Valuing a business like Costco (NASDAQ:COST) is difficult due to a number of reasons. Above all, it is difficult to quantify the customer loyalty and goodwill Costco has built over the years. One might argue that a company's brand value ought to translate into higher cash flows and better margins, but the problem is that the financials do not always 'fully' reflect all the great aspects of a business. Still, discussing a company from a valuation perspective can be insightful.
Last time, I discussed a number of catalysts that could drive COST higher. Here I discuss how those factors could affect Costco's valuation.
To determine the fair value of Costco's stock, I use a 5-year DCF model, modelling for a 3% terminal FCF growth rate. My model uses WACC, calculated using the CAPM, as the discount rate. The model is based on important assumptions concerning Costco's revenue growth and (adjusted) EBITDA margin which I will explain in detail.
Costco generates income by selling merchandise to consumers through its warehouses at competitive prices. It also derives a significant proportion of its operating income from membership fees. So in order to project Costco's total revenue growth, I will first separately forecast the company's net sales from warehouses and membership revenue and then I shall combine the two.
Costco has managed to grow sales by opening new warehouses each year. In recent years, Costco's store growth has been slowing down, especially in the U.S. Going forward, I don't expect the company to increase the total number of its warehouses at an increasing rate despite the strong anticipated growth in international warehouses.
Year | Total warehouses in operation | YOY growth |
2011 | 592 | - |
2012 | 608 | 2.70% |
2013 | 634 | 4.28% |
2014 | 663 | 4.57% |
2015 | 686 | 3.47% |
(Source: Costco' latest 10-K filing)
By the end of fiscal 2016, Costco is likely to have at least 716 warehouses in operation, having already opened 12 new (not including relocations) warehouses in the first half of the year. The company is expecting to add 18 more in the second half. From 2016 onwards, I project total number of warehouses to increase annually by 5% in 2017 and by 4% from 2018-2020. So we have:
Projected number of warehouses:
FY 2016 | FY 2017 | FY 2018 | FY 2019 | FY 2020 |
716 | 752 | 782 | 813 | 846 |
Costco's average sales per warehouse have grown steadily from $146 million in 2011 to $162 million in 2015. In coming years, new membership sign-ups will help Costco generate at least $160 million in average sales per warehouse. I forecast the average sales per warehouse to be $164 million (slightly above the three-year average) for 2016, $166 million for 2017, and $162 million (consistent with the three-year average) for 2018-2020.
(Source: Statista)
Multiplying the projected average sales per warehouse by the projected number of warehouses gives us Costco's net sales for 2016-2020:
Projected Net Sales (in millions):
FY 2016 | FY 2017 | FY 2018 | FY 2019 | FY 2020 |
$117,424 | $124,832 | $126,684 | $131,706 | $137,052 |
I now turn to the second component of Costco's revenue.
From 2011 onwards, Costco's cardholders have grown by ~6.2% per annum on average. As discussed in the previous article, Costco's new Visa cards will greatly attract individuals and small businesses wanting to maximize their rewards. Also, I wouldn't be surprised to see a remarkable increase in the number of younger cardholders. In short, I am expecting to see a rapid expansion in the company's overall membership base.
(Source: Costco's 10-K filings)
If the number of cardholders increases by 7% and 10% in 2016 and 2017, respectively, and by 5% each year beyond that, the company could realistically amass more than 100 million cardholders by the end of 2020. We, therefore, have:
Projected number of cardholders (in thousands):
FY 2016 | FY 2017 | FY 2018 | FY 2019 | FY 2020 |
86,991 | 95,690 | 100,475 | 105,498 | 110,773 |
Now to project Costco's membership revenue, it is helpful to look at the company's average membership fee per cardholder for the period 2011-2015. Note that the 5-year average is ~$31.2. Costco is certain to increase its basic membership fee either this year or next year, so that should lead to a notable increase in membership revenue. Of course, if the growth in the number of cardholders outstrips the growth in total membership fees, the average membership fee per cardholder will fall. However, given the increasing penetration of executive members, apart from the imminent increase in basic membership fees, I don't think this is very likely, especially after the transition to Visa cards. So I project the average membership fee per cardholder to be $34, above the 3-year average, for 2016-2020.
(Source: Costco's filings)
Multiplying the projected average membership fee per cardholder by the projected number of cardholders, gives us Costco's membership revenue for 2016-2020:
Projected membership revenue (in millions):
FY 2016 | FY 2017 | FY 2018 | FY 2019 | FY 2020 |
$2,943.90 | $3,253.46 | $3,416.15 | $3,586.93 | $3,766.28 |
Hence, we have Costco's estimated consolidated revenues for 2016-2020:
FY 2016 | FY 2017 | FY 2018 | FY 2019 | FY 2020 |
$120,367.90 | $128,085.46 | $130,100.15 | $135,292.93 | $140,818.28 |
Furthermore, for my DCF model, I have assumed EBITDA margin to be 4.1% for 2016 and 4.5% after that. Historically, Costco's EBITDA margin has been 3.7-4.1%, so I model for this to continue on the upper-end.
Costco's capital expenditures have been 1.5-2.1% of revenues over the past five years. From 2016 until 2020, I see capex running around 1.8% of revenues, consistent with the 5-year average. Similarly, projections of D&A, tax rate, and net working capital have been made in line with historical data.
Key Assumptions | Terminal FCF Growth Rate | WACC | Fair Value | |||
Low | 3.0% | 7.0% | $118.36 | |||
Mid | 3.0% | 6.0% | $157.74 | |||
High | 3.0% | 5.0% | $236.61 | |||
Projections | ||||||
Fiscal Years Ending | Aug-15 | Aug-16 | Aug-17 | Aug-18 | Aug-19 | Aug-20 |
($ in Millions) | ||||||
Revenue | 116,199 | 120,368 | 128,085 | 130,100 | 135,293 | 140,818 |
% Growth | 3.2% | 3.6% | 6.4% | 1.6% | 4.0% | 4.1% |
EBITDA | 4,751 | 4,935 | 5,764 | 5,855 | 6,088 | 6,337 |
% of Revenue | 4.1% | 4.1% | 4.5% | 4.5% | 4.5% | 4.5% |
Calculation of FCF | ||||||
Projected Unlevered Cash Flow | ||||||
Aug-16 | Aug-17 | Aug-18 | Aug-19 | Aug-20 | Terminal | |
EBITDA | 4,935 | 5,764 | 5,855 | 6,088 | 6,337 | 6,337 |
D&A | (1,129) | (1,202) | (1,221) | (1,269) | (1,321) | (2,632) |
EBIT | 3,806 | 4,562 | 4,634 | 4,819 | 5,016 | 3,705 |
Pro forma Taxes | (1,294) | (1,551) | (1,576) | (1,638) | (1,705) | (1,260) |
NOPAT | 2,512 | 3,011 | 3,058 | 3,180 | 3,310 | 2,445 |
Capital Expenditures | (2,368) | (2,520) | (2,559) | (2,662) | (2,770) | (2,770) |
NWC Investment | 157 | 291 | 76 | 196 | 208 | 6 |
(+) D&A | 1,129 | 1,202 | 1,221 | 1,269 | 1,321 | 2,632 |
Free Cash Flow | 1,430 | 1,984 | 1,795 | 1,984 | 2,069 | 2,313 |
% Growth | 39% | -9% | 10% | 4% | ||
Calculation of Equity Value | ||||||
Model | ||||||
Low | Mid | High | Market | |||
Enterprise Value | 52,383 | 69,771 | 104,598 | 66,972 | ||
(+) Cash & Equivalents | 3,633 | 3,633 | 3,633 | 3,633 | ||
(+) Investments & Other | 1,222 | 1,222 | 1,222 | 1,222 | ||
(-) Debt | (4,975) | (4,975) | (4,975) | (4,975) | ||
(-) Minority Interest & Other | 0 | 0 | 0 | 0 | ||
(-) Preferred Stock | 0 | 0 | 0 | 0 | ||
(-) Other | 0 | 0 | 0 | 0 | ||
Value of Common Equity | 52,263 | 69,651 | 104,478 | 66,852 | ||
Diluted Shares Outstanding | 442 | 442 | 442 | 442 | ||
Implied Stock Price | 118.36 | 157.74 | 236.61 | 151.40 | ||
Upside / (Downside) | -21.8% | 4.2% | 56.3% | |||
You can see complete calculations here.
According to the calculations shown above, we get Costco's market value of equity equal to ~$70 billion in the 'mid' scenario by subtracting the market value of debt and adding back cash and investments to enterprise value. Dividing this figure by the diluted shares outstanding, we get a fair value of $157.74, representing an upside of nearly 4.2% from the closing price on April 14, 2016.
Conclusion
I reiterate my bullish stance on Costco. The fact is that Costco rarely sells at a low multiple and that alone should not deter potential investors. Under reasonable assumptions, my DCF model yields a fair value close to $158 for Costco, implying that the company's shares are slightly undervalued but definitely worth buying at the moment due to Costco's strong business model and potential to surprise on the upside. Costco is one of those great businesses trading at a fair price at the moment that Buffett insists on buying. You can't go wrong with Costco.
Disclosure: I am/we are long COST.
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.