The Warehouse Weigh-In: How Is Costco's Financial Condition Holding Up?

Oct.23.13 | About: Costco Wholesale (COST)

Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.

Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of Costco (NASDAQ:COST) in order to get some clues as to how well this company is doing.

I will go through the balance sheet, reviewing the most important items, in order to assess the financial condition of Costco. The information that I am using for this article comes from Costco's most recent annual report, which can be found here. Note that this article is not a comprehensive review as to whether Costco should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.


Costco operates 638 membership warehouses, and offers members low prices on nationally branded and private label products in numerous merchandise categories, in order to produce high volumes and rapid turnover of inventory. Of their warehouses, 454 of them are in the United States, while 85 are in Canada, and 34 are in Mexico. The rest are spread out amongst the United Kingdom, Japan, Taiwan, South Korea, and Australia. The company plans to open 13 additional stores by the end of calendar 2013. They also operate 3 e-commerce websites. Costco recorded 72% of its fiscal 2013 sales in the United States, while 16% came from Canada, and 12% came from elsewhere.

Cash and Cash Equivalents

The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.

As of Sept. 1, 2013, Costco had $6.12B in cash and short-term investments that can easily be converted into cash. These short-term investments account for $1.26B of the total position here and consist of mostly government and agency securities. This is a lot of cash for a company that has a market capitalization of $51.6B. This means that the company is trading at 8.4 times its cash position, which might make the stock very attractive to value-oriented investors.

During fiscal year 2013, Costco paid out $3.56B in dividends. Of this dividend payout, $3B was the result of a special dividend that the company paid in December 2012, in an attempt to keep investors from having to pay a higher tax rate on their dividends due to the fiscal cliff debacle. Their total dividend payout for fiscal 2013 dwarfed the $446M that was paid out in fiscal 2012. When it comes to share repurchases, the company issued a net $16M in shares, due to executive compensation. This compares with $1.31B in buybacks during fiscal 2012. In April 2011, a $4B buyback plan was authorized, and there is currently $3B that is still remaining on it. During the last 12 months, the company generated $1.36B in free cash flow.


With retail companies like Costco, I like to keep an eye on inventory levels. I usually like to see inventory levels stable or slightly rising from one year to the next. If I see inventory levels rising, then I want to see revenues rising as well, to indicate higher demand for the company's products. I don't like to see rapidly fluctuating inventory levels that are indicative of boom and bust cycles. In some instances, if inventory ramps up without increases in volumes or revenues, then it may indicate that some of the company's products are going obsolete.

At the end of fiscal 2013, Costco had $7.89B worth of inventory, which amounts to 7.66% of the company's sales for that year. At the end of fiscal 2012, this level was at 7.31% of sales, while at the end of fiscal 2011, it was at 7.63% of sales. This shows that the company's inventory levels are steady relative to the revenues. I don't see anything here that would indicate boom and bust cycles or the possibility of a large number of their products going obsolete. So, I see nothing to worry about here at this time.

Current Ratio

Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.

If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.

The current ratio of Costco is 1.19, which is pretty decent.

Quick Ratio

Most of the time when it comes to short-term liquidity, I end the discussion at the current ratio. However, with companies that have a large chunk of their current assets in inventories, one has to wonder whether all of that inventory can quickly be converted into cash in the event that the company suddenly needs it. Some of the inventory might be obsolete, or have to be disposed of for less than it was originally valued at. Given that inventories currently constitute over one-quarter of Costco's current assets, this is a very real concern here.

To address this issue, I calculate what I call the quick ratio. The quick ratio is calculated simply by subtracting the inventory from the total current assets and then dividing the remainder by the current liabilities. I usually like to see a quick ratio of at least 1.0. That way, even if the company's inventory is worthless, they will still have enough other current assets on hand to meet their short-term financial obligations in the event of an unlikely disruption to their operations.

The quick ratio of Costco is 0.59. This is less than ideal. As it stands right now, the company could stand up to a 32% markdown in the value of its inventory from current levels before their current assets would fall below their current liabilities.

However, the amount of emphasis that you put behind this figure when doing your independent research on Costco depends on how you feel about the likelihood of the company's operations coming to a grinding halt. With operations in more than 600 warehouses all around the world, I find it hard to imagine the company's operations coming to a complete stop, requiring Costco to suddenly expend all of its current assets in order to meet its short-term obligations. Now, if the company in question had its operations concentrated in just one or two places, or focused on selling just one or two products, then I might be more concerned. So, while the quick ratio of Costco is less than ideal, I don't see a need to push the panic button at this time.

Property, Plant, and Equipment

For retail companies like Costco to operate, a certain amount of capital expenditure is required. Land has to be bought, stores have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant, and equipment, as companies that constantly have to upgrade and change their facilities to keep up with competition may be at a bit of a disadvantage. However, another way of looking at it is that large amounts of money invested in this area may present a large barrier-to-entry for competitors.

Right now, Costco has $13.9B worth of property, plant, and equipment on its balance sheet. This figure is slightly above the $13.0B that it reported at the end of fiscal 2012, and the $12.4B that the company reported at the end of fiscal 2011. This increase is due largely to the company opening up new stores, as it attempts to grow. In its 10-K filing, the company said that 55% of these assets are in buildings, 21% are in fixtures and equipment, and 21% is in land.

Return on Assets

The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher the better, although lower returns due to large asset totals can serve as effective barriers-to-entry for would-be competitors. The formula for calculating return on assets looks like this:

Return on Assets = Net Income / Total Assets.

For Costco, the return on assets would be $2.04B in core earnings over the last 12 months, divided by $30.3B in total assets. This gives a return on assets for fiscal 2013 of 6.73%, which is decent. I also calculated Costco's returns on assets over fiscal 2012, fiscal 2011, and fiscal 2010 for comparative purposes. This can be seen in the table below.

Symbol 2013 2012 2011 2010
COST 6.73% 6.31% 5.45% 5.46%
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Table 1: Consistent Returns On Assets At Costco

These are good returns on assets that are very consistent. Over the last three years, Costco's asset base grew from $23.8B to $30.3B, while its core earnings grew from $1.30B to $2.04B, showing that the company's earnings are outpacing its asset base, which is what we want to see.

Short-Term Debt Versus Long-Term Debt

In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.

Fortunately, this is not a problem at all for Costco, as they don't have any short-term borrowings at this time.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.

Right now, Costco carries $5B of long-term debt. This is higher than the $1.38B that it carried one year before, as well as the $1.25B that they carried at the end of fiscal 2011. During fiscal 2013, the company issued $3.5B in senior notes, with interest rates ranging between 0.65% and 1.70%, and maturities ranging between 2015 and 2019. Of the company's long-term debt, 76% of it is due within the next 5 years, starting in fiscal 2016. This worries me a little bit, when considering the company's free cash flow generation and earnings power. However, with their sizable cash position, they should be able to manage it.

In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of the company's core earnings over the last 3 fiscal years. The average core earnings of Costco over this period is $1.74B. When you divide the long-term debt by the average earnings of the company, here is what we find.

Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings

For Costco, here is how it looks: $5.00B / $1.74B = 2.87 years

This is a good number for Costco, in that it can pay off its long-term debt with an amount that is equal to less than 3 years worth of company earnings. Due to the earnings power of Costco, I believe that the company's long-term debt should be manageable. It's just the fact that so much of it matures in the next five years that worries me.

Debt-To-Equity Ratio

The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Costco stacks up here.

Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity

For Costco, it looks like this: $19.3B / $10.8B = 1.79

In the table below, you can see how this ratio has changed over the last few years.

Symbol 2013 2012 2011 2010
COST 1.79 1.18 1.18 1.19
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Table 2: Debt-To-Equity Ratio At Costco

In Table 2, we see that Costco's debt-to-equity ratio had been steady from 2010 through 2012. However, we see a substantial bump in fiscal 2013. This bump is due mostly to the company's $3.5B long-term debt issue that occurred back in December 2012. While the company didn't spell out exactly why they borrowed this money, it was probably done in order to help finance that special dividend that cost the company $3B ahead of the fiscal cliff.

Another reason why the company's debt-to-equity ratio is less than ideal is their almost $10B in accounts payable and accrued salaries and benefits. While many people will not include this figure in their debt-to-equity calculations due to the fact that the figure doesn't represent actual borrowings, I include it due to the fact that it still represents money for which the company is on the hook.

We'll need to monitor this figure for Costco as the years and quarters progress. Hopefully, they can reduce it as time goes on.

Return On Equity

Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.

Return On Equity = Net Income / Shareholder Equity

Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks.

The return on equity for Costco is equal to $2.04B in net income, divided by shareholder equity of $10.8B, which is equal to 18.9%.

To illustrate how the returns on equity of Costco have changed over the last few years, I have created the table below for the return on equity.

Symbol 2013 2012 2011 2010
COST 18.9% 13.8% 12.2% 12.0%
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Table 3: Returns On Equity At Costco

The returns on equity at Costco had been very consistent, between fiscal 2010 and 2012, as the company's earnings grew at about the same rate as its equity position. However, in fiscal 2013, we see a bump up in this figure. This increase is due to a combination of earnings growth and a reduction in the company's equity position. Overall, these returns are good, and they show that management is making efficient use of its equity. However, I am concerned about the debt increase that has inflated this figure somewhat.

Retained Earnings

Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:

Retained Earnings = Net Income - Dividend Payments - Stock Buybacks

On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.

On its most recent balance sheet, Costco shows a retained earnings figure of $6.28B. In the table below, you can see how this figure has grown over the last three years. Over this time period, we see that retained earnings actually fell by almost 5%. They had been slowly on the rise until 2013, when the company paid out that special dividend. Given that this dividend was a one-time event, we should expect retained earnings to resume its steady growth.











Click to enlarge

Table 4: Retained Earnings At Costco


After reviewing the most recent balance sheet, there are a few things to like about Costco's financial condition. One is the fact that the company has a sizable cash position, which might make the stock attractive to value-oriented investors. It also gives the company flexibility when it comes to paying down debt, buying back stock, and paying dividends. Another is the fact that inventory levels have been at a very consistent percentage of sales over the last few years, reducing the likelihood of any boom and bust cycles that might otherwise trip them up going forward. The company has shown decent returns on assets and equity over the last few years, that have been highlighted by earnings growth and increases in the company's asset base as it continues to grow.

Things that concern me include the less than ideal debt-to-equity ratio, which is due to the $3.5B debt issue back in December 2012, and the company's large amount of operating expenses. We'll see how the company addresses this matter going forward. While the company's long-term debt appears to be manageable, I am concerned about the fact that most of the debt comes due within the next five years. They should be able to pay it off, but it will take some discipline. Their sizable cash position that's north of $6B can certainly help here. Depending on where interest rates will be later on, refinancing some of the debt may or may not be an option.

While this is not a comprehensive review as to whether Costco should be bought or sold, I think that its overall financial condition is fair. Investors should not let the company's debt-to-equity ratio alone deter them from buying the company's shares or doing further due diligence.

To learn more about how I analyze financial statements, please visit my new website at this link. It's a new site that I created just for fun, as well as for the purpose of helping others make good financial decisions.

Thanks for reading and I look forward to your comments!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.