Value Thoughts – Costco Wholesale Corporation

Costco Wholesale Corporation (Nasdaq: COST) operates membership warehouses based on the concept that offering its members low prices on a limited selection of nationally branded and selected private-label products in a wide range of merchandise categories will produce high sales volumes and rapid inventory turnover.

This turnover, when combined with the operating efficiencies achieved by volume purchasing, efficient distribution and reduced handling of merchandise in no-frills, self-service warehouse facilities, enables the company to operate profitably at significantly lower gross margins than traditional wholesalers, mass merchandisers, supermarkets, and supercenters.

The company currently operates 581 warehouses, 425 in the United States and Puerto Rico, 80 in Canada, 22 in the United Kingdom, seven in Korea, six in Taiwan, eight in Japan, one in Australia and 32 in Mexico. The company also operates Costco Online, an electronic commerce web site.


Financial information presented herein, is based on the company’s most recent SEC Form 10-K filing for year ending August 29, 2010, as filed with the Securities and Exchange Commission on October 15, 2010.

Short-Term Investment Valuation

The stock closed recently at $78.30, with first First Resistance at $79.37, a 1% increase from the recent close and Second Resistance at $83.95, a 7% increase from the recent close.

The stock price should find First Support at $70.96, a 9% decline from a recent close, and Second Support at $53.41, a 32% decline from a recent close.

Daily Relative Strength is currently 42, with the stock price continuing to correct from an oversold condition.

Earnings Growth Valuation

Our earnings growth valuations are based on the spread between year over year earnings growth and the current PE.

In the case of Costco Wholesale Corporation, the company had a year over year earnings growth of 30%, ending FY10 with earnings of $4.52 per share.

With a trailing twelve month PE of 17, the spread between earnings growth and the PE is about 1.8, meaning that for an investor focusing on earnings growth, the stock should be trading near $86.25, a $7.95 increase from a recent close.

Fundamental Investment Valuation

Liquidity: The company ended FY10 with a Current Ratio of 1.16, a Quick Ratio of 0.56, a Cash Ratio of 0.47, and a Cash Conversion Cycle of 2.5 days. In addition, Goodwill and Intangibles comprised less than 1% of Total Assets, and the company had a Book Value of $24.28 and a Tangible Book Value of $24.28.

Profitability: For FY10, the company had a Gross Margin of 14%, an Operating Margin of 3.5%, a Net Operation Margin After Taxes (NOPAT) of 2.6%, a Return On Invested Capital (ROIC) of 16%, and an Effective Tax rate of 35.6%.

Debt: For FY10 the company had Total Debt of $2.17 billion, a year over year decrease of 7%. Additionally, the company paid an average annual Interest Rate 5.12%, a year over year increase of 0.43%, had a Debt to Cash Ratio of 0.46, and a Debt to Equity Ratio of 0.50.

Cash Flow: The company’s FY10 Operating Cash Flow was $6.60 per share, a year over year decrease of 11%, and its Free Cash Flow was $3.48, a year over year decrease of 43%.

Dividends: During FY10 the company paid a dividend of $0.76 per share, a 13% year over year increase. Based on a recent close of $78.30, the Dividend Yield is 0.97%.

Fundamental Valuation: Based on our review of the company’s latest annual financial information we think a Reasonable Value Estimate for the company is in the $50-$52 range.

Value Thoughts

In late April 2011, the company announced that the Board of Directors had authorized a stock repurchase plan of up to $4 billion, and that the plan would expire in April 2015. It should come as no surprise that we are not fans of this plan.

The main reason we are not fans of this plan is because the company has debt that we believe should be eliminated first. While we are aware that the vast majority (about $1.9 billion) of the company’s debt is in the form of Senior Notes, half of which are due in March 2012 and half of which are due in March 2017, we simply feel such plans are an unnecessary drain on company cash, and serve no real business purpose.

Instead of a stock repurchase plan, we believe management should consider the shareholders by paying off the company’s debt and then dramatically increasing dividends. Once those things are done, then consider a share repurchase plan.

With all of that said, considering a Recent Close of $78.30, an estimated Merger and Acquisition payback of 12 years (assuming EBITDA remains the same), year over year earnings growth of 30%, as well as year over year free cash flow growth of 43%, we think, on a fundamental investment basis, the stock is currently OVER PRICED, and not a candidate for additional research for the Wax Ink Portfolio..



We have no position in Costco Wholesale Corporation, and no plans to initiate a position in the next 5 business days. Additionally, we have received no compensation to write about a specific stock, sector, or theme.