Despite some signs of economic progress, employment trends have been relentlessly disappointing. Macro uncertainty across the Atlantic only further keep growth sluggish. I am still nevertheless optimistic about increases in consumer expenditures and thus take a bullish outlook on retail.
In this article, I will run you through my DCF model on Costco (COST) and then triangulate the result with a review of the fundamentals against Wal-Mart (WMT) and Target (TGT). I find that Costco is fairly priced by the market right now and higher returns can be found at competitors.
First, let's start with an assumption about the top-line. Costco finished FY2011 with $88.9B in revenue, which represented a 14% gain off of the preceding year. I model per annum growth hovering around 12.7% over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 87.3% of revenue versus 9.7% - 9.2% for SG&A, and 1.5% - 1.4% for capex. Taxes are estimated at 35.5% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I model this figure hovering around -0.3% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $86.27, implying that the market has it just about right.
All of this falls within the context of mixed results:
[E]arnings per share came in at $0.90, up 14% from last year's second quarter earnings per share of $0.79. This was on a 10% sales increase and there weren't any big unusual items either in this year's or last year's second quarter earnings…
The FX impact on our foreign operations year-over-year in Q2, assuming flat year-over-year FX rate, essentially hit us by about $5 million pretax earnings in the second quarter. We had an 8% increase in membership fee income. This included very little impact from the recent announced fee increase, a little less than $1 million. This is due to the nature of deferred accounting, and I'll talk about that in a minute.
We had a lower year-over-year gross margins as we continue to invest in pricing. We had good SG&A expense improvement and we had a smaller year-over-year LIFO charge, $6 million last year in the quarter versus $2.5 million and we had a favorable year-over-year income tax rate comparison.
From a multiples perspective, Costco is also more expensive than its larger peers. It trades at a respective 24.3x and 19.1x past and forward earnings versus 12.9x and 11.1x for Wal-Mart and 13x and 11.5x for Target.
Consensus estimates for Wal-Mart's EPS forecast that it will grow by 8% to $4.85 in 2013 and then by 8.9% and 10.6% in the following two years. Assuming a multiple of 13x and a conservative 2014 EPS of $5.24, the stock would hit $73.36 for 25% upside. For a company that is as sustainable as Walmart, this upside definitely merits an investment. Perhaps the most exciting aspect about Wal-Mart is that its past multiple can remain virtually flat to get this kind of returns. Chances are that when the economy hits full employment, the multiple will rise - not hold flat.
Consensus estimates for Target's EPS forecast that it will hold flat at $4.27 in 2013 and then grow by 13.6% and 19.8% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $4.81, the stock would hit $62.53 for 12.4% upside. What makes Target so attractive is that it properly "targets" the upper-income and lower-income markets whereas Wal-Mart and Costco have come under criticism for alienating the former group. Target has roughly the same volatility as the broader market while its peers are substantially less volatile. This allows for possibly higher risk-adjusted returns as the economy eventually moves towards full employment.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.