Costco Wholesale Corporation: Financial Analysis - Research Paper Example

? Costco Wholesale Corporation: Financial Analysis Introduction Costco Wholesale Corporation is the fifth largest retailer and the largest membershipwarehouse in the United States (2011 Top 250 Global Retailers, 2011), having presence in Japan, Mexico Australia, Korea and the United Kingdom. Founded in 1983, Costco has, as of 2011, gone on to establish 582 warehouses worldwide, 492 of which are located in the United States (Audited Financial Statement 2011, 22). The business model of Costco is centered around memberships which allows customers access to the product catalogue of the company at significant discounts. As such, the company is following the low price high turnover approach, under which Costco has registered a sales revenue of $88.9 billion and a net profit bottom line of $1.46 billion in 2011 (Audited Financial Statement 2011, 47). The financial figures included in the financial analysis are taken from the audited financial statements of Costco Wholesale Corporation 2010-2011 and figures used in calculations are in $ million. Competitive and Corporate Strategy Analysis Being a major player in the wholesale retailer industry, Costco has devised its own unique approach to create its own niche in the market and face the industry's challenges. The following SWOT analysis illustrates certain aspects of those challenges faced by Costco and the strategy it hopes will improve upon its current market share. Strengths The business model of using a membership to allow customers to avail significant discounts has helped Costco to maintain a loyal client base. The retailer is famous for offering unparalleled discounts and promotes a “treasure hunt” shopping environment. This strategy involves offering large discounts on certain items which will be available for a short period of time, and as such increases turnover by volume. Expansion by Costco to foreign countries is giving a boost to their sales and allowing them to benefit from economies of scale and better inventory management. Aggressive expansion plans to increase the number of warehouses to 1,000 in the next ten to twelve years (Audited Financial Statement 2011, 4) will help the company to improve upon its market share. Weaknesses Despite the large discounts, Costco is known to offer a catalogue that offers a limited range of products, mainly high end, high value products and certain private labels. Unavailability of certain items might force customers to abandon Costco as a preferred retailer. Opportunities Costco's business model has the potential to be successful in foreign countries, and the company should further expand its warehouses in foreign countries to tap potential markets. Also the company should look towards increasing its product catalogue and further enhance its online shopping experience to increase turnover and customer satisfaction and retention. Threats Since Costco is in competition with the world's largest retailers like Walmart, Target and Kohl's, the company faces threats from significant changes and sales strategies that these chains might use to dent Costco's market share. At the same time, Costco's business model of high turnover faces risks from a sluggish economy. Accounting Distortions A company's financial statement is a document that records and reports the business performance of the company over the current fiscal year. However, there are a number of accounting principles and policies that the company can use to structure the financial statements and have material effects on transactions and closing balances in certain accounts. These differences in accounting methods that lead to different results in financial statements are known as accounting distortions. The accrual method of accounting involves recording a financial transaction as it occurs, regardless of the final cash settlement. This method of accounting is favored by Generally Accepted Accounting Principles (GAAP), which is the accounting system used by Cotsco. This means that it is probable that out of the $87 billion sales recorded by Costco in 2011, not all were cash based and it is likely that the company has not received a comparable amount in cash. If the sales were reported on cash basis, the company sales would have been greatly deflated compared to its present level. Also following the GAAP can lead to distortions in the value of short term investments of Costco worth $1.6 billion in 2011 when it comes to reporting the investments' value and changes in valuation. Another source of accounting distortions comes from differences in reporting methods for inventory. There are many ways in which companies report inventory on their balance sheet, but FIFO and LIFO are the two methods used often. The main difference between the two lies in how the inventory is reported in cost of sales and closing inventory, with FIFO leading to greater profitability on account of lower cost of sales and a higher closing inventory level, assuming an inflationary environment. Costco reports its merchandise inventories on LIFO basis while its inventories related to foreign operations are reported of FIFO basis. Differences in inventory valuation resulting from the two methods are recorded by the company under the tab of merchandise costs to adjust inventory to LIFO. These differences are based on the inflationary environment, for example, in 2011, inventories at Costco valued using the LIFO method were lower than the value under the FIFO method due to inflationary trends in 2011. On the other hand, owing to an overall deflationary environment in 2009 (Audited Financial Statement 2011, 29), the company recorded an opposite effect and recorded a benefit to merchandise costs to cater for the differences in inventories valued at LIFO. Accounting for depreciation can also result in accounting distortions based on the assumptions and method of depreciation used. Costco depreciates its property and building using the straight line method and a useful life estimate of 5-50 years for buildings and 3-20 years for equipment (Audited Financial Statement 2011, 54) . Repair and maintenance costs are expensed when incurred whereas costs of refurbishment that increase the useful life of the asset are capitalized. Accelerated method of depreciation, which appropriate a higher cost of depreciation of the asset in the earlier years of its use, would lead to a different depreciation charge based on the period of use of the asset. Similarly, a change in the useful life estimates of the asset will affect depreciation and might lead to accounting distortions. Quality of Earnings There are a number of definitions which are used to refer to the quality of earnings of a company, including the reasonableness of earnings and the amount of earnings derived from increased sales or reduced costs rather than extraneous earnings or accounting anomalies which can result from management discretion. For the purpose of this report, we will analyze earnings quality based on the accruals ratio using the balance sheet approach, which serves as a measure of discerning the amount of company earnings that are accrual based. The following steps will help us calculate the accruals ratio and determine the quality of earnings for Costco: Earnings = Cash Earnings + Aggregate Accruals Aggregate Accruals = Accrual Basis Earnings – Cash Earnings a) Calculate Net Operating Assets (NOA) for the current period (t) and previous accounting period (t – 1) NOA is a measure of changes in all the non-cash balance sheet items for the 2010-2011 accounting period. NOA (t) = (Total Assets (t) – Cash (t)) – (Total Liabilities (t) – Total Debt (t)) For the years 2010 – 2011, the NOA for Costco is as follows: NOA (t = 2011) = (26.761 – 4.009) – (14.188 – (0.9 + 1.253) = 10.717 NOA (t = 2010) = (23.815 – 3.214) – (12.885 – (0.026 + 0 + 2.141) = 9.883 b) Calculate Aggregate Accruals Aggregate accruals shows the change in a company's NOA over the accounting period Aggregate Accruals = NOA (t) – NOA (t – 1) = 10.717 – 9.883 = 0.834 c) Calculate Accruals Ratio Accruals Ratio = (NOA(t) – NOA(t-1)) / ((NOA(t) + NOA(t-1)) / 2) = (0.834) / (20.6 / 2) = 0.081 Since the accruals ratio is very low, this shows that Costco's earnings have a low component of aggregate accruals which implies that the company has a high quality of earnings. Ratio Analysis Following table lists the different business performance ratios of the company related to profitability, efficiency, liquidity and solvency: ___________________________Costco Ratio Analysis_________________________________ 2009 2010 2011 change from 2010-2011 Profitability Return on Sales.............................. 1.52% 1.67% 1.64% -1.8% Return on Assets............................. 4.94% 5.47% 5.46% -0.2% Return on Equity........................... 10.75% 11.92% 11.63% -2.4% Liquidity Current Ratio................................. 1.11 1.16 1.14 -1.7% Efficiency Inventory Days.............................. 31 days 30 days 31 days AR Days …................................... 4 days 4 days 4 days Solvency Leverage....................................... 1.175 1.178 1.128 -4.2% Debt / Assets................................. 10.13% 9.10% 8.05% -11.6% Profitability Return on Sales = Net Income / Sales Return on Assets = Net Income / Total Assets Return on Equity = Net Income / Equity As can be seen from the ratios above, profitability saw a rise from 2009 to 2010 mainly on account of an increase in comparable sales and an increase in sales at new warehouses set up in 2009 and 2010. Also foreign currencies, particularly in Canada, Japan and Korea appreciated against the dollar which positively impacted sales in 2010 and 2011. However, this increase in sales and profitability is not very visible in the profitability ratios for 2011 since the company registered a LIFO inventory charge in 2011 from higher cost of merchandise inventories, mainly food and gasoline. Return on Equity saw a decrease of 2.4% in 2011 YoY despite a net profit of $1.462 billion due to a greater increase in equity on account of a rise in retained earnings and a higher foreign currency translation adjustment from 166 (2010) to 366 (2011). Liquidity Current Ratio = Current Assets / Current Liabilities Despite an increase in Cash holding of the company and a rise in accounts receivable in 2011 by about 25% and 17.7% respectively, current ratio fell slightly from 1.16 to 1.14 in 2011. The reason for this slight decrease can be attributed to a 10% increase in accounts payable and payment of the current portion of long term debt of $900 million in the current year 2011. Efficiency Inventory Days = Merchandise Inventory / Merchandise Costs * 365 Account Receivable Days = Net Receivables / Sales * 365 The inventory days and days in receivables have stayed the same over the past three years, indicating the company is maintaining the same efficiency level despite the increase in 14.1% in sales in 2011 YoY and increase in inventory and accounts receivables by 17.7% and 9.2% respectively. Solvency Leverage = Total Liabilities / Equity Debt to Assets = (Short term Debt + Long term Debt) / Total Assets Even though total liabilities have increased by 10.1% in 2011 YoY on account of increased accounts payable and other current liabilities, the equity of the company has increased by 15% due to increase in retained earnings and higher other comprehensive income due to foreign currency translation adjustment. This has improved the leverage of the company, which has fallen by 4.2% in 2011 YoY and signals to greater financial strength of the company and its ability to continue as a going concern in the foreseeable future. Debt-to-assets has significantly improved from 9.10% to 8.05% in 2011 YoY on account of greater investment by the company in fixed assets, which have seen an approximately $1.2 billion investment in buildings and improvements in 2011. The debt level of the company has remained stagnant at the $2.153 billion mark, with efforts by the company to repay its debt by earmarking $900 million of long term debt as current portion to be repaid in 2011. Projecting FCF Free Cash Flow (FCF) is a measure of the company's financial performance that represents the ability to expand in the future. It is the amount of funds left over after taking out the expenditure related to maintenance of the current asset base and is a measure of the resource available at the company's disposal to pursue activities that increase shareholder's value for example capacity expansion and acquisitions etc. FCF is calculated as operating cash flow netted against capital expenditures as shown by the formula: FCF = CFO – Int(1 – tax rate) – FCInv where CFO is Cash Flows from Operations Int is the finance/interest cost of the company FCInv is the fixed capital expenditure incurred For Costco, the FCF are listed below: _________________________Costco FCF 2008-2011__________________________________ 2008 2009 2010 2011 Cash Flow from Operations ....... 2,206 2,092 2,780 3,198 Finance cost ............................... 103 108 111 116 Tax rate ...................................... 35.6% 36.4% 35.6% 35.3% Fixed Capital Expenditure ........ 1,599 1,250 1,055 1,290 Proceeds from Sale of Equipment 48 7 4 16 FCF …........................................ 588.7 780.3 1,657.5 1,848.9 % change YoY ............................ 32.5% 112.4% 11.5% ______________________Costco FCF Projections 2011-2016___________________________ 2011 2012 2013 2014 2015 2016 Sales (growth rate: 10-25%) 87,048 95,753 105,328 126,394 151,672 189,590 Net Income (1.6% of Sales) 1,462 1,532 1,685 2,022 2,427 3,033 Cash Flow from Operations 3,198 3,064 3,370 4,044 4,854 6,066 (2 * Net Income) Finance Cost 116 70 70 70 70 70 Tax rate 35.3% 36% 36% 36% 36% 36% Fixed Capital Expenditure 1,290 1,419 1,561 1,795 2,154 2,585 (growth rate: 10-20%) FCF 1,849 1,600 1,764 2,204 2,655 3,436 Rationale for Assumptions Sales: Costco had 582 warehouses worldwide as of 2010 and has the ambitious expansion plan of going up to a capacity of 1,000 warehouses over the next ten to twelve years. The approximately 14% increase in sales in 2011 YoY is the result of setting up of new warehouses as well as the weakening of the dollar which positively impacts Costco's sales. Thus with the upcoming increase in warehouses and an under pressure dollar currency, a conservative sales growth estimate of 10% has been used during 2012 to 2013, which will increase to 20% in 2014-2015 and 25% in 2016 as new warehouses come online. Finance cost: The company has listed a $900 million portion out of $2.141 billion of its long term debt as current portion to be repaid in 2011 (Audited Financial Statement 2011, 46). However, according to the financial statements for 2011, the company has no further debt maturing within the next five years and lists the remaining $1.25 billion long term debt to be repaid some time after five years. Hence we have fixed the finance cost over the next five years to represent the cost attributed to the long term debt remaining. This estimate is also reiterated by the fact that the company enjoys positive cash flows which can be utilized for any capital expenditure as desired and has no urgent need of any short term borrowing. Fixed Capital Expenditure: The company has stated one of its long term objectives to increase the number of warehouses to 1,000 from 582 in 2010. This will involve significant capital expenditure over the next ten years. Since the company is already in the process of setting up warehouses over the past two to three years, we have taken a growth in capital expenditure of 10% from 2012 to 2013, which will increase in 2014 and 2015-2016 to 15% and 20% respectively. The increase in growth in the later years is based on the assumption that as the company increases its revenues, it would have greater capacity to appropriate a greater amount of funds towards capital expenditure. Calculate WACC Weighted Average Cost of Capital (WACC) is the company's cost of capital that is proportionately weighted on the different sources of capital and its costs. The following is used to calculate WACC: WACC = (Equity / (Equity + Debt) * Re) + (Debt / (Equity + Debt) * Rd * (1 – Tax rate)) where Re = cost of equity Rd = cost of debt A company's cost of debt can be the weighted average interest rate of the rates charged to the different credit facilities utilized by the company. Cost of equity can be calculated using the CAPM model: E(R) = Rf + beta(i) (E(Rm) – Rf) where Rm = expected market return Rf = risk free rate beta(i) = beta of the security The rate on US 10 year Treasury yield curve was 3.40% (US Department of the Treasury) in 2011 and will serve as the risk free rate. The average expected market return from 1927 through 2010 has been 11.71% (Marotta, 2012). Walmart, a supermarket chain seen as a competitor of Costco, has an estimated beta of 0.37 (Anderson, 2011). Therefore, assuming Costco's beta is 0.40, Costco's cost of equity is as follows: E(R) = 3.4 + 0.4(11.71 – 3.4) = 6.724% Majority of Costco's long term debt is in the form of Senior Notes of $1.096 billion and $899 million due March 2017 and March 2012 respectively (Audited Financial Statement 2011, 65) . The interest rates on the two debt instruments are 5.5% and 5.3%. Therefore, we will take Costco's cost of debt as 5.4%. WACC = (12,573 / (12,573 + 2,153) * 6.724) + (2,153 / (12,573 + 2,153) * 5.4 * (1 – 0.36)) = 4.901 + 0.505 = 5.41% DCF Analysis Discounted cash flow analysis can be used to arrive at a fair valuation of the company based on the cash flow projections of the company discounted using the WACC using the formula: Discounted Cash Flows = CF1 / (1 + R) + CF2 / (1 + R)^2 + …...+ CFn / (1 + R)^n where R = discount rate (WACC) ______________________Discounted Cash Flows 2012-2016___________________________ 2012 2013 2014 2015 2016 Projected FCF 1,600 1,764 2,204 2,655 3,436 Discounted FCF 1,517.9 1,587.6 1,881.8 2,150.5 2,640.3 Terminal Value and Company Valuation To calculate the company's terminal value, we will use the perpetuity growth model, which assumes that the cash flows of the company will grow at a constant rate indefinitely. For the purpose of this assignment, we will regard the projected cash flow of year 2016 as a perpetuity and discount it using the WACC and the growth rate of the cash flows. The growth rate of the cash flows is generally assigned a value that is above the long term inflation expectation, below or equal to the expected long-term GDP growth rate of the economy and below the risk free rate used in the valuation. Since the USA inflation was around 1.6% (Malik Crawford et al, 2011) from 2010-2011 and expected to increase to 2% in the future, GDP growth rate of the USA was 1.7% during 2007-2011 (World Bank) with an expectation of a 2-2.5% in the near future, and the risk free rate used is 3.4%, for the purpose of this calculation we will use 2.5% as growth rate of cash flows. Terminal Value (TV) = FCF(2016) * (1 + g) / (WACC – g) where g = growth rate of cash flows TV = 2,640.3 * (1 + 0.025) / (0.0541 – 0.025) = 93,000.3 TV discounted to t = 0: 93,000.3 / (1.0541^5) = 71,462.3 Enterprise Value = Sum (of discounted cash flows) + Discounted TV = 9,778.1 + 71,462.3 = 81,240.4 Fair Value of Costco = Enterprise Value – Debt = 81,240.4 – 2.143 = 81,238.6 Total shares outstanding (2011) = 433,510,000 Fair Value per share = 81,238.6 / 433.510 = 187.4 Costco Wholesale is currently going through a period of expansion, with plans of more than doubling its warehouse capacity to 1,000 within the next ten to twelve years. The company has posted a consistently strong bottom line and projections also show strong cash flows. Since the share price of Costco Wholesale was $80 in 2011 (latest share price: $96.92) (nasdaq.com) against projected fair value per share of $187.4, it is under valued and is recommended as a buying opportunity for investors based on the growth plans of the company and the future warehouse expansion. Works Cited Anderson, Spencer. "Walmart Corporation." Henry Fund Research, Mar. 2011. Web. . Marotta, David John. "CAPM: The First Factor of Investing."Forbes. Forbes Magazine, 19 Mar. 2012. Web. 15 Dec. 2012. "Daily Treasury Yield Curve Rates."US Department of the Treasury., 2011. Web. Dec. 2012. . "GDP Growth (annual %)." World Bank, 2011. Web. 15 Dec. 2012. . Crawford, Malik, Andrew Mauro, and Jonathan Chruch. "CPI Detailed Report Data for January 2011."CPI Data. N.p., 2011. Web. . "2011 Top 250 Global Retailers."STORES.org. STORES, 2011. Web. 15 Dec. 2012. . Costco. "Audited Financial Statements 2011." (2011): n. pag. Web. 15 Dec. 2012. . Costco. "Audited Financial Statements 2010." (2010): n. pag. Web. 15 Dec. 2012. . Nasdaq, Costco share price December 15th 2012, http://www.nasdaq.com/symbol/cost Read More