Description

Investment Summary

We think Costco is a reasonably priced, growth compounder that merits investment consideration. Shares today trade at 40% below our long-term estimate of intrinsic value.  The world's second largest retailer is one of the best operators in the industry, enjoys a remarkably positive brand, a long history of earnings growth, and loyal membership base that will grow steadily for many years as the company continues to invest internally generated capital into location enhancements and new stores both in United States as abroad. We like Costco's business fundamentally: as the company is an innovative retailer, focused on a high quality experience for its customers; but also from a capital management perspective: where management has demonstrated a prudent history of returning capital to its investors through both dividends as share buybacks.

The company's membership warehouse business model is simple to understand and follow. We believe it operates on a flywheel principle where a focus on lower prices and areputation for value and price authority produce a quality membership experience that leads to high membership retention rates, successful new store launches and growth in membership count.  Membership growth then leads to improvised purchasing power that Costco exercises in the form of improved services and benefits, as well as lower prices, to its members.  This in turns attracts more members. What this company is able to do with 11% gross margins is nothing short of incredible in our view.  Management takes a long-term approach to generating shareholder value, and we think we're only in the middle innings of a sustained growth story. This strikes us as one of those great companies where long term value will be realized to owners who can, in the words of one its board member's words, sit on their asses.

(N.B We're also members and frequent buyers of their $4.99 Rotisserie Chickens.)

Catalysts

There are many elements to growth story here in the next 24 months. Some of the slow release catalyst we're following include:

1) Accelerated store openings over the next 3 years - We expect Costco to open 30 to 35 stores a year for the foreseeable future. New store opening will likely reach 40 stores a year by 2020.

2) Effects of IT Modernization - A system wide IT upgrade has represented a drag to SG&A over the past 6 quarters, however the company will begin to see the benefits tied to the new system and realize margin benefits through lower SGA in FY 2016 as the company prepares to be able to accommodate double its current business over the next 10 years.

3) Active campaign to upgrade Gold Star to Executive Memberships - About 60% of Costco members pay $55 a year in membership dues, but management is pursuing active measures to upgrade more members to Executive membership $110 in membership dues. We expect successful up-selling combined with the new co-branded credit card with Citi to represent an ongoing boast to current margins.  Additionally membership prices hikes in the next 2 years (Costco tends to raise membership rates by $5 every 5 years; and we expect a price hike by mid 2017) will as well benefit near term earnings.

4) Benefits of termination of agreement with American Express - Switching its co-branded credit card from AmEx to Citi/Visa early next year will lift operating margins. Although the company has indicated that it will return the majority of the savings from the new Citibank credit card partnership to customers through improved product pricing. So while not the majority of the savings will not directly flow through to the bottom line, it's another example of customer savings that improves Costco's competiveness, delivers value to members, and marginally enhances the appeal of membership.

5) Balance sheet leveraging - Costco has one of one of the most pristine balance sheets in retail: with about 1.6X rent-adjusted leverage and 13X fixed-charge coverage. We think this one is unlikely, but the company is over-capitalized and has the capacity to responsibiliy return capital as it did with a $5 dividend earlier this year.    There is the possibility of semi regular special dividends being disbursed to investors.  Costco employees have unusually high equity components to their compensation, so management perceives these dividend distribution to reward a broader set of stakeholders than just existing shareholders.

6) Continued growth of E-Commerce - Currently the e-commerce business represent 4% of sales, but enjoys 20% year over year growth. Costco's e-commerce operations occur today in just four countries (US, Canada, Mexico and the UK). We expect organic growth to continue at a high double digit rate in existing markets as well as the e-commerce expansion into markets where Costco already has physical stores: including Japan, Korea, Taiwan, and Australia.

7) Expansion of Gas Stations to the majority of properties - Costco has realized some of the most consistent traffic growth patterns in retail, and one of its significant drivers in recent years has been from gasoline sales.   (GasBuddy.com frequently cites Costco as the lowest gas price vendor in the market.   If you have the time, you can buy gas runs $0.30 cheaper a gallon than other stations.) As stores open new gas stations, SSS, customer in store shopping frequency and inventory turnover in those properties increases markedly.  Today nearly all new U.S. and Canadian warehouses are opened with a gasoline station. Gas is a big, albeit volatile, business for the company, with last year's sales in excess of $11bn. For the last 12 months sharp declines in gas prices powered outsized margin increase and likely contributed to accelerating membership growth. We expect gas to continue to drive shopping frequency.

8)  Broader Communication of Company's Ancillary Services - Costco has an array of incredible member services and financial products which are not fully utilized or known by its members and prospective members.  The company's active promotion of these services will assist sales trends over the next several quarters. 

I'll throw out a couple of these ancillary services as a public service announcement for fellow VIC members: Costco's car buying program is an incredible, haggle free way to quickly get to $2 to $3k below a dealer's invoice price.  Costco also a offers a competitive program for discount car repairs so you don't get bilked by the dealership's service department.  Costco Tire offers onsite tire sale and installation for about 20% less than other tire vendors. Costco Travel is another remarkable service: where you can find savings off up to 50% compared to other discount travel sites like Priceline. Especially car rentals and travel packages.   A single car rental can easily save you the amount of annual executive membership.

Costco's pharmacy services are broadly recognized as offering the lowest prescription prices in the industry.  A recent study by Consumer Reports found shoppers could save more than $100 per month by shopping for generic drugs at Costco over major drugstore chains like CVS. Consider these price differences:

• Lexapro: $7 at Costco vs $126 at CVS
• Lipitor: $17 at Costco vs. $150 at CVS
• Plavix: $15 at Costco vs. $180 at CVS

That can be some material savings for members when you consider that some of these drugs are lifetime prescriptions. Interestingly in California you don't have to be a member to use Costco's pharmacy.  Additionally.  Costco's optics and hearing aid department services are some of the lowest cost providers in the market as well.  

Lastly there's an excellent, large sized combination topping pizza to be had for $9.95.

Business Description

Costco currently operates 690 warehouses, including 482 in the United States, 90 in Canada, 36 in Mexico, 27 in the United Kingdom, 23 in Japan, 12 in Korea, 11 in Taiwan, 7 in Australia and 2in Spain. The Company plans to open up to an additional 9 new warehouses before the end of calendar year 2015 and 30 more stores in 2016.  Costco owns the land and building for about 546 of its stores. The real estate holdings are siginificant.  Additionally 95 of its 144 leases are land-leases only, where Costco owns its building; which keeps leases expenses relatively low.

The company has approximately 45 million paying members.   60% of members are regular gold star members who pay $55 in an annual membership dues, while the remaining 40% are Executive Members who pay a $110 and realize 2% savings on their purchases.  Executive members represent almost two-thirds of the company's sales.

On average warehouse stores are approximately 144,000 square feet, with newer units running slightly larger.  Floor plans are no frills, and designed for self service and economy in the use of selling space and handling of merchandise. The warehouse layout enables the company operate profitably at significantly lower gross margins than traditional wholesalers, mass merchandisers supermarkets, and supercenters.  Costco has great working capital management: and is able to sell inventory before it's required to pay many of its merchandise vendors: meaning most of its inventory is financed through payment terms provided by suppliers rather than by working capital.

One of the beautiful properties of Costco's model is that by strictly controlling the entrances and exits of the warehouses and using a membership format, the company has incredibly low rates of inventory losses (shrinkage), dramatically below those of typical discount retail operations. This savings is recycled back into the operations in the form of lower prices, better paid employees, and more satisfied members.

The company's product and pricing strategy is to provide members with a broad range of high quality merchandise at prices consistently lower than they can obtain elsewhere. Shopping at Costco's locations is percieved by members to be an entertaining experieince with product demonstrations, food samples, and seasonal products that introduce a treasure hunting element to the member's experience.   Company buyers limit specific items in each product line to fast-selling models, sizes, and colors; and Costco carries an average of approximately 3,700 active stock keeping units (SKUs) per warehouse, significantly less than other comparable retailers. Many products are sold in manageable, and sometimes lampooned bulk forms: like  cases, cartons, or multiple pack quantities only.  The company also enjoys a Nordstrom type reputation for customer satisfaction in how it generally accepts returned merchandise.

For FY 2015 Costco's sales breakdown was

Food (including dry and institutionally packaged foods) ........................................................ 22 %

Sundries (including snack foods, candy, tobacco, alcoholic and nonalcoholic

beverages, and cleaning and institutional supplies) .............................................................. 21 %

Hardlines (including major appliances, electronics, health and beauty aids,

hardware, garden and patio, and office supplies)................................................................ 16 %

Fresh Food (including meat, produce, deli, and bakery) ...................................................... 14 %

Softlines (including apparel, small appliances, and home furnishings) ............................... 11 %

Ancillary and Other (including gas stations, pharmacy, food court, and optical) ............... 16 %

Leadership wise there's a lot to appreciate in Costco.  Management, led by Craig Jelnick, who replaced the former Co-Founder James Sinegal, is a talented operator and has successfully continued to post some of the top traffic growth numbers in retail.  Costco is run ethically, and frequently rated by Forbes as one of the nation's best employers.  Employees working in the Company’s membership warehouses receive pay and benefits significantly above nearly all other competitors in retail. Costco has also realized both shopper and employee goodwill, as well as postive PR for its refusal to open on Thanksgiving Day to allow employees time off with their families.

The long-term investment in its workforce has benefited the company with the lowest employee turnover rates and the lowest inventory loss rates in the industry. I view this is in contrast to Amazon which treats its factory workers like convicts. And paying its employees well actually accelerates Costco's flywheel.  Minimal turnover and shrinkage are investments in lower pricing - which bring merchandise to the shelves at lowest possible cost - and helps Costco advanced its reputation among its members for as a low price authority. That strategy has resulted in customer loyalty: with U.S. and Canadian members renewing at a 91% rate; and worldwide renewal rates at around 88%.

We think the Costco model works across the world.  Originally a west coast business, the company has an strong base in the California and the Mid-West but expansation into foreign markets has generally been successful.  Management expects ultimate store count to be 50% domestic and 50% abroad,  and we believe there is potential for 2,000 locations worldwide.  The company funds new store expansion with internal cash flow, and opened up 30 new warehouse in FY 2015.  (Annualized sales of which was the company's highest ever  at $108 million per location. Notably average annual sales of all warehouses also reached an all-time high this past year – at $164 million per warehouse; with  165 locations generated annual sales greater than $200 million. Of these, 60 warehouses exceeded $250 million in annual sales – including two with sales in excess of $400 million (Oahu and Seoul)).

If there was a Berkshire style retailer truly operating on its own, we'd argue this is it. Charlie Munger has been a long standing member of the board.  But also some other noteworthy members including Jeff Brotman and James Sinegal (co-founders of Costco respectively); Bill Gates Sr,  Jeff Raikes (Former CEO of the Bill and Melinda Gates Foundation), and Hamilton James (President and Chief Operating Officer of Blackstone).  And while we doubt Berkshire would be able to afford a $100bn purchase of Costco, for what it's worth, Buffett has frequently referred to his not buying Wal-Mart decades back as one of his biggest mistakes and we've contemplated whether Costco could represent a second chance for Berkshire.  There would certainly be interesting overlap in promoting many of Berkshire's services (insurance, autos, homes,) to Costco's nearly 82mm card holders. But $100bn is an enormous and improbable check, even if paid with stock.

Our Approach to Valuation

We take a fairly fuzzy approach here to valuing the company, and would be interested in learning how other investors view valuing this business in the comment section. The general approach we've taken involves addressing the following questions.

1) What's the Value of Existing Stores

2) What's the Value of Future Stores

3) What's the Value of Land and Building Holdings

It's a gross simplification here but we've performed but to understand and value existing stores we performed a 4 wall analysis.  An average store does $165mm in sales, and realizes a net income of about $3.5mm.  For those stores where the company does not own the land, we estimate net income to be closer to $3mm per store.  To avoid double counting the benefit of the company's sizeable real estate holdings, we go with rental properties economics and project a mature 5% long term earning growth existing stores, and at a 10% discount rate get a value of approximately $52mm per store.  With 690 stores, this represents approximately $36bn of value.

As for future stores: over the next 30 years we believe there's a potential for an additional 1,300 stores globally.  Roughly 500 more in the U.S and 800 more abroad. A new store runs between $40 and $50mm to build and equip. This includes land purchases which in recent times have averaged about $10mm per location. We believe the discounted value of the future stores represents approximately $28bn.

Today Costco owns 542 (~80%) of its stores and land.  Including real estate in prime locations in California and Hawaii.  In all the company owns about 78mm square feet.  At $400 a square foot that's $31bn of value. As Costco opens new stores its strategy is to own the land and building outright. Which was occurred in the majority of the new store openings in FY 2015.  We expect this to continue in the future.

In all this amounts to about $95bn of value.  The company has roughly zeor net debt.  At today's price, this represent approximately 40% upside to the stock's current valuation.  Thought differently, you can be buying the business and be getting the a very significant real estate portfolio for minimal cost.

Conclusion

One of the things makes Costco unique as a retailer is that its growth and profitability depends less on sales and more on its membership revenue.  We believe the business is steered to increased member satisfaction and spur membership growth.  It's a simplification to say that Costco doesn't realize a profit on its merchandise but exclusively on membership fees: but it's not a bad way to conceptulize how the business works. The company reinvests its merchandising profit into a higher quality experience for its members (through the lowest prices, well paid and highly efficient staff, quality management); and the numbers suggest that the majority of the company's returns do come from membership fees. You can note a high, historic correlation between Membership Fees (of $2,533mm in FY 2015) and Net Income ( of $2,377mm in FY 2015).

To the extent that this connection is valid, we see the main path for compounded earnings growth for Costco to come from successful investment in new stores.  With the current store count is 690 stores, there's a long way before the company reaches its potential of 2,000 stores globally. Should Costco's value proposition gain the same sort of recognition among consumers worldwide as it does in California and the Mid-West, we expect shares will provide an attractive to return for many years ahead.

Catalyst

1) Accelerated store openings over the next 3 years

2) Effects of IT Modernization

3) Active campaign to upgrade Gold Star to Executive Memberships

4) Benefits of termination of agreement with American Express

5) Balance sheet leveraging 

6) Continued growth of E-Commerce

7) Expansion of gas stations to the majority of properties

8)  Broader communication of company's ancillary services