanding.  Over 2000 employees received options and executives named in the proxy garnered just 6% of the total awards.

 

Almost every Costco statistic is mind-boggling.   To cite a few:   25 warehouses have annual sales over $200MM and one does over $300MM.  Last year the company sold 27MM rotisserie chickens in the US,  $3 billion in gasoline, 2MM pairs of prescription glasses, and processed over 1 billion photo prints at its one-hour photo centers. 

 

 

Food             31%

Sundries       29

Hardlines      16

Softlines       12

Other             12

Last week management preannounced disappointing 4th quarter (8/31) earnings, due mostly to furniture markdowns and a combination of softer sales and higher returns in high-end consumer electronics.  Note that Costco has an extremely generous--very arguably too generous--return policy:  Except for computers, customers can bring back purchases at any time.  On the conference call management noted that SG&A is under good control and comps actually picked up in August to 7%.  It is clear throughout retailing that high gas prices and somewhat diminished consumer confidence are having an impact on spending.  The recent shortfall should not prove to be more than a bump in the road and creates an opportunity.

 

Management plans on ramping up the new store opening schedule in Fiscal 2007 and beyond:  Over the last four years the new store average has been slightly more than 20/year (26 net new stores in the year just ended).  For the new fiscal year, openings should accelerate to the low-mid 30’s and should stay in that range for several years.  Longer term, management has suggested that Costco can double its store base.  As CFO Richard Galanti stated on a recent conference call, “What we constantly surprise ourselves with is how many more you can add to an existing market.”  For example, Costco plans to open another 3-4 warehouses in its home Puget Sound market, where over 60% of households are already members, over the next 2 years.  New stores continue to open very successfully in stronghold markets like LA (42 stores now--ultimate potential for 10 or 15 more) and Phoenix.  The international potential is also very meaningful.  Japan, for instance, turned profitable last year ahead of schedule and clearly can support more units.  Over the next couple of years we would expect Costco to enter a new country--most likely Australia or China.

 

New warehouses in existing markets are targeted to achieve a fully allocated 15% cash on cash ROI within 3 years while those in new markets are allowed 5 years.  Typically infill stores have first year sales of $70-80MM net of the cannibalization impact on adjacent warehouses, which averages under a year.  With fixtures and equipment, new warehouses require a capital investment averaging $28MM.  Costco seeks wherever possible to own both the land and buildings.  Other capital spending runs about $250MM annually for depots, remodels, IT, and pure maintenance.

 

While the Costco mantra is to pass on savings and efficiencies to their customers, management has committed itself to margin improvement going forward.  CFO Galanti stated on a recent call, “Our mission is to lower prices and improve margins a little bit” and Jim Sinegal reaffirmed this on the call last week.  A number of factors argue more modest margin improvement over the next few years:  SGA leverage that is starting to take hold, less impact from the Executive Membership 2% rebate, further maturation of the non-Canadian international business which currently has much lower margins, more private label penetration, less impact from gasoline, and the recent membership fee increase which will flow through over the next few quarters.  On the other hand, the more aggressive store opening schedule will act as an offset.

 

The model below assumes 30 basis points of operating margin improvement over the next 4 years and 6% comp sales growth.  It further assumes that Costco uses its current net cash position (about $2.35 billion) and all free cash generation through 2010 to repurchase stock--or not quite $6 billion.  Note that Costco has been repurchasing stock at this rate since last summer ($1.69 billion as of mid-July) and would still have a superb balance sheet.  Given these assumptions, EPS growth would be 15% annually using F06 as a base.

 

 

                                                                                                               

 

                2006       2007       2008       2009       2010                      

                                                                                                               

Sales     57800    63580    69940    77360    86170                   

Fees       1195       1345       1505       1680       1870                      

                                                                                                               

Revenue                58995    64925    71445    79310    88040                   

                                                                                                               

Op. Man.                0.028      0.0288   0.0295   0.0302   0.031                     

Op. Inc.  1618       1831       2063       2344       2671                      

                                                                                                               

Int. (Net) 130         95           60           30           0                             

                                                                                                               

P-T Inc.  1748       1926       2123       2374       2671                      

                                                                                                               

Tax Rate                0.375      0.375      0.375      0.0375   0.0375                  

                                                                                                               

Net Inc.  1093       1204       1327       1484       1669                      

                                                                                                               

FD Shrs.                480         456         441         429         419                        

                                                                                                               

EPS        2.27        2.64        3.01        3.46        3.98       

 

If Costco can produce growth along these lines, we believe the total return should easily exceed 15% (a $70+ stock, or 17.5X forward earnings, in three years).               

 

We also examined Costco more in real estate terms.  Given the high percentage of owned property,  the fact that membership fees account for over half of EBITDA, and the remarkably steady comp growth this seems like a reasonable exercise. Net cash flow (subtracting about $250MM in maintenance CapX) in the year just underway should approximate $3.25/share, or a 7.3% cap rate on a stock of $44 (subtracting net cash).  This seems to us like modest undervaluation compared to high-quality real estate and a 10-year yield under 5%., Even more importantly, though, it gives Costco no credit at all for the substantial future value of opening new warehouses.  In F07, for example, Costco should open about 35 stores.  Looking out five years, these stores should produce net income of about $85MM.  And, of course, this should be able to continue for many years to come as Costco is clearly far from saturating the US and Canada, let alone international markets.  All in all, we believe fair value for the stock is in the high $50s or low $60s.  We think management and the Board (Charlie Munger has been a Director for almost 10 years) sees what we see and is buying back stock aggressively in response.

 

We think the only significant risk is a serious consumer recession where comps decline to the very low single digits and earnings probably go down slightly in one year.