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  • CostcoWholesaleCorporation-BuyNYSE:COSTUSD187.82

    TargetPriceUSD155

    Author1ChristopherAllanEquityAnalystB.Comm/B.IBFinancechrisallan@carleton.ca

    KeyFinancialData

    MarketCap 80.46B

    S&PCreditRating A1

    DebttoEquityRatio 60.2

    PricetoEarnings 27.17

    EV/EBITDA 12.88

    DividendYield 1.06

    OperatingMargin 3.19

    ReturnonAssets 7.71

    RevenueGrowth1yr 8.68

    InsidethisReport

    InitialResearchUpdatedResearch

    PriceTargetChange

    RatingChange

    Tuesday,December5,2017

    ResearchHighlights/InvestmentThesis CompetitiveBusinessModel

    Costco operatesmembershipwarehouses that offers itsmembers low pricesonbrandnameandprivatelabelproducts.Theselowpricesareenabledbytheoperatingefficienciesofvolumepurchasing,efficientdistributionandanofrills,self service environment that rapidly turns over its inventory of 3,700 SKUs,much lower than the 60,000 SKUs competitors hold on average. TheseoperatingefficienciesallowthecompanytohaveanaveragemarkupinthelowteensvsotherlowpriceretailerssuchasWalmartthataverages20%markups.Costco is able to be the low cost provider due to the fact that the companymakesthemajorityofitsmoneyonmembershipfeeswhilesellingmerchandiseatvirtuallyzeroprofit.

    WideEconomicMoatCostco has a wide economic moat which is a result of its cost advantage,intangiblebrandassetsandtosomeextentnetworkeffects.Thecompanyhasboasteda90%renewalrateofmembersandhastheabilitytoraisepricesonitsmembershipfeeswithoutadropintherenewalrate.

    RichlyValuedWhilewearevery fondof thequalitativestoryof thecompany, itappearsasthough we are not alone in our admiration of the business model as thecompanyisrichlypriced.Weconductedascenarioanalysisandnotedthatthecurrentmarketpriceimplies6%revenuegrowthwithEBITDAmarginsof3.7%,which is on par with historical averages. While we do not think that this isunattainable,webelievethatthisimpliesthatupsidepotentialisdiminished..

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  • SPROTTSTUDENTINVESTMENTFUND

    1EQUITYRESEARCHNYSE:COST

    CompanyOutlook/OverviewCostcoWholesale Corporation operates globally as amembership-onlywarehouse club, catering to

    businessandindividuals. In2017,Costcosmembershipbaseconsistedof36,600GoldMembersand

    10,800BusinessMemberswith38%ofpaidmembershavingupgradedtoanExecutiveMembership.

    Costco operates 741 warehouses across North America, United Kingdom, Japan, Australia, Spain,

    FranceandIcelandwithlicensingagreementsinTaiwanandKorea.Costcosdiverselineproductscan

    becategorizedby:Foods,FreshFoods,Sundries,Hardlines,SoftlinesandOthers(ancillarybusinesses).

    InFY2017,Costcohadnetsalesof$126.172Bwith87%beingderivedfromoperationsinCanadaand

    the United States. Foods, contributing 21% of net sales, consist of dry foods, packaged foods and

    groceries.Sundries,which includecandy,beveragesandcleaningsupplies,makeup20%ofthetotal

    sales. The hardline category consisting ofmajor appliances, electronics and furniture accounted for

    16% of sales. Fresh foods made up 14% of sales, while softlines which includes apparel and small

    appliances made up 12% of sales. The last 17% of FY2017 net sales can be attributed to Costcos

    ancillary businesses which include gas stations, optical dispensing centers, food courts, hearing-aid

    centersandpharmacies.

    InFY2017,netsalesincreasedby9%withe-commercesalesgrowingby15%,accumulatingto4%of

    totalsales.Witha lowgrossmarginof11.33%,Costcoreliesontheir90%membershiprenewalrate

    andtheirmembershiprevenuewhichgrew4%,contributing$2.6Btototalrevenue.Thisiscompared

    tonet incomeof$2.3B,evidencethatnearlyallofCostcosnet incomeisderivedfrommembership

    fees.Costcoreinvested$2.65Bintothebusinessthroughexpansionofdistributionandtransportation

    systems,newwarehouseopenings and$1.2B returned to shareholders through stock-buybacks and

    dividends,producing$2.35Binnetincome.

    Source:Bloomberg

    Softlines12%

    Foods21%

    Hardlines16%

    Sundries20%

    FreshFoods14%

    Ancillary17%

    Figure1:SalesbyProductType

  • SPROTTSTUDENTINVESTMENTFUND

    2EQUITYRESEARCHNYSE:COST

    MarketSize&Structure

    Costcooperates intheretail industrywith5.1%ofmarketshare in2016forU.S. foodandbeverage

    purchases.Withintheretailindustry,CostcoconductsbusinessthroughtheWarehouseClubssector,

    facingcompetition fromSamsClubandBJs.Overall,Costcohas43%fewerSKUs instorethanBJs

    and33%fewerSKUsthanSamsClubyetCostcodominatesthesector.Costcohas62%marketshare,

    comparedto30%and8%marketsharefromSamsClubandBJs,respectively.TheWarehouseclubs

    sectorisestimatedtogenerateapproximately$191Binrevenuein2017.ThissectorgrewataCAGRof

    7.2%between2001and2016intheU.S.whiletheinternationalsectorgrewat10.8%.U.S.retailsales

    haveincreasedataCAGRof3.3%forthesametimeperiod.With87%ofsalesstemmingfromtheU.S.

    andCanada, thisbriefoverviewwill focusonthesetwomarkets.Retail sales inCanadafromAugust

    2016toAugust2017haveincreased6.9%whileretailsalesintheUnitedStateshaveincreased3.2%.

    In comparison to thegrowth in retail sales, therehasbeena16.2%growth in grocerye-commerce

    salescausedbytheAmazoneffect.TheAmazoneffectistheconsumershifttowardsshoppingonline.

    Regardless of Amazons disruption efforts, only 8.9%of retail sales are conducted online,while the

    remaining91.1%arestillconductedinstore.Adaptingtothesectortrends,Costcohasbeguntoshift

    towardsmultichannelofferingswiththeironlinesalesgrowingby15%inFY2016.Evenwiththisshift,

    Costco wont be threatened by Amazon as they share a similar profit model of low margins/high

    turnover.Despitebothcompaniesoperatinginretailwithmembershipservices,Costcofocusesonthe

    shopping experience. Costco gives consumers the convenience of a one-stop shop providing extra

    services tomake the shopping experience efficient. Customers can pick up groceries for theweek,

    changetheirtires,filltheirprescriptionsandgetaneyeexamallinonetrip.Thehighcostassociated

    with fulfilling online orders for Amazon is made up with their more expensice membership fee.

    According toMorgan Stanley, 50% of Costcomembers also have an Amazon Primemembership. If

    these two businesses were direct competitors, members would choose one membership over the

    other.Lowercosts,easyreturns,shoppingasasocialactivityandbeingabletoseeandtouchproducts

    Source:Bloomberg Source:Bloomberg

    2%

    98%

    Figure2:RevenueBreakdown

    MembershipFees Sales

    72%

    28%

    Figure3:OperatingIncomeBreakdown

    MembershipFees SalesProfits

  • SPROTTSTUDENTINVESTMENTFUND

    3EQUITYRESEARCHNYSE:COST

    beforebuyingthemareallreasonswhyBrickandMortarstoresareheretostayfortheforeseeable

    future.

    ValueChain

    Costco utilizes a low-cost leadership strategy, outputting high volumes with low margins, enabling

    them to sell large quantities at competitive prices. Alongside this strategy, Costcohas been able to

    implementanefficientsupplychaintoprovidecustomerswithhighqualityproductsatanaffordable

    price. Selling, General and Administrative Expenses (SG&A)which consists of all operating costs for

    Costcoin2017is10.1%comparedtoWalmartwhichis21.2%.Thecompanybelievesinkeepingonlya

    limited number of products at their warehouses to ensure that every product meets the quality

    standard Costco customers expect. Having fewer products to order, track and display means cost

    savings forCostco.Carryinga smalleramountof SKUsallowsCostco to increasepurchasingpower.

    Less shelf space means more competitive bidding by suppliers, resulting in the acquisition of

    merchandise at the best possible price. Costco buys products in bulk, directly frommanufacturers,

    which then get delivered to one of their distribution centers, reducing material handling. Costco

    utilizesacross-dockingtechniquetomoveproductsfromdepotstotheirwarehouses.Tothegreatest

    extent, goods are handled in full pallets at the depot to reduce product handling. This process

    increases handling efficiency and reduces storage costs associated with traditional multi-step

    distribution channels. Merchandise is then displayed on the same industrial pallets on which it is

    shipped,reducinglaborcosts.Warehousesoperateonanaverageof70hoursaweek(Walmart77

    hrs.),which ismuch shorter thanother retailers, loweringoperating costs relative to the volumeof

    sales. While most retailers spend large sums of money on marketing, Costco does not have an

    advertisingbudget.ThecombinationofthesefactorsallowsCostcocustomerstopurchasehighquality

    productsatabelowaveragecost.

    Source:FungGlobalRetailandTechnology

    Costco62%

    BJ's8%

    Sam'sClub30%

    Figure4:U.S.WarehouseMarketShare

  • SPROTTSTUDENTINVESTMENTFUND

    4EQUITYRESEARCHNYSE:COST

    Moat

    LowCostLeader

    Costcopurchasesproductsfrommanufacturersinbulkorderswhichallowtheirsupplychaintoexploit

    economies of scale. Economies of scale results in reduction in fixed costs associatedwith ordering,

    transportation and quantity discounts from suppliers. Costcos warehouses are also cost efficient.

    Operating costs are reduced through shorterweekly operating hours. Concrete floorsmanifest low

    maintenance costs. Products displayed on shipment pallets reduce labor costs. Finally, warehouses

    carryaround3,700SKUscomparedtootherretailerswhocarryaround60,000SKUs,

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