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Summary

  • Costco has been doing pretty well recently.
  • In the past year, it has rallied approximately 10% and is trading near its 52-week high.
  • By utilizing fundamental analysis, I reveal whether the discount store, is still trading at a discount.

(click to enlarge)

Source: Google Finance

As seen above, Costco (NASDAQ:COST) has been doing very well lately. In this article, I will analyze Costco's historical financials, and determine whether you, as an individual investor, should buy, hold, or sell Costco.

If you have read my previous articles, you would know that my go-to methods for valuing companies fundamentally, is a discounted cash-flow analysis ("DCF").

Unlike my previous articles however, I will not go through the DCF in depth.

Historical Financials

All figures are in millions of USD, except for per share data. (click to enlarge)

Source: SEC Filings

Net sales and membership fees

As seen above, from 2011 to 2013, net sales grew by 11.5% and 6% in the years 2012 and 2013 respectively. In FY2014 Q2, net sales grew by 6%, according to SEC filings.

Membership fees grew by 11.1% and 10.2% in the years 2012 and 2013 respectively. In FY2014 Q2, membership fees grew by 2%.

Summing these two line items, we get a total revenue growth rate of 11.5% and 6.1% in the years 2012 and 2013 respectively.

Costs and expenses

As seen above, merchandise costs remain steady at about 87.4% to 87.6% of sales, indicating that as revenue grows, Costco is able to enjoy economies of scale, and reduce cost per unit of revenue growth. Costco's management briefly touched on this in their quarterly reports, and it is reassuring to see that they are walking the walk.

Selling, general and administrative expenses have similarly hovered at about 9.6% to 9.8% of sales, further supporting my earlier statement regarding economies of scale.

As for pre-opening expenses, they too, remain at approximately 0.1% of sales.

From this, we can gather that Costco has been efficiently growing their sales, as when revenue increases, their costs and expenses do increase too, but they do not increase as well, indicating efficiency of operations.

Operating income

Being in the retailing business, where companies in the industry have high volumes and low margins, Costco is no exception, with operating income margins remaining steady at 2.7% of sales. Suffice to say, this increasing profitability is a result of cost efficiency.

(click to enlarge)

Source: SEC Filings

Interest income and expense

Costco has very little debt, thus has a very low interest expense, relative to their sales.

As seen above, interest expense has remained steady at 0.1% of sales.

Interest income, presumably derived from short-term investments in treasuries, has similarly hovered at about 0.1% of sales.

By subtracting these two line items from operating income, we arrive at pre-tax income, which is steady at 2.7% to 2.9% of sales.

Taxes, non-controlling interest and net income

As seen above, from 2011 to 2013, Costco's tax rate has hovered at about 32.4% to 36.1% of pre-tax income. These volatility in tax rates are due to the different jurisdictions that Costco has operations in, and the varying profitability of those operations.

Costco has minority investments in other companies, and those companies affect Costco's profitability as a whole. However, as seen above, in the grand scheme of things, non-controlling interest has very little effect on Costco's profitability, being a mere 0.1% of sales.

Excluding non-controlling interest, Costco has a net profit margin of 1.6% to 1.9%.

(click to enlarge)

Source: SEC Filings, author's own calculations

As seen above, Costco has EBIT margins of 2.8% to 3.0% of sales, EBITDA margins of 3.7% to 3.9% of sales, and EBIAT margins of 1.8% to 2% of sales.

(click to enlarge)

Source: SEC Filings

Depreciation & amortization

As seen above, depreciation & amortization has decreased from 1% of sales to 0.9% of sales from 2011 to FY2014 Q2. From this, we can gather that as sales increase, depreciation & amortization has decreased, possibly due to reduced capital expenditures, implying higher cash flows.

Stock-based compensation

Stock-based compensation has increased from 0.2% to 0.4% of sales.

Excess tax benefits on stock-based awards has remained steady at 0.1% of sales.

Other

Other non-cash operating activities, are close to 0% of sales.

Deferred income taxes has decreased from 0.1% of sales to nearly 0% of sales.

Summing these line items up, we arrive at net adjustments to non-cash charges, which has decreased from 1.3% of sales in 2011 to 1.1% of sales in FY2014 Q2.

(click to enlarge)

Source: SEC Filings, author's calculations

Merchandise inventory

As seen above, Costco has been increasing investment in inventory, anticipating higher demand for goods, reflected by an increase in merchandise inventories from 0.7% of sales in 2011 to 0.8% of sales in FY2014 Q2.

Accounts payable

As for accounts payable, it has decreased from 0.9% of sales to -0.1% of sales.

Other assets & liabilities

As for other operating assets and liabilities, it has increased from 0.4% to 1.2% of sales.

Summing these three line items, we arrive at net changes to working capital, which has decreased from 0.6% of sales to 0.3% of sales.

Capital expenditures

As for capital expenditures, it has increased from 1.5% of sales to 2% of sales from the years 2011 to FY2014 Q2.

Unlevered free cash flow

Taking into account all of the above, we arrive at free cash flows of $1.9bn in 2011, decreasing to $1.4bn in 2013, and $0.6bn in the first two quarters of FY2014.

Projected financials

Now that we have a gauge of Costco's financials, through its historical financials, we can begin forming assumptions regarding its future growth in revenues, costs, and profits.

(click to enlarge)

Source: SEC Filings, author's own estimates

Sales and membership fee projection

As seen above, I have projected net sales to grow by 10% year-over-year, with sales increasing from $110.5bn in 2015 to $147bn in 2018. The reason for these aggressive projections is due to the fact that Costco has been aggressively expanding their presence in different countries, by opening new warehouses (27 since fiscal 2013). This is supported by the increase in capital expenditures seen in historical fiscal 2013.

I have also projected membership fees to increase by 10% year-over-year, from $2.4bn in 2015 to $3.2bn in 2018, also supported by the opening of new warehouses.

Thus, total revenue is projected to increase from $112.9bn in 2015 to $150.2bn in 2018.

Cost and expense projections

As for merchandise costs, I have projected it to remain steady at 87.5% of sales, an average of the previous historical years.

Regarding SG&A and pre-opening expenses, I have also projected it to remain steady at 9.7% and 0.05% of sales respectively, an average of the previous historical years.

Thus, operating income is projected to increase from $3.1bn in 2015 to $4.1bn in 2018.

(click to enlarge)

Source: SEC Filings, author's own estimates

Interest expense and income

As for interest expense, and interest income, I have similarly projected them to be -0.1% and 0.1% of sales respectively, an average of the previous historical years.

Interest expense is projected to increase from $120mm to $159mm.

Interest income is projected to increase from $101mm to $134mm.

Thus, pre-tax income is projected to increase from $3.1bn to $4.1bn.

Tax rate and non-controlling interest

As for the tax rate and non-controlling interest, I have also projected them to be 34.7% of pre-tax income, and -0.1% of sales respectively.

Thus, net income including non-controlling interest is projected to increase from $2bn in 2015 to $2.7bn in 2018.

(click to enlarge)

Source: SEC Filings, author's own estimates

As seen above, net income attributable to Costco, that is, excluding the effects of non-controlling interest, is projected to increase from $2.1bn to $2.8bn.

EBIT, EBITDA and EBIAT, are projected to increase from $3.2bn to $4.3bn, $4.2bn to $5.7bn and $2.1bn to $2.8bn, from the years 2015 to 2018, respectively.

(click to enlarge)

Source: SEC Filings, author's own estimates

As seen above, depreciation & amortization, stock-based compensation, excess tax benefits on stock-based awards, other non-cash operating activities, and deferred income taxes, are projected to remain steady at 0.9%, 0.3%, -0.1%, 0.01% and 0.02% of sales respectively, an average of the previous historical years.

Thus, we arrive at net adjustments to non-cash charges of $1.3bn in 2015, increasing to $1.7bn in 2018.

(click to enlarge)

Source: SEC Filings, author's own estimates

As seen above, increase in merchandise inventories, increase in accounts payable and other operating assets and liabilities, are projected to stay flat at -0.7%, 0.5% and 0.6% of sales respectively, an average of the previous historical years.

Thus, net changes to working capital is projected to increase from $363mm in 2015 to $483mm in 2018.

Capital expenditures is projected to stay flat at 1.7% of sales, an average of the historical years, ipso facto, increasing from $1.9bn in 2015 to $2.6bn in 2018.

Hence, unlevered free cash flow is projected to increase from $1.8bn in 2015 to $2.4bn in 2018.

Source: SEC Filings, author's own calculations

As seen above, I have calculated the weighted-average cost of capital ("WACC") to be 7.5%.

Using this figure of 7.5% as the discount rate, I have discounted Costco's projected free cash flows from 2015 to 2018 to the present.

Then, I have projected Costco terminal value from 2018 and beyond, using a long-term growth rate of 3.20%, and WACC of 7.5%.

Summing these together, and subtracting net debt, preferred stock and non-controlling interest, I arrive at an equity value of $48bn, giving me an implied share price of $110.54.

Conclusion

Even with extremely aggressive estimates on Costco's future growth (10% year-over-year sales and membership fee growth), and conservative estimates on Costco's costs and expenses, Costco's implied share price is still under its current share price.

However, one thing to consider is that Costco has very low debt-to-EBITDA. Its interest expense-to-EBITDA is also similarly very low. Hence, there might be opportunities for Costco to raise debt in order to fund expansions, and lower their cost of capital. But, considering the Fed has been hinting in rising interest rates in the near future, Costco would need to raise debt quickly to take advantage of the current low interest rates.

Source: SEC Filings, author's own calculations

However, even if Costco raises an additional $5bn in debt at 2% interest, as shown above, it would only lower its cost of capital to 7%, resulting in an implied share price of $115.03, a small premium to its current trading price.

Thus, even if Costco manages to raise debt, it would have little effect with respect to its share price.

In summary, I feel that Costco shareholders should start liquidating their positions as it seems that Costco would have to perform way above expectations to warrant people buying its stock at its current price.

My analysis of Costco using Excel is available here.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in COST over 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.