Financial Analysis of Costco Wholesale Corporation - Essay Example

Financial Analysis of Costco Wholesale Corporation Introduction In today’s world there are ample investment opportunities available to an investor. One can invest in stocks of a company, real estate, derivatives, gold etc. But this multiple investment opportunity brings along the risk associated with the respective class of the asset. While investment in gold depends on the price level and the performance of the gold market, the investment in stocks of companies depends on the financial performance of the company, its market reputation, track record of dividends and various other financial parameters. Besides this the comparison of the company’s ratios with that of its peers gives an idea about its financial health. An analysis of the debt-equity ratio of the company highlights the leverage of the company. Usually, a company with a high debt-equity ratio is considered as a risky proposition. The high level of debt increases the financial burden of the company thereby making it vulnerable to the unjustified demands of the lenders. As the stake of the lenders is high they try to control the affairs of the company leaving little authority for the shareholders. This is not looked upon favorably by the market participants and they react by selling off their shares in the company pulling down its market price significantly. All these factors deserve due consideration while investing in Costco. About the company Costco Wholesale Corporation has a global warehousing chain operating as “Costco Wholesale” that offers branded and quality goods at a lower price as compared to the other retail or wholesale sources. The company is based in Washington and its shares trade on the Nasdaq under the ticker name ‘COST’ (Costco, “Company Profile”). Financial Analysis Analysis of the Income Statement- The revenue of the company has moved up steadily over the last two years with $ 72483 million in 2008 and US$71422 million in the year after. This has increased nearly 18 percent over the last three years. It recorded a net income of $1103 million for the year ended 2005-06. The revenue of the company increased consistently after this but there was no substantial increase in the net income in the following years. Even though the revenue for the period 2008-09 increased by nearly 18 percent over the last three years, the net income for the period was reported at $1086 million, signifying a decrease of nearly 1.54% as compared to $1103 million in 2005-06. This is not a good sign. It indicates that the company is not able to manage its resources efficiently. Generally, a rise in the revenue is accompanied by a rise in the net income of the company but this has not happened in the case of Costco. This may be due to various factors like increase in the operating or non-operating expenses. The operating cost of the company has remained stable at approximately 87 percent over the years. This is measured as the percentage of Operating Cost over Revenue. But there has been a sharp rise in the non-operating expense of the company as is visible from the financial statements. The interest expense of the company was $12.57 million in 2005-06. This increased nearly 760 times to $108 million for the period 2008-09, which can be attributed as the main reason for the fall in the profit margin of the company. It also highlights the huge financial obligations that the company has undertaken over the years. This has wiped out a significant amount of its earnings resulting in low per share earnings for its shareholders. The basic EPS of the company has consistently remained below $3 in the last four years. In 2004-05, the company reported an EPS of $2.27. This increased to just $2.53 in 2008-09 which is an increase of merely 11.45 percent over the last four years. From this it is clear that the company has not been able to make any significant profits for its shareholders. The earning per share (EPS) is the highlight for the shareholders. A consistently low EPS is not good news for its investors. EPS represents the profit available to the shareholders (Costco-b, “Fundamentals - Annual Income Statement”). It is expressed as- EPS = Profit after tax/Number of outstanding shares The total outstanding share of the company for 2008-09 is 435.97 million. This was high initially in 2004-05 at 472.48 million. But since then the company has consistently reduced its equity exposure. With the fall in the shares outstanding the EPS of the company must have moved up but this did not happen for Costco. Despite the fall in the number of shares the EPS of the company remained more or less the same. There was no significant increase in the EPS of the company (Costco-c, “Fundamentals - Annual Balance Sheet”). Analysis of the Balance Sheet- The long term debt position of the company has nearly trebled over the last four years. This was $710.68 million in 2004-05. In 2008-09 the company had a long term debt of $2206 million. This shows that the company has increased its leverage significantly. It has been seen that the highly leveraged companies have to forego many lucrative investment opportunities on account of being overburdened with debt repayments. This seems to be true for Costco as well. In the last five years the revenue of the company has increased by only 8.22 % (Costco, “Fundamentals – Snapshot”). Moreover, the company ranks tenth in the industry in terms of long term growth rate. It has a 5 year growth rate of 13.22% (Yahoo Finance-c, “Cost vs. Industry leaders”). The investors invest in a company based on its growth statistics. A higher growth prospect indicates that the company will be able to generate higher earnings for its shareholders and vice versa. But the company is lagging in growth terms as per the industry standards. Going by the growth standards Costco does not appear to be a viable investment option. The total debt to equity position of the company is 21.41 percent. In terms of market capitalization Costco is the second highest after its business rival Target Corporation. While its competitor reported an EBITDA of $6.09 billion, the same for Costco is less than half at $2.53 billion (Yahoo Finance-a, “Direct Competitor Comparison”). Analysis of company ratios- The current ratio of the company is 1.13. This is very low as per industry standards. Current ratio is given as current assets/ current liabilities. A high ratio indicates that the company is capable of taking care of its short term obligations. This is less than its prime competitor Target Corporation which has a current ratio of 1.80 (Yahoo Finance-b, “Financial Highlights”).A low current ratio is not a good sign for the investors. The operating margin of the company is 2.53% which is much less than the Target Corporation of 6.51%. This is less as per industry standards at 4.39 percent. A high margin means that the company is able to exercise control over its operating expenditures whereas a low margin indicates management inefficiency making it unattractive to the investors. The net profit margin of the company is 1.51%. Net profit margin represents net profit expressed as a percentage of revenue. A high net profit margin highlights the efficiency of the management in controlling the non-operating expenditure. As the net profit margin of the company is low it shows the inability of the management in exercising control over its non-operating costs. Despite the consistent increase in the Gross profits of the company the company has not been able to push up its net profit margins. This can be partly due to the rise in the non-operating expenses of the company. Figure-Comparison of Gross Profit and Net Profit in the last four years- The above graph shows that the gross profit of the company has increased steadily over the years. But there was no correponding increase in the net profit of the company as is evident from the flat net profit curve. Even in the year when the gross profit is rising there is a fall in the net profit margin of the company. This indicates a mismanagement of resources. The dividend yield of the company is 1.22%. Dividend yield is expressed as a percentage of market price of the company. The shareholders desire for a high Dividend yield on their investment. Often the investors hold onto their long position for enjoying a high rate of dividend income. So this lures the investors in retaining their long position in a share. Therefore, a stock with a high rate of dividend is attractive for the shareholders. But the rate of dividend for Costco is only 0.72 percent making it unattractive to the shareholders. The Dividend per share of the company for the current period is $0.70. Its competitors have declared roughly the same amount of dividend but with a higher dividend yield. This shows that the company is overpriced as per this standard making it unsuitable for investment. The price earning ratio of the company is 23.53 times. It can be interpreted as it will take nearly 23 years for the investors to recover the value of their investment from the earnings of the company. This ratio is high as per the industry standards. While the average price –earning ratio for the industry is 16.79 times and most of its peers have a lower P/E ratio reflecting their higher amount of earnings. From this viewpoint the company looks unworthy of investment. The asset turnover ratio of the company is 3.25 times. This ratio examines how well the company is able to utilize its assets. A low ratio indicates an improper utlization of the available resources. The low asset turnover ratio of the company indicates that the management has failed to use its asset base effectively. This highlights the weaknesses in resource management. The company has significantly high volume of assets as is evident from the Balance Sheet. Based on this, it had the capability of generating higher volume of revenue but the inability of the management in doing so is a serious concern. In terms of revenue growth, the company ranks eleventh in the industry. Despite the large volume of assets the low asset turnover ratio and low revenue growth show that the management is not capable of managing the available resources. Due to the dismal growth scenario it is doubtful whether the company will be able to generate sufficient returns for its investors. When there are performers in the industry with anticipated revenue growth rate of as high as 12.70 percent the investment in Costco does not look viable. The impact of the low asset turnover ratio of the company is also reflected on the return on assets. For this year the company has managed to earn only 4.92 percent on its asset base. It is apparent that the company has employed more assets than its ability to maintain. Ideally the company increases its assets to generate a higher volume of business. Costco has increased its asset base significantly over the years. In the last four years, it has increased its assets base by nearly 31 percent. It has invested heavily into machinery. In 2004-05 the company had investments worth $2181.74 million in machinery which increased to $3265.00 million during the period 2008-09, an increase of nearly 50 percent. But the returns of the company have not moved up in the same proportion highlighting the inefficient use of the available resources. In terms of EPS growth the company ranks ninth in the industry. The EPS measures how much earnings the company is able to generate for its shareholders. A low EPS makes a company unattractive as it results in a low dividend declaration. The investors are attracted to companies paying a higher amount of dividend. This is only possible if the company has a high EPS. So the low EPS of the company makes it unattractive to the investors. Another way of assessing an investment opportunity is through the “return on equity”. The return on equity is the amount of return that the company is able to earn on its equity capital. As the equity investors undertake a large amount of risk, by contributing towards the initial capital of the company, consequently they demand for higher returns on their investment. If the company is not able to meet their demand they might even withdraw their investment. The return on equity of Costco is 11.35 percent (Costco-e, “ Fundamentals - Ratios”). The company ranks eighth in terms of return on equity. This looks dismal as compared to the market leaders. The ROE achieved by the market leader in the industry is 23.59 percent. This is a major factor considered by the investors while acquiring the shares of a company. The returns earned by the managers such as the return on equity, return on asset and the return on investment is considered as the benchmark by the investors. A high return means an efficient utilization of resources and a low return signifies mismanagement of the resources. From this viewpoint the investment in the company does not seem to be lucrative. Conclusion From the above analysis, investment in Costco appears to be unworthy. The net income of the company which is indicative of the managerial efficiency has remained almost flat for the last four years. Usually, the net profit of the company determines the amount of dividend the company will distribute among its shareholders. The low rate of dividend along with the low growth in the profit margin of the company is a major hurdle in attracting investors. Generally, the investors prefer to invest in the companies with high level of earnings as it increases the chance of higher dividend. This is not true for Costco as is apparent from its low EPS and consequent low dividends. The growth prospects of the company also appear to be dismal. In the last three years the company has just been able to increase its revenue by 18 percent. The company ranks eleventh in terms of revenue growth in the industry. A rise in the EPS or DPS is only possible if the company is able to boost its revenue. As the company fails on this parameter it is doubtful if the investment in the company will yield any gains. Besides this the inefficiencies of the manager as is evident from the low return on asset is a major impediment in the growth of the company. In terms of long term growth rate, the company is far behind its competitors. The company does not feature even in the top five companies on this parameter. The low earnings and the high price of the company have raised the price-earning ratio of the company. So, the high P/E ratio is not indicative of the company’s prospects. At present, the shares of the company are trading at $59.09. The highest price recorded by the company in the 52 weeks is $61.25. As the shares of the company are already close to its 52 week highest chances of any substantial gains from the shares are limited (Yahoo Finance-d, “Summary”). This is mainly due to the weak fundamentals of the company. Based on the fundamentals and the low ranking in the industry the company does not appear to be a lucrative investment opportunity. Reference Costco-a. Company Profile. No Date. Investor Relations. January 11, 2010. < http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-homeprofile>. Costco-b. Fundamentals - Annual Income Statement. No Date. Investor Relations. January 11, 2010. . Costco-c. Fundamentals - Annual Balance Sheet. No Date. Investor Relations. January 11, 2010. . Costco-d. Fundamentals – Snapshot. No Date. Investor Relations. January 11, 2010. . Yahoo Finance-a. Direct Competitor Comparison. No date. Competitors. January 11, 2010. . Yahoo Finance-b. Financial Highlights. Target Corp. January 11, 2010. . Yahoo Finance-c. Cost vs. Industry leaders. Costco Wholesale Corporation. January 11, 2010. . Costco-e. Fundamentals – Ratios. Investor Relations. January 11, 2010. . Yahoo Finance-d. Summary. Costco Wholesale Corporation. January 11, 2010. . Bibliography University of Notre Dame. Financial Ratio Analysis. No Date. . Read More