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PriceSmart, Inc. (NASDAQ:PSMT) is a small scale wholesale club company with potential upside if it can continue its growth trajectory. It operates in Central America and the Caribbean and has been growing quite rapidly in the past two years. PriceSmart's comparable companies in the United States would be Costco Wholesale Corp. (NASDAQ:COST) and BJ's Wholesale Club, Inc. (NYSE:BJ).

"PriceSmart, Inc. owns and operates warehouse clubs in the United States, Latin America, and the Caribbean. Its warehouse clubs sell consumer goods and perishable foods at low prices to individuals and businesses, as well as offering ancillary services, which include food courts, tire centers, and photo centers. As of August 31, 2010, the company operated 27 warehouse clubs in 11 countries and 1 U.S. territory, including 5 in Costa Rica; 4 each in Panama and Trinidad; 3 in Guatemala; 2 each in Dominican Republic, El Salvador, and Honduras; and 1 each in Aruba, Barbados, Jamaica, Nicaragua, and the United States Virgin Islands. PriceSmart, Inc. was founded in 1994 and is headquartered in San Diego, California." (from Yahoo!Finance)

Table 1: Comparable Companies
Ticker Price ($/share) Enterprise Value ($ Billions) Trailing P/E Forward P/E Revenues (ttm) ($ Billions) Fiscal Year End
COST $ 75.04 $ 27.8 24.6 18.6 $ 79.9 August
BJ $ 49.37 $ 2.3 18.9 15.2 $ 10.8 January
PSMT $ 37.68 $ 1.1 20.9 15.6 $ 1.5 August

Data sourced from Yahoo!Finance on February 13, 2011.

Discounted Cash Flow Analysis

I completed a discounted cash flow analysis on PriceSmart to evaluate it as a potential long investment. The discounted cash flow method is one of the basic tools for valuing companies. Essentially it states that the value of an enterprise is equal to its future cash flows discounted at an appropriate rate to account for the risk in those cash flows. This methodology produces a value that is reflected to the expected cash flow. It does not provide any insight into potential variations or risks.

The appropriate discount rate is based on whether the cash flows have been adjusted for servicing debt or are prior to debt service. I used the unlevered free cash flow method which targets an enterprise value. The appropriate discount rate should then reflect both the cost of debt and the cost of equity. In this case, a weighted average cost of capital (WACC) is appropriate. The required equity return can be calculated using the Capital Asset Pricing Model (CAPM) with an equity risk premium, an equity beta, and a risk free rate (approximated by the 10 year U.S. Treasury Bond rate). The unlevered free cash flow in its simplest form equals net income + depreciation/amortization – changes in working capital – capital expenditures + interest expense * (1 – tax rate).


Table 2: WACC Components
WACC Component Value
Risk Free Rate 3.65%
Beta 0.95
Equity Risk Premium 6.0%
Required Equity Return 9.4%
Cost of Debt 6.0%
WACC 9.1%

Beta is sourced from Yahoo!Finance, 10-Year T-Bond is from seekingalpha.com, cost of debt and equity risk premium are estimated.
Table 3: Net Income Calculation ($ Thousands)
Year Status Revenue Revenue Growth Net Margin Net Income
2008 Historical 1,119,876 NA 3.4%
2009 Historical 1,251,628 11.8% 3.4% 42,340
2010 Historical 1,395,891 11.5% 3.5% 49,337
2011 Projected 1,549,439 11.0% 3.6% 56,400
2012 Projected 1,719,877 11.0% 3.7% 64,144
2013 Projected 1,909,064 11.0% 3.8% 72,861
2014 Projected 2,119,061 11.0% 3.9% 82,671
2015 Projected 2,352,158 11.0% 4.0% 93,707
2016 Projected 2,610,895 11.0% 4.1% 106,118

Historical data sourced from Yahoo!Finance on February 13, 2011. Projections based upon 11% revenue growth with improving SG&A efficiency to drive down net margin.

Table 4: Working Capital Assumptions
Year Status Days Receivables Days Payables Days Inventory
2008 Historical 1.5 48.7 44.5
2009 Historical 1.4 44.0 40.3
2010 Historical 1.7 48.6 41.3
2011 Projected 1.7 48.6 41.3
2012 Projected 1.7 48.6 41.3
2013 Projected 1.7 48.6 41.3
2014 Projected 1.7 48.6 41.3
2015 Projected 1.7 48.6 41.3
2016 Projected 1.7 48.6 41.3

Historical data calculated from Yahoo!Finance and projections based upon most recent full year.

Table 5: Unlevered Free Cash Flow ($ Thousands)
Year Status Net Income Depreciation Change in Working Capital Capital Expenditures Unlevered Free Cash Flow
2008 Hist. 38,106 11,370 (8,447) (23,571) 12,314
2009 Hist. 42,340 13,898 (76) (49,347) 546
2010 Hist. 49,337 15,260 10,358 (50,207) 31,646
2011 Proj. 56,400 15,260 25,108 (50,207) 47,035
2012 Proj. 64,144 15,718 5,138 (51,713) 33,398
2013 Proj. 72,861 16,189 5,844 (53,265) 41,446
2014 Proj. 82,671 16,675 6,447 (54,863) 50,420
2015 Proj. 93,707 17,175 7,112 (56,508) 60,614
2016 Proj. 106,118 17,691 7,847 (59,334) 71,047

Historical data is from Yahoo!Finance and projections based upon methodologies described above. Capital expenditures and depreciation were escalated to maintain certain operating metrics.

Table 7: Price Appreciation Potential ($ Millions)
Valuation Component Value
Enterprise Value $ 1,661
Debt and Liabilities $ 68
Cash $ 75
Potential Equity Value $ 1,668
Current Equity Value $ 1,130
Potential Appreciation 48%
Data based on model projections. Current Equity Value from Yahoo!Finance.
Conclusion

PriceSmart, Inc.'s current valuation may offer significant price appreciation potential based upon the assumptions used in my model. Furthermore, relative to its comparable companies, it appears to have a consistent valuation despite stronger growth prospects.

One challenge for PriceSmart will be to continue growth within its existing geographical market. Furthermore, the required equity return at 9.4% might be too low for the country risk and challenge of operating stores in so many different countries. Slower revenue growth, stagnant margins and a higher beta (1.5 versus .95) would suggest a fair valuation. The key trade offs for the company will be ability to grow profitability and better leverage its scale.

Additional analysis should be completed before making an investment decision.

Source: PriceSmart: A Growing Latin American Wholesale Club With Potential Upside

Additional disclosure: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.