Studies in Applied Finance - Krieger Web Services · 3/21/2018 · The working paper is an in-depth financial analysis of Costco Wholesale Corporation (COST). Our analysis examines

INVESTMENT THESIS FOR COSTCO WHOLESALE

CORPORATION (NASDAQ: COST)

Arshad Amin Ajani

Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business

Enterprise

Studies in Applied Finance

SAF/No.21/March 2018

InvestmentThesisforCostcoWholesaleCorporation(NASDAQ:COST)

ByArshadAminAjani

Disclaimer:Theseresearchreportsareprimarilystudentreportsforacademicpurposesandare

notspecificrecommendationstobuyorsellastock.Potentialinvestorsshouldconsulta

qualifiedinvestmentadvisorbeforemakinganyinvestment.Thisstudywascompletedon

October16

th

,2017.

AbouttheSeriesThestudiesinAppliedFinanceSeriesisunderthegeneraldirectionofProfessorSteveH.Hanke

([email protected]),Co-DirectorofTheJohnsHopkinsInstituteofAppliedEconomics,Global

Health,andstudyofBusinessEnterpriseandDr.HesamMotlagh([email protected]),aFellow

atTheJohnsHopkinsInstituteofAppliedEconomics,GlobalHealth,andstudyofBusiness

Enterprise.

Thisworkingpaperisoneinaseriesonappliedfinancialeconomics,whichfocusesoncompany

valuations.TheauthorsaremainlystudentsatTheJohnsHopkinsUniversityinBaltimorewho

haveconductedtheirworkattheInstituteasundergraduateresearchers.

AuthorArshadAjani([email protected])isagraduateofTheJohnsHopkinsUniversitywithadegreein

Economics.HeconductedtheresearchforthispaperwhileservingasProf.Hanke’sresearch

assistantatTheJohnsHopkinsInstituteofAppliedEconomics,GlobalHealth,andstudyof

BusinessEnterpriseduringtheFallof2017.Currently,ArshadisanInvestmentBankingAnalyst

atBNPParibasinNewYork.

SummaryTheworkingpaperisanin-depthfinancialanalysisofCostcoWholesaleCorporation(COST).

OuranalysisexaminesCOST’sbusinessmodelandiscombinedwithourproprietaryDiscounted

CashFlow(P-DCF)modelandaMonte-Carlosimulation.Thisresultsindistributionsofprobable

freecashflows.Inadditiontothesequantitativefactors,wealsoexaminecompensationplans

ofCostco’sexecutivestoassessthedegreetowhichtheexecutives’compensationincentives

arealignedwiththeobjectiveofcreatingshareholdervalue.

AcknowledgementsManythankstoProf.SteveHankeandDr.HesamMotlaghforguidanceanddraftcomments.

Keywords:COST,Costco,Wholesale,DiscountedCashFlow,FreeCashFlow,Monte-Carlo

Simulations,InvestmentThesis,Compensation.

InvestmentThesisforCostcoWholesaleCorporation(NASDAQ:COST)byArshadAminAjani

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Rating:Sell–EstimatedFreeCashFlowperShare:$131.05

CompanyName CostcoWholesaleCorporationDate 10/16/17

Fiscalyearends(currentperiod) 08/2017(08/2017Q4)

CurrentPrice $157.4952weekhigh(date) $182.72(06/06/17)52weeklow(date) $136.59(11/04/16)

MarketCap $69,432MEnterpriseValue $70,613M

TotalDebt $6,659MCash $5,779M

NetDebt/EnterpriseValue 1.25%Dividend 1.26%

SharesOutstanding/Float 437.20M/429.70MCurrentP/E 27.27x

2019P/E(EPS) 22.66x($7.01)*2018P/E(EPS) 24.68x($6.44)*2017P/E(EPS) 27.28x($5.82)*

2016EPS $5.33**2015EPS $5.24**2014EPS $4.65**

*ConsensusEstimatesasof10/16/2017**ComparableActualfromBloomberg


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TableofContents

ExecutiveSummary................................................................................................................3

Catalysts&Risks....................................................................................................................3

CompanyDescriptionandHistoricalPerformance..................................................................3BusinessSegments...........................................................................................................................3HistoricalPerformance.....................................................................................................................5

ModelAssumptions................................................................................................................7BalanceSheetandIncomeStatement..............................................................................................7ValueDrivers....................................................................................................................................8ModelResults..................................................................................................................................9

QualitativeAnalysis...............................................................................................................13A.CapitalSourcesAnalysis.............................................................................................................13B.HistoricalAllocationAnalysis......................................................................................................15C.CompensationandCorporateGovernance.................................................................................17

Conclusion.............................................................................................................................20

Appendix...............................................................................................................................21

Citations................................................................................................................................22


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ExecutiveSummaryCostcoWholesaleCorporationisthelargestAmericanmembership-onlywarehouseclub.CostcoisheadquarteredinIssaquah,WashingtonbutopeneditsfirstwarehouseinSeattlein1983.Costcooffersproductsacrosssixmajorsegments:foods,sundries,hardlines,freshfoods,softlines,andancillaryacrossthreemajorgeographicregions:UnitedStates,Canada,andOtherInternationalcountries.Basedonhistoricalaveragesandinsightsfromearningscallreports,ourProbabilisticDiscountedCashFlow(PDCF)modelinconjunctionwithMonte-CarlosimulationsrevealthatCOST’sestimatedfreecashflowpershareis$131.05.Thisisbasedoffofaveryoptimisticapproachtakingintoaccountstronge-commerceandnewwarehouselocationopenings.Debtanalysishasrevealedstrongcorporateratingsaboveinvestmentgrade.Managementcompensationisfoundtobequitevagueinnatureandexactmanagementincentiveishardtogauge.Atthetimeofthisevaluation(10/16/17),sharesofCOSTaretradingat$157.49,thereforeourestimatedFreeCashFlowperSharerepresentsa16.79%discounttothemarketshareprice.Astherearealsolargeuncertaintieswithfuturegaspricesandforeignexchangeeffects,werateCOSTasaSELL.

Catalysts&Risks

• LargedependencyonUSandCanadianoperationsthatcomprise87%ofnetsalesand85%oftotaloperatingincomein2017

• Abilitytocapture,maintain,andgrowstrongmembershiployaltyandbrandrecognition• FailuretodevelopandmaintainrelevantmultichannelexperiencesforCostcomembers,

especiallywithcompetitionfromAmazondeliveryservices• Inabilitytoattract,train,andretainhighlyqualifiedemployees• Volatilityingaspriceandforeignexchangecurrencyrates• Naturaldisasterscontinuetostronglyeffectinternationaloperations

CompanyDescriptionandHistoricalPerformanceBusinessSegmentsCostcooperatesandcompeteswithmultipleindustries.Itsprimarysegmentisthewarehouseclubthatincluderetailmerchandisethatissoldtocustomersinmostlylarge,wholesale,quantities.Theseclubsareattractivetobargainhuntersandsmallbusinessowners.WarehouseclubslikeCostcoareabletokeeppriceslowthroughtheir“no-frills”modelwhichoperatesonavolumemarginratherthanamaximumprofitperitembasis.ExamplesofotherwarehouseclubsoperatinginthissectorincludeSam’sClubandBJ’sWholesaleClub,bothofwhichoperateintheUnitedStates.Costco,liketheotherwholesaleclubs,hasmembership-onlychainsthatofferyearlymembershipstotheircustomers.


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CostcoalsocompetesagainstalargergroupofretailcorporationsanddiscountdepartmentstoressuchasTarget,Walmart,andTheKrogerCompany.TheCompany’sbusinessoperationscanbebrokendownintomerchandisecategoriesorgeographicalregions.Merchandiseinventorybreakupisasfollows:

• Foods(includingdryfoods,packagedfoods,andgroceries)–~22%oftotalrevenue• Sundries(includingsnackfoods,candy,alcoholicandnonalcoholicbeverages,and

cleaningsupplies)-~21%oftotalrevenue• Hardlines(includingmajorappliances,electronics,healthandbeautyaids,hardware,

andgardenandpatio)-~16%oftotalrevenue• FreshFoods(includingmeat,produce,deli,andbakery)-~14%oftotalrevenue• Softlines(includingapparelandsmallappliances)-~12%oftotalrevenue• Ancillary(includinggasstationsandpharmacy)-~15%oftotalrevenue1

Foraccountingpurposes,theCompanyreportsitsyearlyrevenuedatabylocationseparatedintothreemajorcategories.CostcoisprimarilyengagedinmembershipwarehousesintheU.S.,Canada,Mexico,U.K.,Japan,Australia,Spain,Iceland,andFrance.Thethreemajorgeographicsegmentsfollowedbytheirpercentageofnetsalesduring2017areasfollows:

• UnitedStatesOperations–73%netsales• CanadianOperations–15%netsales• OtherInternationalOperations–13%netsales

Toillustratetheimpactthateachgeographicsegmenthasontheoverallrevenue,figure1belowshowsyearlyrevenuebylocationfromfiscalyear2013tofiscalyear2017.TheUnitedStatesandCanadacombinedconsistofover80%oftotalrevenue.ForthepurposeofthispaperwewillhighlightthemajorchangesinU.S.locations,becausechangesinU.S.operationsgreatlychangeourestimatedFreeCashFlow.Figure1belowemphasizesthestrengthofU.S.operationsbyillustratingthesizeadvantageithas.However,regardlessofsize,U.S.operationshavestillbeenabletoshowstrongsignsofgrowthsince2013,evenstrongerthanhistoricgrowthofothercategories.Wewillhavetoremaincognizantofthistrendwhenprojectingfuturerevenuegrowth.

1SECFilingAnnual10-KReport(https://www.sec.gov/cgi-bin/viewer?action=view&cik=909832&accession_number=0000909832-16-000032&xbrl_type=v#)


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Figure1:COSTSegmentedRevenuebyYearSource:COST10-K

HistoricalPerformanceCostco’scommonstockperformancecomparedtotheS&P500isshowninfigure2below.

Figure2:COSTStockPerformancevs.theS&P500Source:BloombergTerminal.Command<GP>Accessed:10/16/17

0100002000030000400005000060000700008000090000100000

2013 2014 2015 2016 2017

Revenue(USD

millions)

Year

Business SegmentRevenue

UnitedStatesOperations CanadianOperations OtherInternationalOperations


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Overthelastfiveyears,Costco’ssharepricehaskeptaconsistentlygeneralupwardtrendalongwiththemarket.Indeed,COSThasabetaof1.0,meaningitmovedalmostcompletelyintandemwiththebroadermarket.However,gaspricesandforeignexchangerateslargelyaffectCostco’sstockprice.Overthepastfiveyears,foreignexchangerateshaveincreasedinterestincomeasmuchas94%anddecreaseditbyasmuchas10%.DiscussedintheearningcallaswellasintheCompany’sannual10-Kreport,therecentlargeswingsingaspricesandcurrencyexchangerateshavebeenastrongpredictorofpositiveornegativeyearsfortheCompany.Onekeyeventtonoteduring2017istheAmazonacquisitionofWholeFoodsMarket,Inc.AftertheacquisitiononJune16th,2017,Costco’sstockpriceplunged7.2%.ThisacquisitionaffectednotonlyCostcobutalsomuchofitspeergroup,includingTarget,Walmart,andKroger.AlthoughthisdealcouldprovideWholeFoodsMarketwithacompetitiveedge,asmanyinvestorssuspect,wecontendthefundamentalprospectandvaluationoftheCompanyremainedunchangedduringthisbuyoutpropositionasaresultofCostco’suniquebusinessmodelofofferingproductsatcostinexchangeforanannualmembership.HoweversensitiveCOST’ssharepriceistoAMZN’srecentmoves,webelievethatCostco’sloyalmembershipbasewillcontinuetogrowregardlessofthisrecentacquisition.Next,itisimportanttodiscusstheCompany’sgrossmarginanditsfocusonensuringstabilityinMerchandiseCostsandSelling,General,andAdministrativecosts.Figure3tracksMerchandisecostsandSelling,General,andAdministrativecostsoverthelastfiveyearssince2013.

Figure3:COSTStabilityinMerchandiseandSelling,General,andAdministrativeCostsSource:COSTSEC10-KFromfigure3above,wecanimplicitlyobservethelowgrossmargin(1-MerchandiseCost)thatCostcooperateswith.ThisislargelyduetoCostco’sbusinessmodeloffocusingonsellingvolumewithsmallerprofitmargins.However,whenweseethatrecentgrossmarginisonly

87% 86% 86% 86% 86%

10% 10% 10% 10% 10%

0%

20%

40%

60%

80%

100%

2013 2014 2015 2016 2017

PercentageofR

evenue

Year

StabilityinMajorOperatingCosts

MerchandiseCosts Selling,General,Administrative


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around~11%wemustalsoobserveoperatingcoststoevaluatetheCompany’shistoricalefficiencies.Asapercentageofrevenue,wefindthatCostco’sabilitytokeepitsoperatingcostsstablehasbeenveryeffective.Ontheotherhand,itisalsohardtoseeanymajorgrowthinefficienciesorpotentialincreaseingrossmarginfromcuttingthesecosts.Costco’smainavenuetoexperiencegrossmarginincreaseissimplybyfocusingonincreasingtotalNetsales.Managementdiscussedreachingtheirexpansiongoalsofincreasingtoplinerevenuenumbersbyincreasingmembershipsacrossregionsaswellasgrowingtheironlinepresence.However,therewerenospecifictargetsforcuttingcostsorchangesinoperatingleveragestofollow.OverthepastseveralyearsCostcohasbeencommittedtoopening,onaverage,25storelocationsperyearwith60%ofthesestoresopeningintheUnitedStates.Referringbacktoourgrossmarginanalysis,itisclearthattheCompanyhasbeensuccessfulinincreasingtheirpercentgrossmargininrecentquarters.Thisisalsoachievedbyleveragingtheireconomiesofscale,bykeepingthecostsofopeningnewstorelocationslow.Evenaftertakingintoconsiderationanycannibalizationofsalesthatmayoccurinthesenewlocations,Costco’srevenueshaveseenstrongupwardtrendsthatfurtherhelpbolstertheirmargins.

ModelAssumptionsNowthatwehavediscussedthehistoricalperformanceofCOST,weturntothemodelthatwillbethefoundationforourquantitativeanalysis.ThePDCFuseshistoricalaveragesandstandarddeviationsofgrowthandmarginsastheunderlyingbasisofourfutureprojections.ForCostco,weprojectedrevenueacrosseachofthecompany’sgeographiclocations.WefindthatCostcomodelsbetterwhenbrokenupintomulti-businessgeographysegmentsratherthanmultinationalbusinessesasperitsmanagementstructureandgrowthprospectsthateffectcertainlocationsratherthanspecificbusinesslines.Further,datathatwasprovidedonthe10-KSECfilingsforrevenuegrowthwerebetterorganizedforeachbusinesssegmentratherthaneachregion.

BalanceSheetandIncomeStatementTheresultsarecontainedinthe‘BalanceSheet’and‘IncomeStatement’tabsoftheaccompanyingspreadsheet.StartingatthetopofthebalancesheetwenoticedasubstantialdecreaseinCashandCashEquivalentsfrom2015to2016.Thisisprimarilyaresultofacceleratedvendorpaymentsofapproximately$1.70billionmadeinthelastweekoffiscal2016,inadvanceofimplementingamodernaccountingsystematthebeginningofthenextfiscalyear.Endofyearpaymentstovendorshavepreviouslyalsocreatedsmallfluctuationsincashbalances;however,2016wasabnormallylargeandsowehighlightithere.In2017,alargeportionofcurrentdebttotaling$2.20billionwasre-paid.Thisincludeda$1.10billionpaymentofa1.125%SeniorNotepaidinMay2017whichincludedtheprincipalandinterestaccruedanda$1.10billionpaymentofa5.50%SeniorNotethatwaspaidoffinMarch


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2017whichalsoincludedtheprincipalandinterestaccrued.Bothdebtpaymentswerecompletedthroughthecompany’sexistingsourcesofCashandCashEquivalentsandShort-Terminvestments.Wewilldiscussotheroutstandingdebtobligationslaterinthisinvestmentthesis.Switchingovertotheincomestatement,wenoticethatfiscalyear2017wasrelativelystrongintermsofgrowthinNetsales.Thislargejumpfrom2016isdirectlycorrelatedwithanincreaseinnewwarehouselocations.Otherstrongfactorsforthisgrowthconsistof:increaseingasolinepricesandfavorableforeignexchangeeffects.NetsaleswerealsonegativelyimpactedbyslowerthanexpectedgrowthfromOtherInternationalOperations.ComparablestoresalesalsodrovetheCompany’sstrongsalesgrowthbyhittingrecordshoppingfrequenciesandanincreaseinaverageconsumerticket(amountspentpercustomerpervisit).Lastly,cannibalizationofsalesbetweenwarehouselocationsalsohashadastrongnegativeimpactonthegrowthofsales,2howevertheoverallneteffectofopeningwarehouselocationsisstillverymuchpositive.Merchandisecostsconsistofthepurchasepriceofinventorysold,shippingcharges,andallcostsrelatedtotheCompany’sdepotoperations.Merchandisecostsincreasedsubstantiallyinfiscal2017asaresultofstrongersales.Nootherdescriptionhasbeengivenforthiscategory,butoveralleffectofMerchandiseCostsongrossmarginhasleftapositiveimpactonpercentageofgrossmargin.Selling,general,andadministrative(SGA)costsincreasedin2017especiallyinthefourthquarter(Q4)becauseofHurricaneHarvey.Lastly,asarepeatingthemethroughoutthisinvestmentthesis,foreignexchangeratestookalargetollonInterestIncomein2017.EffectsofforeignexchangedecreasedInterestIncomeby$12.00millionwhiletheremaining$6.00milliondecreasewasduetoorganicdecline.

ValueDriversTheresultsarecontainedinthe‘ValueDrivers’taboftheaccompanyingspreadsheetThetopportionofthetabstartswithannualRevenuefollowedbyitsannualgrowthrate.Thishelpsusunderstandexactlyhowstrong2017’sgrowthratewascomparedtothepreviousfiveyears.ThisreiteratesthevolatilityofCostco’sbusinessbasedontwomainfactors:gasolinepricesandforeignexchangeeffects.Although2017washistoricallyhighcomparedtothepastfewyears,managementbelievesthatrevenuegrowthcloseto8.00%canbeachievedmovingforward.In2017,netsalesincreasedby9%primarilyduetoa4%increaseincomparablestoresalesduringthesameyear.ThereisalargedependenceonoveralleconomicfactorstopositivelyaffectNetsales.However,managementstatesthatmuchofthisyear’sgrowthcanalsobeattributedtotheirnewe-commerceplatformthattheyintroducedayearago.Thenewe-commerceplatformisstillinprogressandisslowlymakingitswaytoCostcoWarehouselocations.2Transcripts,S.(2017,August17).CostcoWholesaleCorporation(COST)Q42017Results


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Thisyear,e-commercewasup15%to$4.60billioninUS,Canada,UK,Mexico,KoreaandTaiwanwhicharetheprimarymarketsthatcurrentlyhavethisservice.ForQ4,theCompanyreportedrecordgrowthof27%inthesamesegment.Improvedsearchfunctionality,streamlinedcheckoutprocess,improvedmemberabilitytotrackorders,andtheadditionofnewwell-knownandhighendmanufacturerssuchasMarmot,Spyder,ExOfficio,GEAppliancesandJiffyLubeServiceswillcarrythissegmentandhelpCostcoachievestronggrowthespeciallyintheUnitedStatesoperationsforthenextfewyears.Asanalyzedearlier,historicalMerchandisecostfortheCompanyasapercentageoftotalrevenuebasishasremainedstable.SGAandPreopeningexpensesfornewlocationsalsoshowsimilarsignsofstagnationandwillmakeforaveryreliableassumptionwhenwebegintotuneourmodel.Turningtothecashflowdrivers,wedefineWorkingCapitalas:CurrentAssets–CurrentLiabilities–CashandCashEquivalents.BecauseofouruniquedefinitionforWorkingCapitalcombinedwithCostco’ssubstantialamountofcashonhand,theWorkingCapitalcalculationrevealsanegativeworkingcapitalformostyears.Later,wewilldiscusscreditfacilitiesandotherdebtinstruments.However,managementstatesthattheCompanyalsousescreditfacilitiestohelpprovideforWorkingCapitalneeds.AsCostcocontinuestofocusonincreasingthenumberoflocationsandwarehousesthattheyownandlease,CapitalExpenditures(CAPEX)haveincreasedoverthepastfewyearsto2.75%oftotalrevenueinfiscalyear2017.Thisfigurerepresentsa13.00%decreasefrom2016.However,CAPEXisexpectedtoremainrelativelysteadyoverthelongrunasCostcocontinuestofocusonincreasetheirnumberofwarehouses.Wedonotexpectmajordeviationfromtheirhistoricyearlywarehouseopenings.

ModelResultsValuesarecontainedintheP-DCFandMCtabsoftheaccompanyingspreadsheetForthepurposeofthisinvestmentthesis,wehavedecidedtoportrayoptimisticassumptionstohelpsolidifyoursellrecommendation.WebeginwithourModelTuningParameters.Aspreviouslymentioned,2017wasanunusuallystrongyearforCostcoandassuchwesawasignificantincreaseinRevenueanddecreaseinSGAcosts.However,forthismodelwehavedecidedtoprojectsimilargrowthratesfortheCompanyintothefuture.ThiswillhelpusassesthegrowthpotentialoftheCompanyandhelpusgainabetterunderstandingofpotentialEstimatedFreeCashFlowperShare.Assuch,webeginbytargetingan8%Revenuegrowthrateoverthenext10years.Intheannualreportandespeciallythroughtheearningscall,managementsuggestedthatstronggrowthinthefutureisexpected.ConsensusestimatesalsotargetagrowthplayforCostcointhefuture.However,mostestimatesandprimarysourcessuggestlongtermgrowthofNetsalesto


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decreaseandstabilizeafterafewyearsofstronggrowthfromnewlyimplementede-commercestrategies.Here,wehaveprojectedsalestogrowatan8%ratecontinuouslyforthenext10yearswithoutanydeclineorplateautoamorelikelylong-termgrowthrate.Accordingly,wehaveprojectedthehighestgrowthratetotheUnitedStatesOperationswhichwesettothisyear’sgrowthrateof8.44%whichisaround3.00%higherthanthehistoricalaverageoverthelastfiveyears.Secondly,weprojectCanada(asthesecondstrongestgrowerin2017)togrowatarate3.70%higherthanitsfive-yearhistoricaverage.Lastly,wecreateascenariowherethesmallestportionofRevenue,OtherInternationalOperations,isprojectedtogrowatarateapproximatelyequaltoitsfiscal2017rateof8.00%(whichis1.00%morethanitshistoricaverage).Here,wepushedthelimitsofexpectedgrowthinallthreecategorieswhichwillcreateabiased“bestcasescenario”forCostco.Managementstatedinthe10-KthatthedeclineinSGAin2017wasduetothenewco-brandedVisaCreditCard.TheyalsospecifiedthatthisdeclineinSGAcostswasananomalyandthatitwouldbetoughtomatchnextyear.However,becausewewantedtocreateanoptimisticsituationthatisstillwithinthehistoricboundsofCostco’spreviousperformance,wehaveprojectedSGAcoststomimic2017trend.WehaveconsideredCostco’shistoricaverageforSGAandhaveprojectedforaslightmarginofimprovement.Merchandisecostshavealsobeensetcloseto2017marginstoaccountforsimilarlong-termassetgrowthastheCompanypreparesformoresalesandstoreopeningsinthefuture.Non-operatingcosts,asexemplifiedintheValueDriverstab,havebeenverystableoverthepastfiveyears,regardlessofthequantityofsales.Assuch,wefinditappropriatetoleavenon-operatingcostsattheirhistoricaverageasthereisalsonomanagementguidanceofanyfuturechangesinthesecosts.Overthepastfewyears,theCompanyhastriedtoopenaround25to30newwarehouses(totalof715warehousesasofSeptember2017)eachyearandfor2017,thistargetwasreached.Combiningthiswithalackofmanagementguidanceonanychangesofwarehousegrowth,weprojectlongtermcapitalexpenditure(CAPEX)tomaintainitslong-termhistoricgrowthrate.Next,wecomparethemodeltuningparametersthatinclude:FreeCashFlowReturnonInvestedCapital(FROIC),PotentialFreeCashFlowYield(PFCFY),LongTermAssetTurnover(LTAT),andLongTermAsset/InvestedCapital(LTA/IC).Althoughourassumptionsareontheoptimisticsideofthespectrum,itisimportanttocheckthatourmodeldoesnotgotoofaroutoflinewiththehistoricrange.Comparingourmodel’sprojectionsversushistoricalminimums,averages,andmaximumswenoticethatourmodelisreasonablynearhistoricdata.Althoughourmodelpushesthemodelassumption,wetrytoreasonablyevaluateCostco’sabilitytostriveforlong-termgrowth.Figure4belowrepresentsthemodeltuningparametercomparisons.


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Figure4:ModelandHistoricalModelTuningParametersSource:COSTSEC10-KandP-DCFTabScreenshotThefreecashflowpershareobtainedfromtheseassumptionsis$131.05.Thecurrentpriceuponthisevaluationis$157.49pershare.Thisrepresentsa16.79%downsidetothisinvestment.Wearehavingahardtimejustifyingthecurrentsharepricewitha10%discountrate,letaloneanypotentialupside.Toasseshowwell-determinedtheseforecastedvalueswere,weperformedaMonte-Carlo(MC)Simulation(seefigure5).Further,wenoticethattheMCSimulationisrelativelydominatedbytheMerchandisecosts.However,reflectingbackonhistoricnumberswecanassesthepracticalityofourassumptionwhenwerealizethathistoricMerchandisecostshavebeenverystableoverthepastfiveyears.OursensitivityanalysisoftheMCsimulationcanbeviewedinfigure6.Aswenotice,MerchandiseCostsstronglyaffectthesensitivityoftheMonte-Carlosimulation.However,asmentionedbeforewebelievethatMerchandisecostsshouldaccountforsimilarlong-termassetgrowththatwehaveseenin2017astheCompanypreparesformoresalesandstoreopeningsinthefuture.Assuchwehaveconfidenceinour85%assumptionbutdoacknowledgethestrongweightithasonourmodel.

Min Avg Max Trend Min Avg Max TrendFROIC 13.39% 14.38% 15.13% 10.23% 10.98% 12.44%PFCFY 2.29% 2.30% 2.31% 1.83% 1.95% 2.05%LTAT 0.20 0.20 0.20 0.20 0.21 0.22LTA/IC 118.56% 125.85% 132.23% 110.87% 116.03% 123.88%%DCFinTV 55.11%

ModelTuningParametersModel Historical


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Figure5:Monte-CarloSimulationSource:CrystalBall,MonteCarloSimulationonEstimatedFCF/Share

Figure6:Monte-CarloSimulationSensitivityAnalysisSource:CrystalBall,MonteCarloSimulationSensitivityAnalysisonEstimatedFCF/Share


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QualitativeAnalysisA.CapitalSourcesAnalysisAsmentionedearlier,Costcoprioritizesusingdebttofundtheirworkingcapitalneedsonadailybasis.TheCompanyusesCashandCashEquivalentsaswellasproceedsfromShort-termInvestmentstopayoffthelong-termSeniorNotedebtobligations.Currently,thecompanyisresponsibleforthefollowingSeniorNotesincludingthosethatweredueearlierthisyear.Figure7belowoutlinestheTotalLong-TermDebttheCompanycurrentlyholds.March2017andDecember2017maturitieshavealreadybeenpaidasofMarchandMayofthisyear,respectively($2.20billionintotal).

Figure7:ListofCurrentLong-TermDebtObligationsSource:COST10-KTheCompanyalsousesshort-termcreditfacilitiesasitsmainformofshort-termborrowing.Totalshort-termborrowingfromcreditfacilitiesincreasedfrom$400millionin2016to$833millionin2017.Attheendof2017and2016,therewerenooutstandingborrowingsunderthesecreditfacilities.During2017,theamountofshort-termborrowingwasdeemed“immaterial.”However,in2016,theaverageshort-termborrowingwasaround$90.00millionandcarriedanaverageinterestrateofjust0.52%duringtheyear.TheCompany’scurrentNetDebt/EnterpriseValue(EV)is1.25%(NetDebt/EBITDAis16.05%).Thisshowsthatmanagementhasbeenontracktokeepacashbalancelargeenoughtofunddebtobligations.TheCompany’scorporatedebtratingsareasoutlinedinfigure8.AlthoughCostco’sdebtmakesupasmallpercentageoftheirtotalEV,itisimportanttoconsider


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potentialrisk.Asseeninfigure8,theCompanymaintainsstronginvestmentgradecorporateratingsbythreemajorratingagenciesandcontinuetohave“stable”or“positive”outlooks.Thisisastrongsignthattakingondebtisanonissue.

Figure8:COSTCorporateBondRatingsSource:BloombergTerminal.Command:<CRPR>Accessed:11/01/17Asfordebtdistribution,theCompany’sdebttimelineisfullofdebtobligationsthatexpirealmosteveryyearforthenextfiveyears.Althoughinitiallyalarming,Costcohasastronghistoryofcarryingalargeamountofcash(relativetolong-termdebt).Figure9belowgraphicallyrepresentsthedebttimeline.


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Figure9:DebtDistributionTimelineSource:BloombergTerminal.Command:<DDIS>Accessed:10/28/17

B.HistoricalAllocationAnalysisAstrongtrendthattheCompanyhasindulgediniskeepingtheamountofCAPEXconstant.Thisisdirectlyaresultofopeningupnewinternationalwarehouselocations.TheCompanywillfocusitsattentiononoperationswithintheUnitedSates;however,significanteffortisbeingmadetoincreasestorelocationsinCanadaandabroadaswell.Thisefforttoremainconsistentinthenumberofwarehouseopeningsperyearhasbeenmentionedearlier,butisalsoakeypartoftheircapitalallocationstrategytoboosttop-linesalesgrowth.ManagementbelievesthatthecannibalizationofsalesbetweenstorelocationsisstronglyovercomebytheincreaseinRevenueandmembership.Duringthepastfiveyears,Costcohasnotattemptedtomakeacquisitions.ThemostrecentbuyouttheCompanyparticipatedinwasin2012whentheyboughtoutthe50%non-controllinginterestintheCompany’sjointventureinMexico.Subsequenttotheacquisition,Costcoincluded100%ofMexico'soperationswithin"netincomeattributabletoCostco"inthe


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consolidatedstatementsofincome.Costcoisnotexpectedtostrayfromtheirhistoricallackofacquisitionsandassuch,noadjustmentsweremadeinthemodelforanysuchfuturebuyout.Costcousestwomethodstoreturncapitaltoitsshareholders.Oneisthroughdividendsandtheotheristhroughyearlystockrepurchaseprograms.Eachyearmanagementauthorizesaround$4.00billionofsharerepurchases.DuringthepastfiveyearsCostcohasneverfullyexecutedthesesharerepurchases.However,theyfrequentlyrepurchaselargechunksofstocksaveragingaround$350.00millionwhich,inouropinion,pushesthestockpriceevenhigheraboveitsalreadyovervaluedprice.Dividendsaremoresystematicallyapproachedwitharounda$0.05increaseeachyeartotheirquarterlydividend.Thissendsastrongsigntoinvestorsthatthecompanyismeetingitsexpectationsandisgrowingatasteadypace.Thisincreasesinvestorconfidenceandkeepsinvestorssatisfied.Figures10and11belowshowyearlysharepurchasesandquarterlydividendamountsbyyear,respectively.

Figure10:COSTHistoricYearlyShareRepurchasesSource:COSTSEC10-K

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Figure11:COSTHistoricDividendPaymentSource:COSTSEC10-K

C.CompensationandCorporateGovernanceBeforedivingdirectlyintomanagementcompensation,wewillevaluatetheboardofdirectorsthatparticipateonvariouscommittees,includingtheCompensationCommittee.TheCompensationCommittee’sfunctionistoreviewthesalaries,bonuses,andstock-basedcompensationprovidedtoexecutiveofficersoftheCompanyandtooverseetheadministrationoftheCompany’scompensationprograms.Assuch,directorshaveastrongimpactonmanagement’syearlycompensationpackage.

Figure12:CompositionofBoardofDirectorsSource:COSTSECDEF-14A

$0.31$0.36

$0.40$0.45

$0.50

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2013 2014 2015 2016 2017

Dividen

dspaid(USD

pershare)

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Figure12representsa75%independentBoardofDirectors.Costco,likemanyothercorporations,triestoseparatemanagementfromCommitteepositionstopreventconflictsofinterest.AsofAugust2017,JeffreyH.BrotmanpassedawayandchiefoperatingofficeranddirectofBlackstone,HamiltonEvans“Tony”JamesreplacedBrotmanastheChairmanoftheBoard.Thistiltedtheboardevenfurthertowardsindependentdirectors.CompensationfordirectorsisheavilyweightedtowardsStockAwards.Eachnon-employeedirectorearns$30,000.00peryearforservingontheBoardandanadditional$1,000.00foreachBoardandcommitteemeetingattended.Forfiscal2016,non-employeedirectorswerealsogranted2,150restrictedstockunits(RSUs).Thesestockunitsarevestedoverthreeyears,beginningonyearaftertheyhavebeenawarded.Figure13outlinesexactcompensationamountsforeachdirector.

Figure13:CompensationTableforBoardofDirectorsSource:COSTSECDEF-14A

Elementsofmanagementcompensationincludethefollowingsegments:

1. Performance-basedRSUs2. Basesalary3. Cashbonus4. Otherelements

Theseelementsaresortedintotwodifferentlengthsofcompensation:short-termandlong-termperformance.Short-termincentivesareevaluatedonatwelve-monthbasisandconsistsprimarilyofRSUsandtoalesserextent,cashbonuses.Longer-termincentivesalsoconsistprimarilyofRSUsthatvestoverafive-yearperiodandtoalesserextentcertainbenefitplans(i.e.deferredcompensationplanand401(k)retirementplanmatches).


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ChiefExecutiveOfficer(CEO)compensationconsistsof$700,000annualbasesalary(whichisunchangedfromtheprioryear)andacashbonusofupto$200,000(alsounchangedfrom2015)whichisdeterminedbytheBoardofDirectors(theBoard)orCompensationCommittee(theCommittee).TheRSUawardisalsodeterminedbytheBoardortheCommitteeattheendoftheyear.Forfiscal2016,theCommitteegranted35,190performance-basedRSUstoMr.Jelinek.Alsofor2016,theCEOreceivedacashbonusof$81,600.ThecashbonuswasdeterminedbytheCompany’sprogresstowarditspre-taxincomegoal(whichwasnotfullyachievedin2016).OtherNamedExecutiveOfficers(NEOs)2016compensationconsistsprimarilyofperformance-basedRSUs.TheexactamountsawardedwerebasedontherecommendationsofMr.Jelinek.SalariesforotherNEOswerebasedupontherecommendationofMr.Jelinek,whofocusedontheamountofincreasedeservedcomparetoprioryear’ssalarylevel.Basesalariesfor2016wereincreasedby3.00%fromfiscalyear2015.OtherNEOSreceivedcashbonusesofupto$52,640(lessthan2015)asaresultofnotmeetingpre-taxincomegoalfortheCompany.BonuscriteriawereapprovedbytheCommitteeandwerebasedoffMr.Jelinek’srecommendations.Mr.Jelinek’srecommendationfor2016includedapproximately65.00%oftotaleligibleamountofupto$80,000.AsidefromCEOrecommendations,bonus-eligibleemployeesaremeasuredbytheCompany’sattainmentofitsinternalpre-taxincometarget.For2016,thetargetwas$3.64billionusinggenerallyacceptedaccountingprinciples(GAAP)basis.99.00%ofthetargetwasachievedastheactualpre-taxincomewas$3.62billion.SummarycompensationtableforCEOandotherNEOsareasoutlinedinfigure14.

Figure14:SummaryCompensationTableSource:COSTSECDEF-14A


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StockownershiprequirementsforCostcostatethatallexecutiveofficersarerequiredtoownandmaintainatleast12,000sharesofcommonstock.Further,theCompanyprohibitstransactionsthatinvolvehedgingofCompanysharesbydirectorsandexecutiveofficerswithouttheapprovaloftheBoard.PeercompaniesthatCostcolooksattoevaluatetheirmanagementcompensationinclude:Wal-MartStores,inc.,TheHomeDepot,Inc.,TargetCorporation,TheKrogerCompany,andLowe’sCompanies.Thislistofpeercompaniesrepresentsastrongvarietyofcompaniesbiggerandsmaller(intermsofmarketcapitalization)thanCostco.TheCompanyhoweveroutlinesveryfewpeergroupcompanieswhichrestrictsourabilitytocomparecompensation.WhereascompanieslikeTargetandTheHomeDepotlistover30companiesthatmakeuptheirpeergroup,CostcolistsjustfivegivingCostcotheabilitytopickandchoseexactlyhowtheywanttocompensatetheirmanagement.Costco’scompensationisnearlyhalfoftheaverageofitspeergroup.Thisisreflectiveoftheirveryvolatileperformanceoverthelastyearcomparedtotheircompetitors.Overall,theCompanybasescompensationontwomainfactors:i)pre-taxincomemeasuredonGAPPbasisii)discretionofindividualperformancethroughrecommendationofCEO.Thesetwometricsarerelativelyvagueinouropinion.AlthoughGAAPaccountingprinciplesareusedandthereforewecanbesurethatnooddadjustmentsaremade,thereisalackofstrengthwhenitcomestoevaluatingmanagement’sabilitytocreatelong-termvaluefortheCompany.LookingatCostco’speergroupitisapparentthatCostcocompensatesitsmanagementatarelativelylowlevel,howeverthislistismadeupofjustahandfulofnamesandisnotcomprehensivelikemanyofCostco’srivalcompanies.Therefore,werateCostco’smanagementcompensationasneutral.

ConclusionAccordingtoourassumptions,CostcocurrentlyhasanestimatedFreeCashFlowperSharethatislessthanthecurrentstockprice.Thisisafterwehaveassumedextremelyoptimisticgrowthforthenext10years.Secondly,managementdisclosureoffluctuationsandanomaliesinthebalancesheetandincomestatementsareveryscarce.Thereisastronglackofdescriptionofvariationandaccountingchangesfromyeartoyear.Third,neutralmanagementcompensationfurtherdilutesanypotentialvaluepropositionasitishardtogaugeexactlywhatincentivizesmanagement.ForthesereasonsandageneraluncertaintyofgaspricesandforeignexchangeeffectsonCostco’sbusinessoperations,werateCostcoaSELL.


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Appendix

Figure15:COSTInsiderHoldingsSource:BloombergTerminal.Command<HDS>Accessed:11/01/17

Figure16:COSTInsiderTransactionsSource:BloombergTerminal.Command:<GPTR>Accessed:11/01/17


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CitationsEDGAR|CompanyFilings.(n.d.).RetrievedOctober16,2017,from

https://www.sec.gov/edgar/searchedgar/companysearch.htmlCostcoWholesaleCorporation.(2017).Annualreport2017.RetrievedfromSECEDGAR,from

https://www.sec.gov/Archives/edgar/data/909832/000090983217000014/cost10k90317.htm

CostcoWholesaleCorporation.(2017).Quarterlyreport2017.RetrievedfromSECEDGAR,from

https://www.sec.gov/Archives/edgar/data/909832/000090983217000009/cost10q50717.htm

CostcoWholesaleCorporation.(2017).Proxyreport2017.RetrievedfromSECEDGAR,from

https://www.sec.gov/Archives/edgar/data/909832/000090983216000036/costproxy2016.htm

Transcripts,S.(2017,August17).CostcoWholesaleCorporation(COST)Q42017Results-EarningsCallTranscript.RetrievedOctober18,2017,fromhttps://seekingalpha.com/article/4112046-costco-wholesale-corporation-cost-q4-2017-results-earnings-call-transcript?part=single

Bloomberg.(2017)BloombergProfessional.RetrievedOctober16,2017,fromJohnsHopkins

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Studies in Applied Finance - Krieger Web Services · 3/21/2018 · The working paper is an in-depth financial analysis of Costco Wholesale Corporation (COST). Our analysis examines