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Discount stores are geared toward a specific demographic, and this includes mostly lower-to-middle income consumers. Demand in this industry depends on the spending pattern of consumers and the population growth in areas where these discount stores are located. The overall profitability of discount stores is dependent on their ability to maintain competitive prices, sufficiently locate stores, efficient supply chain management, and reduce costs. Costco Wholesale Corporation (NASDAQ:COST) is one such discount store that is benefiting from its competitive prices while reducing its cost through efficient management of resources.

Company Introduction

Costco is a membership based merchandise club. The company is dedicated to providing its members with quality brands at the best possible prices in the US and Puerto Rico, Canada, the United Kingdom, Mexico, Japan, Australia, and through majority-owned subsidiaries in Taiwan and Korea. The company's membership warehouses are based on the concept of offering its members low prices on branded and private-label products in a wide range of merchandise categories which will eventually increase sales volume and inventory turnover.

Financial Performance

The most important driver of increasing the company's profitability is sales growth, particularly comparable sales growth. The company has achieves sales growth by opening new warehouses and relocating existing warehouses to larger and better-located facilities.

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The company revenues grew at a CAGR of 11.55% over the last five years. Revenues increased by 11.5% to $99.06 billion primarily due to an increase of 7% in comparable sales. The growth in revenue was also the result of an increase in the membership fees by 11.1%, due to new member sign-ups at warehouses open for more than one year, the impact of raising its annual membership fees and increased penetration of its higher-fee Executive Membership program. Operating and net margins also improved on the back of an improvement in warehouse operating costs, largely in payroll.

Management Efficiency

Management efficiency is the key to maximizing return while using the minimum resources. To analyze Costco's management efficiency, I have picked up three ratios as shown below:

Inventory turnover is a reflection of holding costs - the cost of storing inventory. A low inventory turnover reflects a high holding cost. In plain English, the inventory turnover ratio tells us how many times the inventory sold through. So, the company's higher inventory turnover indicates that it was able to sell its inventory more quickly, compared to the industry. Receivables turnover ratio measures a company's efficiency in collecting its sales on credit and collection policies. The higher receivable turnover ratio implies that the company is able to make sales and collect payments from its customers in a more quick and swift manner, compared to industry. This puts the company in a better position as it has to lock up cash for a relatively smaller period of time. Similarly, the company's higher asset turnover indicates that the company is able to generate higher sales by utilizing its assets, compared to the industry.

DuPont Analysis

Another important tool for analyzing management efficiency is Return on equity. In order to analyze ROE and its drivers, I have used a three-step DuPont model.

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The above graph shows the breakup of the company's ROE in three steps. Overall, the company's ROE has taken on an upward trend, increasing to 14.03% in 2012 from 11.30% in 2009, on the back of higher net margins and asset turnover. As you can see that a major portion of this ROE growth has been contributed by the asset turnover, which rose to 3.68 times in 2012 from 3.35 times in 2009, representing an increase of approximately 10%. The company has maintained its leverage ratio at 2.2 times, which also indicates strength of the company. To sum up, the management of Costco is efficaciously utilizing its resources to maximize returns.

Dividends and share buyback

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The company has a strong history of returning value to its shareholders in form of dividends and share buybacks. Over the last four years, the company has paid out cash dividends of $1.47 billion and repurchased stock worth $1.89 billion. The company has consistently increased its dividends at a CAGR of 15%. Higher dividends indicate the company's confidence in its future cash flows.

Valuation

Valuation of the company is important to evaluate the potential return that a particular stock can give. For the valuation of Costco, I have applied the free cash flow to the firm model. In this model, I have made a few assumptions for future growth and cost of capital.

The above table shows the calculation of Weighted Average Cost of Capital (OTC:WACC). In order to compute WACC, cost of equity and cost of debt are required. For the calculation of cost of equity, I have taken a market return of 12.28% (the average return of S&P 500 in the post financial crisis period) and a risk free rate of 2.71% (10 year Treasury bond yield). The beta of the company is 0.52. Applying the formula of CAPM gives a cost of equity of 7.71% for the company. Similarly, the after tax cost of debt is calculated to be 2.95%. Using these costs and given weights, a WACC of 7.58% has been derived using the formula of WACC.

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The above table shows the calculations of the free cash flow to firm model. The operating cash flows and Capex are assumed to grow at the five year historical average of 9.42% and 8.79%, respectively. Further, the long term growth rate is assumed to be 3%. Using these assumptions, I have employed a two stage free cash flow model that uses the historical average growth in the first stage (five years) and the long term growth rate in the second stage (terminal growth). Applying the free cash flow model, I have derived a target price of $124.89 per share, which indicates an upside potential of 8.22%.

Sensitivity Analysis

As you know that the free cash flow model is based on a number of assumptions, a sensitivity analysis has been conducted to gain a better understanding of the impact of any variations in the assumptions of long term growth rate and WACC.

The sensitivity analysis suggests that in the best case scenario where WACC decreases to 5.58% and long term growth increases to 3.2%, the company presents an upside potential of 96.08%. Similarly, in the worst case scenario, where WACC increases to 9.58% and long term growth decreases to 2.80%, the company will offer a downward potential of 25.92%.

Conclusion

Demand for discount stores seems to be optimistic on the back of better pace of recovery and has thus infused hopes of a better economic scenario in the second half of the year and beyond. Moreover, Costco's expansion in the Japanese and Korean markets is expected to provide a huge growth opportunity, as most of the population in the Asia Pacific region falls under the lower and upper middle class.

The company has performed well during the recessionary phase on the back of its efficient management of resources. Moreover, the company also seems undervalued on the basis of free cash flow based valuation. Hence, I believe that the investors should consider investing in this stock.

Source: Is Costco Trading At A Discount To Its Intrinsic Value?