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The time has come for the retail sector to ready itself for the holiday season. Many analysts expect that the government shutdown could have negative consequences on consumer spending and the revenues of the retail sector. However, a recent survey suggests that the shutdown will not affect more than two-thirds of U.S. consumer spending. Therefore, the retail sector can expect slightly brighter holiday sales which should account for 20 to 40 percent of a retailer's annual sales.

The predictions and expectations will largely benefit the Costco Wholesale Corporation (COST). Since the company offers discounted prices to its customers the store will attract many customers affected by the shutdown.

I will analyze the company's financial strength based on its historical performance and future outlook.

Company Profile

Costco is the leading retail wholesaler in the USA. Besides the USA, Costco has warehouses in Puerto Rico, Canada, Australia, Mexico, the United Kingdom, Japan, Taiwan and Korea. More than 70% of its operations are in the USA.

The company is aggressively expanding its operations. Since 2008, it has opened 96 new warehouses. In 2012, Costco purchased 100% interest in its 32 warehouses in Mexico from its joint venture partner. Previously Costco only held a 50% share. By the end of 2013, the company is expected to open 14 new warehouses. The expected square footage growth is 4.5% in comparison to last year's 3% growth.

Revenues

Costco's revenues have shown a positive year over year growth over the last six quarters due to the increased net sales and higher membership fees. In the last three reported quarters the year over year growth plunged but still remained positive. The company creates loyal customers by offering memberships that allow customers access to products at discounted prices.

Membership fee revenue increased by 12% in the third quarter of FY2013 and 14% in the first thirty six weeks of FY13 compared to the same periods of the previous year. This was a result of the raising of annual membership fees, new membership sign-ups, and higher membership renewal rates at warehouses open for more than one year. The membership renewal rate of the company increased slightly in the last reported quarter and reached 89.9% in U.S. and around 86.4% on a worldwide basis.

In addition, the year over year net sales increased by 8% in both the third quarter and the first thirty six weeks of FY13 due to an increase in the comparable warehouse sales and sales at 25 new warehouses opened since the end of the third quarter of FY12. Comparable sales in the third quarter increased by 5% in FY13 and increased by 6 % in the first thirty six weeks of FY13 due to a higher frequency of shoppers.

The sales in the third quarter were negatively impacted primarily due to the change in the Japanese yen and Canadian dollar as well as the gasoline price deflation. Average sales price gallon of gasoline declined by 5%.

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Source: Company's Financials

The revenues in the fourth quarter of FY12 increased due to an additional week in the quarter. The first three reporting quarters each consist of three periods while the fourth quarter consists of four periods. The increase in 2Q13 compared to the first and third quarters of FY13 reflects the seasonality effects. The company generates higher revenues during the winter holiday season.

Margins

The company's financial performance depends heavily on its ability to control costs. Gross margins as well as selling, general and administrative expenses have a substantial impact on its net income.

Costco's selling, general and administrative expenses have increased on a QoQ basis. However, the expenses have declined by 3 basis points on a YoY basis. If we exclude the impact of lower gasoline prices then there is an improvement of 9 basis points on a yearly basis.

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The gross margin of the company in the last reported quarter has improved on both a quarterly basis and yearly basis. Gross margin, as a percentage of sales, increased 12 basis points compared to the corresponding quarter of FY12.

The gross margin in the second quarter declined by 0.98% on a QoQ basis but on a YoY basis it improved by 0.06%. The gross margin in the second and third quarter was positively impacted by a LIFO benefit.

In the third quarter of 2012, Costco's operating margin was at its best compared to the previous five quarters. However, its net margin and net income growth have deteriorated due to higher interest expenses and higher tax expenses. However, the company's three year net income growth, 16.3, is significantly better than the industry average of 9.5.Its net income increased by 39% on a YoY basis.

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DuPont Analysis

The company is achieving higher returns on its equity as a result of its better asset turnover and higher financial leverage. In December 2012, the company issued $3,492 million in aggregate principal amount of Senior Notes. In May 2013, the company's Japanese subsidiary issued $98 million in promissory notes through a private placement upon which semi-annual interest is payable. On the other hand, the stockholder's equity, in the last two quarters, has decreased due to lower retained earnings.

The company's asset turnover was highest in the third quarter of FY13 compared to the first two quarters of the year which denotes that the company now generates higher revenues for every dollar worth of assets.

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Overall, a DuPont analysis of the company shows that its return on equity is improving through artificial means since its financial leverage is increasing and equity is decreasing.

Valuation

In order to derive the fair value of the company's stock I have used the multiple based valuation approach. Through this approach we discover that the stock is highly overvalued on Price-to-earnings ratio compared to the industry average. It is also overvalued on price-to-book ratio but slightly undervalued on price-to-sales ratio. It is also quite undervalued on price-to-cash flows ratio.

As P/E and P/Cash flow ratios are better indicators of a company's financial health I have assigned higher weightage to these ratios.

The calculation suggests that the stock is overvalued with a downside potential of 7.16% showing that the upside potential is already incorporated into the stock's price. Therefore, the stock will not give any benefit to the investors in pricing terms.

Dividends Policy

The company started paying dividends in 2004. Since then it has increasing increased its dividends each year. Its current quarterly dividend rate is $0.31 per share compared to the $0.275 per share rate of the end of the third quarter in 2012.This is an increase of 12.7%.

However, Costco's current dividend yield, 1%, is considerably lower than the industry average of 1.9%.

Conclusion

The company has shown mixed performance results in its last six reported quarters. The upcoming holiday season will further improve its sales making its income more attractive. However, its balance sheet is becoming quite unattractive as it has added large amounts of additional debt and its retained earnings are decreasing which will inevitably lead to a decrease in the value of shareholder's equity.

The company's stock price is unattractive since it has a downside potential which creates loss for investors. Therefore, in my opinion, the stock does not pose a very tempting opportunity for the investor.

Source: Is Costco A Potential Sell?