Valuation and analysis

Valuation and analysis

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Executive Summary

The global recession has created attractive investment opportunities in the stock market. Based on the past ten post-WWII recessions, Standard & Poor's 500-stock index has gone up, on average, 32% one year after the market hits bottom during an economic downturn.[i] Given this statistic, investors may be inclined to purchase stocks without adequate knowledge. While opportunities exist, it is important to analyze companies and value their shares to help select undervalued stocks. The residual income model, or RIM, is particularly useful since it offers a practical way to evaluate companies in any economic environment.[ii]

The following is a comprehensive valuation of Costco Wholesale Corporation, using the RIM framework. Based on the analysis that follows, the resulting recommendation is to short the Costco stock since it is significantly overvalued.

Industry Overview

Costco is classified as a Warehouse Club and Superstore, and therefore competes in the industry with other retailers such as Sam's Club, BJ's Wholesale, and Meijer. This industry is highly competitive and dominated by a few large companies (including Costco) that control some 90% of the market in the U.S. Annual industry revenues in 2008 were estimated at over $350 billion; a market that has seen sales increase by 35% over the last decade.[iii] Demand in this industry is driven primarily by demographics and increases in small businesses, and is significantly impacted by fluctuating commodity prices, foreign exchange rates, and consumer spending trends (see Exhibit 1: PEST Analysis). Large chains tend to dominate the market as they can take advantage of greater purchasing power, sophisticated distribution channels, and favourable financing terms. Profitability is dependent on a high volume of sales, low cost purchasing, and efficient distribution which is achieved by offering a low number of stock keeping units (or SKUs) per warehouse, meaning that the companies limit the number of products offered, yet offer a wider range of merchandise categories, most of which are sold in large sizes or bulk.

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This industry is notorious for its low gross margins due to the intense competition for low costs, which is sustainable due to high volume purchasing and inventory turnover. Warehouse clubs offer a no-frills, self-serve shopping experience across product categories such as food, mass merchandise, pharmacy, and electronics. A critical aspect of the business model is the membership fees and renewal rates; the principal differentiating factor between warehouse clubs and superstores.

An evaluation of the industry (see Exhibit 2: Porter's Five Forces) identifies competitive rivalry and availability of substitutes as the two main threats to key players. The number of direct and indirect competitors for the sale of food and consumer goods, including supermarkets, department stores, and the advent of the superstore, make this industry highly susceptible to substitutes as low pricing is the key success factor in the industry. The threat of new entry is medium given that there are relatively few barriers to entry; however the ability to provide low prices is contingent on economies of scale and favours larger, established companies. While buyers have no bargaining power, buyer power is medium/low due to low switching costs to other retailers. Finally, supplier power is low due to the low number of SKUs offered in-store and the ease with which retailers can replace items with competing products.

Company Overview

Costco Wholesale Corporation pioneered the membership warehouse concept in 1993, and has since grown its business to over $70 billion in revenues. The company operates 559 warehouses in 8 countries (though 70% of warehouses are located in the US) and employs over 142,000 people. It offers a wide variety of products in-store and online (costco.com in the US and costco.ca in Canada), including groceries, electronics, appliances, automotive supplies, jewelry, and office equipment. In addition, Costco offers services such as insurance, financing, optical centres, pharmacies, and self-serve gas stations.

Costco boasts the highest membership renewal rate in the industry at 87% which represented 2.19% of net sales for FY2009, demonstrating member satisfaction with the cost/benefit of their membership dollars.

Costco's strategy is based on offering a limited selection of the best selling national brands as well as their own private label products (under the brand name "Kirkland Signatures") to produce high sales volumes and rapid inventory turn-over. To maximize distribution efficiencies and lower receiving costs, Costco purchases merchandise directly from manufacturers and has containers delivered at one of its 16 cross-docking facilities that distribute products directly to its warehouses, where the goods are sold directly off the shipping skids. The company's average sales per warehouse is the highest in the industry at $135M, more than twice that of its closest competitors (see Exhibit 3: Key Performance Metrics). In addition, Costco's inventory turn-over rate for 2009 was 11.9%, one of the highest in the industry, demonstrating that the company's strategy is producing the desired results. However, Costco's gross margins are among the lowest among its competitors at only 2.5% of net sales for FY 2009, signifying that company performance is highly dependent on sales volume, and also highlights the importance of controlling SG&A costs.

Costco has taken on a number of strategic initiatives, including its expansion into the Asian market with store openings in Korea, Taiwan, and Japan; as well as its first warehouse opening in Australia. In addition, the company invested in additional services for real-time scan and inventory data from over 70 Costco warehouses across Canada to provide market intelligence and "real-time" consumer spending data in an effort to improve customer trending capabilities. Finally, the company's aggressive stock repurchasing program has seen it buy back nearly 17% of outstanding shares worth approximately $57M.

Financial Analysis

Key Considerations

Costco is positioned to excel in the wholesale club retail industry as the market recovers from this latest recession as it attracts a more affluent clientele than discount stores like Wal-Mart or Target. Around 24% of Costco's customers have incomes over $100K.[iv] The more affluent clientele tend to be at the forefront of consumer spending in a recovering economy.

Management has indicated that Costco's long-term gross margin target is 3.5%, up from the current FY2009 margin of 2.5%. Margins are expected to improve thanks in part to the planned expansion of its private label brand, "Kirkland Signature", which was launched in 1995. This will provide the company with greater control over its supply chain, sourcing costs and product quality and inventory. At a recent analyst / investor meeting held at the company's new club opening in Manhattan this past November, management announced its intentions to grow its private label brand from the current level of just under 20% of overall merchandise assortment to over 30% by 2012. Private label brands are growing in popularity in today's economy, particularly among price-conscious consumers. This demand for private label products is forecasted to continue growing, as these products are increasingly comparable in quality to popular brand names, and offer an attractive 'value for money' characteristic.[v] As private labels capture market share from national brands, the latter may be forced to pass along more savings to the consumer, which will lead to further improvements in margins for Costco. Costco will also continue to achieve efficiencies in product packaging, further reducing its costs and contributing to its long-term gross margin goal.

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New store openings are expected to accelerate in new and existing markets from the trough level of only 15 stores in fiscal 2009. Costco opened its first store in Australia in August of this year, penetrating a new, attractive market with growth potential in the vicinity of 20 stores. The company is planning 15-20 new clubs in fiscal 2010, 20 new openings in both 2011 and 2012, and more than 25 per year in 2013 and 2014. Management has indicated its desire to reach 30 new openings per year (as it had reached in fiscal 2007) in the long-run, and has plans to operate as many as 100 warehouse clubs across its three Asian countries (Japan, Korea, and Taiwan) versus the 22 clubs it presently operates. As Costco continues to grow, it stands to gain more control over its suppliers thanks to its growing volume of sales.

Costco currently uses the LIFO accounting method in reporting its U.S. inventories, which leads to higher recognized costs of sales and reduces taxable income. The International Financial Reporting Standards (IFRS), scheduled to be adopted by U.S. firms starting in 2014, explicitly disallows the use of LIFO due to its potential to skew inventory values. [vi] The adoption of IFRS in the States could result in companies incurring a potentially staggering cost upon the change to FIFO.[vii] Preliminary estimates indicate that losses from tax savings for all US companies making the switch to FIFO, at an estimated $106 billion over a 10 year period.[viii]

The adoption of IFRS will not be mandatory until 2014. Yet beyond the loss of tax benefits, IFRS rules also impact rules governing leases, impairment approaches, long-lived and indefinite assets, and property, plant and equipment.

On-line retail spending in the U.S. was $128.1 billion in 2007 and is expected to reach $214.8 billion by 2012, at a compounded annual growth rate of 10.9% for the period 2007-2012.[ix] Costco management has targeted to grow its on-line business to $5 billion in the next few years from its current $2 billion level in FY2009. Online sales provide operating cost benefits to Costco by reducing store inventory cost.

The competitive landscape is also forecasted to change, as rivalry among competitors' intensifies. Wal-Mart recently announced its intentions to cut back on prices and expand its food merchandise in its Sam's Clubs, boldly stating its strategy to steal customers from rivals like Costco by focusing on fewer but bigger initiatives.[x] The impact on Costco's revenues could be significant.

RIM Inputs

Costco's Cost of Equity

The cost of equity for Costco was calculated using the Capital Asset Pricing Model (CAPM) equation. As recommended by Grabowski, we applied the average long-term 20-year T-bond yield of 4.20% as the risk free rate and 6.0% as the equity risk premium given the current market conditions.[xi]

Costco's 60-month historical beta based on the company's capital structure and covariance of stock returns with the S&P index is listed as 0.78.[xii] We verified the beta for estimation error and leverage adjustment by estimating unlevered betas for a group of firms in the same business (see Exhibit 4: Costco Cost of Equity). We averaged the unlevered betas and then re-levered the beta for Costco using the average industry-wide debt/equity ratio. This resulted in a beta of 0.87. Given these inputs, we can calculate the cost of equity for Costco, which is estimated to be

EPS Forecasts

We used average analyst forecasts of EPS over the next five years. In the near term (for 2010 and 2011), we used the average of over 20 analyst forecasts (see Exhibit 5) as reported on NASDAQ. These were found to be $2.89 and $3.22, respectively. According to Bradshaw, a five-year horizon corresponds to the horizon of long-term earnings growth forecasts.[xiii] The average long-term earnings growth forecast of 12.73%[xiv], based on over 12 analyst predictions, was therefore used to forecast EPS for 2012, 2013 and 2014.

Dividend Payout

Costco's 10-K report indicates that profitability and expected capital needs are the two key factors that determine the dividend payout. Historical data was subsequently analyzed to determine the payout ratio going forward (See Exhibit 5: Dividend Payout).

Costco began paying dividends in 2004. The growth trend in dividends, EPS and capital expenditures from 2004 through to 2009 were reviewed. Despite a negative earnings growth and a negative growth in capital expenditures in 2009, Costco increased its dividend payout to 27.3% from 20.7% in 2008. While the decision to increase the dividend payout in 2009 runs contrary to the stated payout determining factors, it signals managements' belief in Costco's future earnings potential.

Given the inconsistencies in Costco's dividend policy, we will assume that Costco will continue its most recent dividend payout of 27.3%. The assumption that firms will continue their recent dividend payout policies is consistent with prior research.[xv]

RIM

Costco's stock price on November 27th, 2009 was $60.03. The per share book value, as reported in the 10-K as of August 30th, 2009 is $22.98. Using the RIM inputs, we begin by determining the value of the stock that can be explained by the book value and the present value of the residual income for the next five years. As illustrated in Exhibit 6: RIM, only 45% of the current stock price, or $27.02, can be attributed from the book value and the first 5 years of RI. Therefore, at least 55%, or $33.01, would need to be derived from the present value of the continuing value in order to justify the current stock price.

Continuing Value Scenarios

The return on common shareholders' equity, or ROCE, is growing over the five year period and remains 3 to 4.5% above Costco's estimated cost of equity of 9.4%. Since ROCE is a key statistic used to forecast RI[xvi], we can assume that RI will continue to grow for some time or at best will remain constant after the five year period.

The following four scenarios were used in determining Costco's continuing value:

1. Constant growth of RI after 2014: Assuming that the estimated RI of $1.51/share in 2014 continues in perpetuity;
2. Growing RI after 2014: A growth rate of 5% to perpetuity was applied based on gross margin improvements and the potential of penetrating existing and new markets;
3. Fading RI after 2014: A fade rate of 0.80 is assumed, which falls at the high end of the industry-specific range[xvii] due to the maturity of the industry;
4. RI growing for 5 years, then fading: A growth rate of 5% for five years based on the reasons mentioned above, followed by a fade rate of 0.68 (average estimate consistent with empirical evidence that shows that the return on equity reverts to the cost of capital over approximately 10 years[xviii]).

Based on our analysis of the industry and company, the most optimistic case for Costco would be to maintain a constant RI. A more realistic case would be the growing and fading RI scenario. As illustrated in the above table, neither scenario justifies the November 27th stock price of $60.03.

We also ran a sensitivity analysis to determine the impact of a change in the cost of equity on the valuations. The third column of the above table displays the varying stock prices for each scenario based on a cost of equity of 8.6%, which is calculated using the CAPM equation with a 5% equity risk premium rather than the more conservative 6%. As we can see, the current stock price still cannot be explained, with both selected scenarios estimating that the stock is currently trading at 30-50% over value.

Reverse Engineering

We reverse-engineered RIM to determine the residual income growth rate after 2014 that would justify a stock price of $60.03 (See Exhibit 7: Reverse Engineering). The implied residual growth rate for Costco to be trading at this price is 6.3%. This is a highly unlikely scenario given that Costco is in a highly competitive industry, and academic research has shown that only a very small percentage of public companies can expect to grow RI indefinitely.[xix]

Recommendation

Based on our analysis, we recommend shorting the Costco stock. According to our RIM analysis, the stock should be trading around $32 to $42.

1. Bickers, Amy, "Stocks to Buy Before the Recovery", Kiplinger Personal Finance (August, 2008). http://www.kiplinger.com/magazine/archives/2008/08/stocks_to_buy_now.html
2. Thornton, Daniel B., "Rim Fundamentals: An Introduction to the Residual Income Model for Valuing Companies' Stocks", Queen's School of Business (September, 2009)
3. Industry Overview: Warehouse Clubs and Superstores, Hoovers (accessed December 4, 2009) http://www.hoovers.com/warehouse-clubs-and-superstores/--ID_316--/free
4. Strasser, David, "Highlighting a Long-Term Story", Janney Capital Markets (November 12, 2009)
5. Palmer, Alex, "Private Labe Growing Rapidly", Brandweek (Sept 22, 2009) http://www.brandweek.com/bw/content_display/news-and-features/packaged-goods/e3i7c69fb437bbee15e35345c87bdf679fe
6. "International Financial Reporting Standards: Considerations for the Retail Industry", Deloitte
7. Must LIFO Go to Make Way for IFRS? Accounting Methods&Periods. Hoffman, Michael. McKenzie, Karen
8. Ibid.
9. Costco Wholesale Corporation. Datamonitor (March 18, 2009)
10. D'Innocenzio, Anna, "Sam's Club Plans to Cut Prices, Offer more Essentials", The Ledger (October 23, 2009)
11. Grabowski, Roger J., "Cost of Capital Estimation in the Current Distressed Environment", The Journal of Applied Research in Accounting and Finance. Volume 4, Issue 1 (2009)
12. Capital IQ
13. Bradshaw, Mark T., "How do Analysts Use Their Earnings Forecasts in Generating Stock Recommendations?", The Accounting Review. Volume 79, No.1 (2004)
14. Capital IQ
15. Ibid.
16. Supra note 2
17. Supra note 11
18. Supra note 11
19. Supra Note 2