costco wholesale corporation - buy · costco wholesale corporation operates globally as a...

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Costco Wholesale Corporation - Buy NYSE: COST USD 187.82 Target Price USD 155 Author 1 – Christopher Allan Equity Analyst B.Comm/B. IB – Finance [email protected] Key Financial Data Market Cap 80.46B S&P Credit Rating A1 Debt to Equity Ratio 60.2 Price to Earnings 27.17 EV/EBITDA 12.88 Dividend Yield 1.06 Operating Margin 3.19 Return on Assets 7.71 Revenue Growth – 1yr 8.68 Inside this Report Initial Research Updated Research Price Target Change Rating Change Tuesday, December 5, 2017 Research Highlights/Investment Thesis Competitive Business Model Costco operates membership warehouses that offers its members low prices on brand name and private label products. These low prices are enabled by the operating efficiencies of volume purchasing, efficient distribution and a no frills, self service environment that rapidly turns over its inventory of 3,700 SKU’s, much lower than the 60,000 SKU’s competitors hold on average. These operating efficiencies allow the company to have an average markup in the low teen’s vs other low price retailers such as Walmart that averages 20% markups. Costco is able to be the low cost provider due to the fact that the company makes the majority of its money on membership fees while selling merchandise at virtually zero profit. Wide Economic Moat Costco has a wide economic moat which is a result of its cost advantage, intangible brand assets and to some extent network effects. The company has boasted a 90% renewal rate of members and has the ability to raise prices on its membership fees without a drop in the renewal rate. Richly Valued While we are very fond of the qualitative story of the company, it appears as though we are not alone in our admiration of the business model as the company is richly priced. We conducted a scenario analysis and noted that the current market price implies 6% revenue growth with EBITDA margins of 3.7%, which is on par with historical averages. While we do not think that this is unattainable, we believe that this implies that upside potential is diminished. . Equity Research 0 500 1,000 1,500 2,000 2,500 3,000 $0 $20 $40 $60 $80 $100 $120 $140 $160 $180 $200 Nov-12 May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 May-16 Nov-16 May-17 Price per Share Daily Volume Stock Price Current Target Price

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Page 1: Costco Wholesale Corporation - Buy · Costco Wholesale Corporation operates globally as a membership-only warehouse club ... Market Size & Structure Costco operates in the retail

CostcoWholesaleCorporation-BuyNYSE:COSTUSD187.82

TargetPriceUSD155

Author1–ChristopherAllanEquityAnalystB.Comm/B.IB–[email protected]

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

RevenueGrowth–1yr 8.68

InsidethisReport

☑InitialResearch☐UpdatedResearch

☐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 SKU’s,much lower than the 60,000 SKU’s competitors hold on average. Theseoperatingefficienciesallowthecompanytohaveanaveragemarkupinthelowteen’svsotherlowpriceretailerssuchasWalmartthataverages20%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..

EquityResearch

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

businessandindividuals. In2017,Costco’smembershipbaseconsistedof36,600GoldMembersand

10,800BusinessMemberswith38%ofpaidmembershavingupgradedtoanExecutiveMembership.

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

FranceandIcelandwithlicensingagreementsinTaiwanandKorea.Costco’sdiverselineproductscan

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 Costco’s

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,evidencethatnearlyallofCostco’snet 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

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MarketSize&Structure

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

purchases.Withintheretailindustry,CostcoconductsbusinessthroughtheWarehouseClubssector,

facingcompetition fromSam’sClubandBJ’s.Overall,Costcohas43%fewerSKU’s instorethanBJ’s

and33%fewerSKU’sthanSam’sClubyetCostcodominatesthesector.Costcohas62%marketshare,

comparedto30%and8%marketsharefromSam’sClubandBJ’s,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 Amazon’s disruption efforts, only 8.9%of retail sales are conducted online,while the

remaining91.1%arestillconductedinstore.Adaptingtothesectortrends,Costcohasbeguntoshift

towardsmultichannelofferingswiththeironlinesalesgrowingby15%inFY2016.Evenwiththisshift,

Costco won’t 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

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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 SKU’sallowsCostco 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(Walmart≈77

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

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Moat

LowCostLeader

Costcopurchasesproductsfrommanufacturersinbulkorderswhichallowtheirsupplychaintoexploit

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

transportation and quantity discounts from suppliers. Costco’s 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

carryaround3,700SKU’scomparedtootherretailerswhocarryaround60,000SKU’s,enablingCostco

to increase inventory turnover and reduce costs associatedwith retaining excess inventory. Costco

then takes these cost savings andpasses it on to the consumer insteadof raisingmargins.Costco’s

efficientoperationmakesitdifficultforcompetitorstocompeteonprice.

BrandLoyalty

Costco‘s business model is a subscription business model, meaning that customers purchase

membershipswiththeexpectationoflowercoststomakeupfortheinitial investment.Costcohasa

self-reinforcing business model with a virtuous cycle. The cycle begins with their low prices on

merchandiseformembers.Competitorscannotcompetewiththeselowmarginsbeacsuetheyactually

needtoturnaprofitonthemerchandisetheysell.Whenmoremembersjointheclub,Costco’sscale

increases.ThisincreaseinscaleallowsCostcotospreadfixedcostsoveralargerbaseaswellasgives

themastrongerpositionwhennegotiatingwithsupplierswherethebenfefitsarepassedbacktotheir

members.With a renewal rate of 90% in Canada and U.S. and 87% internationally, it is clear that

customers consider the advantages of shopping at Costco well worth the membership fee. The

membershipfeeallowscustomerstofeelasiftheyarepartofanexclusiveclubofcustomers.Costco

alsooffersmembersdiscountsongasoline,insuranceandotherservices.Onceanindividualbecomes

amember,theythenfeelcompelledtoshopatCostcotojustifythepaidmembership.

IndustryAnalysis

Porter’sFiveForces

CompetitiveRivalry-High

The retail industry is highly saturated, meaning Costco faces intense competition. Costco faces

competitionfromavarietyofretailerswhospecializeandutilizetheiruniquecompetenciestoforma

competitive advantage. Besides Kirkland Signature brand, Costco sells a variety of homogeneous

products. This means that Costco sells products with a very low level of differentiation amongst

competitors. The retail industry approaches perfect competitionwhereby retailers are price takers.

Should a company raise the price of their product by the smallestmargin; consumerswill buy that

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product somewhere else due to the lack switching costs. Therefore, the Costco faces intense

competitionfromrivals.

ThreatofNewEntry-Low

Anynewcompanycanenterintotheretailorwarehouseclubindustry.Itwillhowever,bedifficult,if

notimpossible,foranewcompanytooperateonthesamesizeandscaleemployedbyCostco.Costco

hasbuiltbrandrecognitionand importantrelationshipswithsuppliersandcustomersovertheyears

that would be very difficult to replicate. Economies of scale, access to supplier and distribution

channels,andhighstartupcostswouldallbechallengesfacedbyanewcompany.Therefore,anew

entrantwouldfaceeconomicbarriersandlogisticalbarriers,reducingthethreatofnewentryintothe

industry.

ThreatofSubstitution–ModeratelyHigh

DuetoCostco’swideselectionofproducts,Costcofacesthethreatofsubstitutionfromawiderscope

ofretailersthanjustWarehouseclubs.Costcofacesthethreatofsubstitutionagainstretailspecialists

suchasBestBuy&Kohl’s,retailgeneralistssuchasWalmartorTargetandinternetretailerssuchas

Amazon. Costco has mildly reduced the threat through their unique private-label brand, Kirkland

Signature.Besidesstoreandprivate-labelbrands,thethreatofsubstitutionishighasmanysubstitutes

existintheindustry,althoughthethreatismitigatedbythepricesavingsofbuyinginbulkatCostco.

BuyerPower-Low

SwitchingcostsareeithernonexistentorverylowforCostcomembersandshouldn’tbeconsideredin

buyer power. There aren’t any switching costs associated with the membership fee as Costco will

refundtheentiremembershipatanytimeifthememberisdissatisfied.Thelowswitchingcostsmeans

that Costco customers can easily transfer to other retailers. In addition, members have many

substitutestochoosefrom,thusconsumerswillchoosearetailerwiththebestoffers.Onthecontrary,

buyer power is reduced through the psychological effect memberships have on members. Even

though members can choose to shop elsewhere, Costco members feel the need to justify their

membership and as a result spendmoremoney on average.Overall, buyers have a small influence

overthepricesatCostco.

SupplierPower-Low

Suppliers play a critical role in providing Costcowith commodities and products to sell. Due to the

large population of suppliers, retailers are not dependent on any one supplier. Since Costco sells

products in bulk, they are an attractive retailer to supplierswho are, in turn, able tomove a large

volumeofgoods.Sincesuppliersareabletosell largervolumesofgoodstoCostcocomparedtothe

averageretailer,supplierswill sell theirgoodsata lowermarkuptoretainbusiness. In2009,Costco

threatened to stop carrying Coca-Cola products due to a pricing dispute. Coca-Cola’s largemargins

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didn’tallowCostcotopassalongpricesavingstotheircustomers,thustheythreatenedtostopselling

theirproduct.Warehouseshavelimitedshelvingspacewhichmakesthebiddingprocessmuchmore

competitive, inturndrivingdowntheprice.Costcoreceivesa largesupplyof inventoryfromvarious

suppliers, which reduces any single suppliers bargaining power as their actions are unlikely to

significantlyimpactthetotalsupplyavailabletoCostco.

IndustryDynamics

E-commerce

New technologies continue to influence the retail industry through e-commerce platforms.With e-

commercesalesgrowingfasterthantotalretailsales(3.6%comparedto1.1%inthethirdquarterof

2017), businesses are beginning to adapt to the change in consumer behavior. E-commerce effects

pricing,productavailabilityandshoppingconvenience.Oneofthemajorplayersinfluencingthistrend

is Amazon.Millions of third-party sellers pay Amazon a fee to take advantage of their distribution

platformandconsumerreach.AccordingtotheU.SCensusBureau,E-commercesalesasapercentage

oftotalsaleshaveincreased4.1%overtheyear.E-commerceopenstheindustrytomorecompetition

aswell as growth opportunities for existing firms. Thedownsides to selling products online are the

logistics involved with delivering each product. Companies who deal directly in the e-commerce

industry have exceptionally low profit margins due to overhead costs. Costs associated with e-

commerceincludeshippingcosts,costsofhandlingreturnandwebsitemaintenancecosts.Thankstoa

pricestudydonebyBMO,lookingatabasketof54items,BMOconcludedthatCostcosellsitemsata

cheaperprice thanAmazon innearlyeverycategory.Evenwithcompetitivepricing,Costco’sannual

membershipfeeismuchcheaperthanAmazonPrime’smembershipfeeat$55and$99,respectively.

Althoughtheretailindustryismovingtowardse-commerce,customerslookingforthemostaffordable

priceswill continue to shop at CostcoWarehousees. Looking at Figure 6, we can see that Costco’s

same-store sales are not as influenced by the change in consumer behaviour compared to

competitors.

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ConfidentSpending

According to Deloitte, the labor market has continued to strengthen, with an average of 181,000

additional jobs intheUnitedStatesalone,permonth, in2016.Disposable incomehas increase3.4%

over the 2016FY alongside a steady increase in average hourly earnings. These factors have hiked

household income,ultimately increasing consumer confidence and consumer spending. Thanks to a

survey conducted by The Nielson Company, 63% of U.S. respondents expressed belief that their

economywasoutof therecession (up13%from2016)andof theremaining37%whobelievetheir

country is still in economic decline, 36% believe theywould be out of it in 2018. This is a positive

outlookfortheretailindustryasaconfidentconsumerwillbethedrivingforcebehindincreasedsales

asretailsalesareup2.5%since2016inNorthAmerica.

GrowthandRiskAnalysis

GrowthOutlook

Costco’ssuccessoriginatesfromafewkeyfactorswhichwilldrivegrowthifmanagedproperly.As72%

of net income is derived frommembership fees, Costco’s growth is dependent on expanding their

customerbasewhileensuringahighmembership renewal rate.Anopportunity forgrowthamongst

memberscanalsoberealizedfromincreasingthenumberofmemberswhoupgradetotheExecutive

Membership.Anaggressive internationalexpansionplanwas implemented in2013to increase their

customerreachbypenetratingnewmarkets.AsofJune2017,Costcooperatesover200warehouses

Source:BloombergBusinesswee

k

11%

63%

23% 22%

5%1.4% 1.6% -1.3%

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Costco Walmart BestBuy Target

Figure5:SalesGrowthComparison (2017)

E-CommerceSalesGrowth Same-StoreSalesGrowth

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outside of the U.S, with a current focus on expanding into Europe. Costco has recently opened

warehousesinParis,FranceandGarðabær,Iceland.DuetotheisolationofIceland,localretailchains

colludeinordertokeeppricesartificiallyinflated.IcelandershaveembracedtheAmericanwarehouse

wholesaler as one in four Icelanders (80,000) have already purchased a membership card to take

advantageofcostsavings.

Although 87% of revenue is driven from Canada and U.S., these markets are actually the least

profitable.InternationalmarketsallowCostcototakeadvantageofcheaperexpenseslikewagesand

benefits. There is also a greater opportunity for growth amongst international markets as the

warehouse club model is much less concentrated. Analysts believe Costco is preparing to expand

locations into the Chinese market as they recently launched an online store on the business-to-

consumersiteTmall.TmallGlobalhasbeenapopularapproachtotestinginternationalbrandsinthe

Chinesemarket.

Finally, Costcomust focus on the retention of existing customers. Costcomust provide its current

customers with reasons to return. Costco has permanently capped margins which allow for

consistently low prices in order formembers to justify themembership fee. Costco only sells high

quality products to ensure persistent customer satisfaction. Costco emphasizes their strong return

policy,whereeveryproductisguaranteed.Finally,Costcohassuchastrongbeliefinthevalueoftheir

membership;membersmayrefundthefullamountatanytimeiftheyaredissatisfied,somethingthat

increasesbrandequityandcustomerloyalty.

MajorRisks

InternationalExpansion

AsCostcolargelydependsontheircustomerbasetodriverevenue,internationalexpansionbecomes

anopportunityaswellasarisk.Costcomayfaceproblemsenteringintomarketswherethecultureis

verydifferent.Thiscanbeseenthroughtheslightly lower internationalmembershiprenewalrateof

87%comparedto90%inCanadaandU.S.Costcocarriesthesameproductsinalloftheirstores,thus

internationalcountrieswillbeexposedtoAmericanandCanadianproducts.Dependingonthemarket,

consumers may react negatively to the unfamiliar products. Costco’s international success may

differentiateduetohouseholdsizes,consumerneedsandeconomicconditions.

E-commerceandCostco’sBusinessModel

Withe-commercesalesgrowingfasterthanretailsales,Costcohasattemptedtobecomelessreliant

ontheirbrickandmortarstoresbyimprovingtheironlineplatform.EconomiesofscaleallowCostcoto

purchaselargevolumesofgoodsandsellthematrelativelylowprices.Onlineshoppingdoesnotalign

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wellwiththisbusinessmodel,astheadditionalcostofshippingoperationsandwebsitemaintenance

increases the price of each good. Additionally, purchasing bulk orders online make home delivery

options difficult. Alongside Costco’s bulk-sized goods is the ever-changing selection of general

merchandise. The unique assortment of items at each visit creates a treasure hunt experience for

customers. This experience is very difficult to replicate through an online platform. Overall, E-

commercehasthepotentialtodisruptorCostco’sbusiness,butthefactthatCostcoisthelowestcost

optionmeansthereisatangiblebenefittoshoppingatCostcoasopposedtoAmazonorotheronline

retailers.

GeographicConcentration

Operationshaveperformedexceptionallywell inCanadaandtheUnitedStateswith87%ofrevenue

stemmedfromthesemarkets.CostcoplacesahighdependencyontheNorthAmericaneconomyand

moreparticularly,California.Californiagenerates32%ofCostco’stotalrevenue.Costcofacestherisk

of being geographically concentrated. Any substantial slowing in the State of California could

significantlyhurtCostco’soverallresults.

Management

InsiderOwnership

Costco insiders have very little corporate control as they hold 0.70% ownership in the company.

Costco’smarketcap is$72.66B, thus0.70%ownershipaccumulates to$528M.Although insidersdo

nothavealargepercentageofownership,theyhaveasignificantamountoftheirownpersonalwealth

invested in Costcomeaning that they have a significant amount of skin in the game, aligning their

interestswithshareholders.

In the last 12months, Costco insiders’ have sold 178,762 (net activity) shares, yet in the last three

months,insidershavepurchased114,497shares(netactivity).ThisisapositiveoutlookforCostcoas

insidersellingisnotalwaysattributedtopoorcorporateattitude.Ontheotherhand,insiderbuyingis

apositivesignastheyareeitherpurchasingthem,whichisindicitiveofabeliefinthelong-termfuture

ofthecompanyorarebeinggrantedincreasedownership,increasingtheirskininthegame.

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TrackRecord

Costcohasaprovenrecordofincreasingvaluefortheirshareholdersthroughreturnsoncapitalabove

theircostofcapitalwithmodestreinvestmentrequirementswhichhasleftthecompanywithexcesss

cashtoeitherreinvestordistributetoshareholders.Wecommendmanagementonthefacttheythey

havechosentoreturnexcesscashaboveandbeyondtheirreinvestmentrequirementstoshareholders

intheformofdividendsandstockbuybacks insteadofreturningexcesscashback intothecompany

forprojectswithlowreturns.Infact,in2017,COSTissuedaspecialdividendof$7,returning$3.9Bto

shareholders.Costcohaspaidout specialdividends in thepastof$7 in2013and$5 in2015. Since

2012,Costcohasdeclared$8.3B inspecialdividends. InAprilof2017,Costcoannouncedadividend

increaseof$0.05 (to$0.50)andasharebuybackprogramof$4Bexpiring in2019. It’s important to

note that a similar buyback program commenced in 2011 but Costco only spent $1.5B of the $4B

budget which is indicitive of the fact that management acts like owners and are unwilling to

repurchasesharesthattheybelievearenottradingatadiscounttointrinsicvalue.Takentogether,itis

clearthatCostco’smanagementhascreatedaswellaspreservedshareholdervalue.

ExecutiveCompensation

Thecommitteeconsideredcompensationdatafromthefollowingpeercompanies:Wal-MartInc.,The

Home Depot., Target Corporation, The Kroger Company and Low’s Companies. The components of

Costco’s executive compensation programs include equity compensation, base salary, cash bonuses

andotherbenefits (healthplans and401(k)plan).According toproxy statements filed for the2016

fiscal year, President and CEO, Walter Craig Jelinek, made a salary of $700,000, a cash bonus of

$81,600, $5,563,064 of stock awards, $57,227 of deferred compensation earnings and $101,385 in

othercompensationforatotalof$6,503,276.In2016,hislong-termincentiveplanmadeup85.5%of

histotalcompensation.

Source:Bloomberg

InsiderOwnership,0.7%

InstitutionalHoldings,37.4%

MutualFundHolders,37.2%

Other,24.7%

Figure6:Ownership Breakdown

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Costco awards performance based RSU’s to their executive officers for management’s long-term

incentiveplan.TheseRSU’sareperformance-vestedforoneyear,timevestedoverfiveyearsandare

investedforlongservice,giventheexecutiveremainsanemployeeatthevestdate.Theperformance

goals consist of executives either achieving a 3% increase in total sales or a 1% increase in pre-tax

income.Managementsabilitytoincreasesalesorincomewillpositivleyimpactshareholdervalue.

Iftheexecutivehasnotbeenwiththecompanyfor25years,theRSUvestsfor20%followingthefirst

year of performance-vesting and an additional 20% for each of the following 4 years years. If the

executive achieved long service with Costco, RSUs are subject to accelerated vesting. Accelerated

vesting for long service consists of 33% fo executiveswith 25 years of, 66% vesting for 30 years of

experienceor100%vestingafter35years.Oncetime-vestingrequirementsaremet,RSU’sarepaidin

sharesofcommonstock.

FinancialStatementAnalysis

Profitability

Costco has realized relatively consistent economic and accounting profitability margins with an

incrementalupward trend.Costco’scompetitivepricingstrategycanbedemonstrated through their

lowprofitandoperatingmargins.Costcoprices itsgoodsatbelowaveragemarkupsaimingtomake

virtuallyzeroeconomicprofitonmerchandisesalesinordertoprovidememberswithconsistentlylow

prices, and intice them to renew theirmemberships. This is because Costco relies onmembership

revenue and not the proceeds from sales for the majority of its net income. Due to Costco’s

competitivepricing strategy, theirprofitabilitymargins trailbehindcompetitorsbut thishasallowed

for a steady increase in same-store-sales and attracting and retaining a loyal customer base. These

marginsarenotexpectedtoincreasemuchintheupcomingyearsastheirstrategyremainsthesame

astheyarenotaimingtomakeanymoneyonmerchandisesales.

Source:Bloomberg

CEO:W.CraigJelinek Amount %ofCompensationSalary 700,000$ 11%Bonus 81,600$ 1%StockAwards 5,563,064$ 86%DefferedCompensationEarnings 57,227$ 1%AllOtherCompensation 101,385$ 2%Total 6,503,276$

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2013A 2014A 2015A 2016A 2017AProfitabilityEBITDAMargin 3.8% 3.8% 4.1% 4.2% 4.3%OperatingMargin 2.9% 2.9% 3.1% 3.1% 3.2%ProfitMargin 1.9% 1.8% 2.1% 2.0% 2.1%ReturnonAssets 7.1% 6.5% 7.2% 7.1% 7.7%

ReturnonEquity 17.6% 17.8% 20.7% 20.7% 23.4%

ReturnOnInvestCapital 13.4% 12.5% 14.0% 14.0% 15.7%

Growth

SinceCostco generatesmostof its profits frommembership fees rather thanproductmarkups, the

company'searningsaremuchmorepredictable thanWalmart, forexample,which riseand fallwith

thelevelofpricecompetitionintheindustry.Membershiprenewalratesarecurrentlysittingat90%

comparedto88%in2010.Renewalratespeakedin2015at91%butthendroppedapercentagepoint

inthefollowingyearasmanagementblamesthedeclineonthecreditcardswitchover.Costcoended

their exclusive partnership of 16 years with American express to partner with Citi. This switchover

droppedCostco’ssharepriceby6%.Costcoislookingtomakeuptherevenueontheslightdeclinein

membershiprenewalratesbyincreasingtheirmembershipfeeforthefirsttimein6years.

Thedeclineinsalesgrowthin2016canalsobeattributedinparttothecreditcardswitchoveraswell

as the 29 new store openings which diluted the average sales per warehouse. Average sales get

diluted because new stores typically beginwith low annual sales compared to existingwarehouses

with a loyalmembership base. For example, first year sales for new locations averaged $87million

compared to $159 million for locations opened at least a decade. As Costco is looking towards

internationalexpansion,theforecastformembershipgrowthandnetincomearelookingpositive.

Source:Bloomberg

Source:Bloomberg

$146

$155

$160$164

$162$159

$167

135

140

145

150

155

160

165

170

2011 2012 2013 2014 2015 2016 2017

Figure7:AverageSalesPerWarehouse(inmillions)

AverageSales

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Solvency

In2017Costcorealizedrecordhighfinancial leverageratiosasCostcoappearstobeincreasingtheir

amountofdebtusedto fundtheirbusinessexpansionrelativetoequity.Withan increasingdebt to

equityratio,thismaybecomeproblematicinthefutureasitmaybecomeunsustainableforCostcoto

pay the increased interest costs. For the mean time investors should not be worried as Costco’s

interest rate coveragehasheld strong around30x suggesting the company is unlikely todefault on

their interest payments in thenear future. An increasing capex ratio is also insignificant due to the

wideswings inoperatingcashflowthatoccurasthecompanyinvests innon-cashworkingcapitalto

openstores.Insteadviewingcapitalinvestmentthroughadifferentlense,asapercentofrevenue,itis

verystableat2%ofrevenues.

Liquidity

Costcohasrelatively low liquidityastheirability topayshort termdebthasbeendeterioratingover

thepast fewyearsas thecurrent ratiodroppedbelow1.0 in2016.Foranormalbusiness, thismay

signifythatCostcomaynotbeabletopayitsliabilitiesinfullinthenearterm.Costcohastheabilityto

operate efficiently with a low current ratio since it is consistent with their strategy of maintaining

relatively small number of SKU’s and focusing on inventory turnover.With high inventory turnover,

Costcoisabletosuppliersaftertheyhavesoldthemerchandise.

Activity

The stable activity ratios indicate Costco’s operational efficiency. Costco’s high inventory turnover

allows for them to utilize supplier’s capital in order to finance inventory rather than capital gained

fromshareholders.Highinventoryturnover,whichisareflectionofoperatingwithalimitednumberof

2013A 2014A 2015A 2016A 2017ALiquidityCurrentRatio 1.19 1.22 1.01 0.98 0.99

CashRatio 0.46 0.51 0.39 0.30 0.33

2013A 2014A 2015A 2016A 2017AFinancialLeverageLong-TermDebttoAssets 16.5% 15.4% 14.7% 12.3% 18.1%Long-termDebttoEquity 45.4% 40.7% 44.8% 32.9% 59.3%DebttoEquity 45.8% 40.8% 56.7% 41.9% 60.2%FinancialLeverage 2.80 2.68 3.15 2.75 3.37InterestCoverage 31.82 29.29 30.06 28.21 31.14CapitalExpenditureRatio 1.65 2.00 1.79 1.24 2.69

Source:Bloomberg

Source:Bloomberg

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SKU’s allows Costco to operate at lower gross margins through economies of scale. A/R and A/P

Turnoverhasbeenverystrongsuggestingthatmanagementhasbeenveryefficientincollectingand

payingdebt.ThisallowsCostcotomaintainstrongrelationshipswithsuppliersinthelong-term.

ShareholderRatios

While the underlying business performedwell, one of the key reasons for growth in EPS originates

fromCostco’ssharebuybackprograms.Aswasdetailedearlier,Costcoiscurrentlyundergoingashare

buybackprogramof$4Bthatissettoexpirein2019.Costco’shasbeenknownfordeliveringvalueto

theirshareholdersthroughincreasingdividendsandspecialdividendpayments.Costco’schieffinancial

officerattributesthespecialdividendanddividendincreasestoCostcohaving“astrongbalancesheet

andfavorableaccesstocreditmarkets”.

Valuation

DiscountedCashFlow

In order to value Costco, we opted to use a scenario based discounted cash flow approach. As a

warehouse club model, we based future revenue growth on growth in the membership base,

membership rate andmerchandise sales growth. For these variables,we included a bear, best and

worst-casescenario.Inthebasecase,revenuegrowthamountedto5%withthebestandworstcases

amounting to 8% and 4% respectively. In addition to revenue growth,we also sensitized operating

margins onmerchandise sales and terminal EBITDAMultiple. In regard to the operatingmargin on

merchandise sales the amounts range from 0.8% to 1.8% in line with historical estimates which

2013A 2014A 2015A 2016A 2017AActivityAccountsRecievableTurnover 94.44 95.90 97.98 95.90 96.14InventoryTurnover 12.27 12.04 11.64 11.51 11.90AccoutsPayableTurnover 12.22 12.10 11.60 12.39 13.09

CashConversion 3.75 3.94 3.61 6.03 6.70TotalAssetTurnover 3.40 3.34 3.40 3.50 3.47FixedAssetTurnover 7.41 7.43 7.38 6.81 6.95

2013A 2014A 2015A 2016A 2017AShareholderRatiosEPSpershare $1.40 $1.58 $1.73 $1.77 $2.09DividendPayout 17.46% 2.84% 12.05% 3.17% 14.57%

Source:Bloomberg

Source:Bloomberg

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culminatedinEBITDAmarginsof2.9%-3.9%.Withrespecttotheterminalvalue,weoptedtousean

exitmultipleduetothefactthatitislesssensitivethanaperpetuityandthecompanyhashistorically

tradedwithin awell-defined rangeof 12X-15XEBITDA thereforewe canbe reasonably confident in

usingthesemultiplesinouranalysis. Inthebasecaseamultipleof13.75isused,withthedownside

andupsideamountingto12Xand14.5Xrespectively.Discountingthesevariablesatadiscountrateof

8%ascalculatedbyBloombergresultsinanimpliedpricepershareof$140inthebasecase,$218in

thebestcase,and$106intheworstcase.Fromtherewetookaweightedaveragepricepershareand

weightedthebasecase60%,bestcase25%andworstcase15%whichculminatedinanimpliedprice

pershareof$155,a10%discounttothecurrentstockprice.

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RelativeValuationTherelativevalutationmodelreturnedanimpliedsharepriceof$119.86usingsimilarcompaniesthat

Costco’smanagementusedintheirpeergroupforexecutivecompensation.Thispeergroupconsisted

ofWal-MartStores,PriceSmartIncorporated,TargetCorporation,KrogerCompanyandLowe’s.These

companies were chosen as they operate in the global retail industry with the bulk of their profits

drivenfromtheCanadianandAmericanmarketwiththeexceptionofPriceSmartIncorporated.Price

SmartwaschosenastheyarethelargestoperatorofmembershipwarehousesinCentralAmericaand

theCarribean.Theproductmixforthesecompaniesarerelativelyhomogeneousinthatoneproduct

maybepurchasedatanyoneofthesecompanies.Themutliplesusedintherelativevaluationmodel

are justas importantas thechosenpeergroup.TheP/Emultiple is crucialas itgenerally takes into

accountpastperformanceandfuturegrowth.With increasingcompetition intheretail industry, it is

importanttorealizehowexpensiveorcheapthestockisincomparisontotheindustry.EV/EBITDAis

alsoextremelyimportantincompanieswithinthesameindustry.Thismultiplegivesinvestorsagood

ideaastohowprofitableabusiness inregardless if theyhavedifferentcapitalstructures. Iavoided

usingtheP/BmultipleasCostcoorretailersingeneralarenotverycapitalintensive.Whiletherelative

valuationimpliesthatCostcoisovervaluted,onemustnotethatwhencomparingCostcotoPricesmart

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Inc, the only other warehouse club included in the peer group that they are trading on par with

eachotherwiththerestfothegrouptrasingatadiscount.Thisislikelyduetothefactthatwarehouse

companies are much more attractive and have the benefit of an economic moat whereas other

retailers havemuch less insulation from competition. Therefore, on a relative basis Costcomay be

fairlyvaluedinrelationtosimilarwarehouseclubs,withtheirpremiumoverotherretailersinthepeer

groupmaybedeserved.

InvestmentRecommendation

Buy,PriceTarget$155

InvestmentPositives

Strong Economic Moat – Costco’s steady return of loyal members has set it apart from retail

competitors.ProvidingqualityproductsatthelowestpriceallowsCostcotoconsistentlyincreasestore

trafficwhileretaininga90%membershiprenewalrate. Theirmembeshiostructurehasledtobrand

loyaltywhichtranslatesintoincreasedsame-storesales.

Shareholder Value - Costco is a shareholder-friendly business. Shareholders benefit from capital

allocation policies in that excess cash gets returned to shareholders in the form of dividends and

special dividends. Rather than investing capital into projects with low rates of return, shareholders

reapthebeneiftsofoperationalsuccess.

InternationalExpansion–Costco’soperatingincomeislargelydependentonmembershiprevenue.In

2013,Costcoimplementedaninternationalexpansionplanwhichhasincreasedcustomerreach.With

recentwarehouseopeningsinIcelandandFrance,CostcolookstomoveoperationsintotheEuropean

PriceMultiples EVMultipleName P/E EV/EBITDACostcoWholesaleCorp. 27.17 12.88Wal-MartStoresInc. 15.45 7.42PriceSmartInc. 27.4 12.99TargetCorp. 12.73 6.33KrogerCompany 15.58 7.8Lowe's 18.37 10.6

Mean 19.45 9.67COSTImpliedShareVal. 118.8 120.9Weight 50% 50%

WeightedPrice 119.86$CurrentPrice 172.61$OvervaluedBy 44%

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market.TheincreaseindomesticandinternationaloperationswillallowCostcotocontinueexhibiting

growth.

InvestmentNegatives

Valuation–TheDCFandrelativevaluationdemonstratedthatCOSTisextremelyovervalued.WhileI

believethereisstilltremendousroomforfuturegrowth,itisdifficulttoarguewiththesciencebehind

thevaluationofacompany

E-Commerce Influence – E-commerce has positively impacted retail sales for many organizations.

Unfortunately for Costco, the shift in consumer spending does not cope well with their Business

Model.Bulkitemsareexpensivetoshipandalsocauselogisticalproblemsintermsofdelivery.

CatalystforRecommendationChangeThekeydriverbehindCostco’ssuccessistheirmembers.IfCostcomembershiprenewalratesbeginto

tapper off or decrese dramatically, the companywill need to be reevaluated. A study organized by

MorganStanleysuggeststhat50%ofCostcomembersalsohaveanAmazonPrimeMembership.Once

online sales and in-store sales begin to converge, Costco members may be more influenced to

purchaseaPrimemembershipoverCostco.However,consideringthecorporationspotentialforfuture

growthanddownsidesofpossiblerisks,webelievethepositivesofinvestingrightnowoutweightthe

negativesofinvestingandthatiswhyourfinalrecommendationisaBuy.

DisclaimerThisreportwaswrittenbyastudentcurrentlyenrolledinaprogramattheSprottSchoolofBusiness.

The purpose of this report is to demonstrate the investment analysis skills of Sprott students. The

analyst isnotaregistered investmentadvisor,brokeroranofficially licensedfinancialprofes-sional.

Theinvestmentopinioncontainedinthisreportdoesnotrepresentanofferorsolicitationtobuyor

sell any securities. This report is written solely for the consideration of this student managed

investmentfundandshouldnotbeusedbyindividualstomakepersonalinvestmentdecisions.Unless

otherwise noted, facts and figures included in this report are from publicly available sources. We

cannotguaranteethattheinformationinthisreportis100percentaccurate,althoughwebelieveitto

befromreliablesources.Informationcontainedinthisreportisonlybelievedtobeaccurateasofthe

day it was published, and it is subject to changewithout notice. It cannot be guaranteed that the

facultyorstudentsdonothaveaninvestmentpositioninthesecuritiesmentionedinthisreport.

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AppendixAPro-formaFinancialStatements FigureA1:IncomeStatementFigureA2:CommonSizeIncomeStatement

2015 2016 2017 2018E 2019E 2020E 2021E 2022E CVRevenues 116,199 118,719 129,025 138,148 147,920 158,385 169,595 181,602 194,463Expenses:CostofGoodsSold/Production 99,544 101,187 109,998 117,245 125,538 134,420 143,934 154,124 165,039SellingandAdministrative 11,445 12,068 12,950 13,496 14,450 15,473 16,568 17,741 18,997OtherExpenses 459 537 596 540 579 619 663 710 761EBITDA 4,751 4,927 5,481 6,867 7,353 7,873 8,430 9,027 9,666

DepreciationExpense 1,127 1,255 1,370 1,341 1,436 1,537 1,646 1,763 1,888EBIT 3,624 3,672 4,111 5,526 5,917 6,335 6,784 7,264 7,779

InterestExpense -124 -133 -134 -157.766 -137.4 -128.685 -107.314 -77.8925 -77.8925EBT(BeforeOtherItems) 3,500 3,539 3,977 5,368 5,779 6,207 6,676 7,186 7,701Non-OperatingItems:OtherItems 104 80 62 - - - - - -EBT(AfterOtherItems) 3,604 3,619 4,039 5,368 5,779 6,207 6,676 7,186 7,701

IncomeTaxExpense 1,227 1,269 1,360 1,833 1,970 2,114 2,271 2,442 2,614NetIncome 2,377 2,350 2,679 3,535 3,809 4,093 4,406 4,745 5,087

CostcoWholesaleCorporationIncomeStatement-USDMillions

2015 2016 2017 2018E 2019E 2020E 2021E 2022E CV

Revenues 100% 100% 100% 100% 100% 100% 100% 100% 100%Expenses:

CostofGoodsSold/Production 86% 85% 85% 85% 85% 85% 85% 85% 85%

SellingandAdministrative 10% 10% 10% 10% 10% 10% 10% 10% 10%

OtherExpenses 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%

EBITDA 3% 3% 3% 4% 4% 4% 4% 4% 4%

DepreciationExpense 1% 1% 1% 1% 1% 1% 1% 1% 1%

EBIT 3% 3% 3% 4% 4% 4% 4% 4% 4%

InterestExpense 0% 0% 0% 0% 0% 0% 0% 0% 0%

EBT(BeforeOtherItems) 3% 3% 3% 4% 4% 4% 4% 4% 4%Non-OperatingItems:

OtherItems 0% 0% 0% 0% 0% 0% 0% 0% 0%

EBT(AfterOtherItems) 3% 3% 3% 4% 4% 4% 4% 4% 4%

IncomeTaxExpense 1% 1% 1% 1% 1% 1% 1% 1% 1%

NetIncome 2% 2% 2% 3% 3% 3% 3% 3% 3%

CostcoWholesaleCorporation

CommonSizeIncomeStatement

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FigureA3:BalanceSheet

2015 2016 2017 2018E 2019E 2020E 2021E 2022E CVAssets:CashandEquivalents 4,801 3,379 4,546 6,773 11,289 15,321 20,665 26,675 31,772AccountsRecievable 1,224 1,252 1,432 1,500 1,500 1,500 1,500 1,500 1,500Inventories 8,908 8,969 9,834 10,000 10,500 11,000 11,500 12,000 12,500OtherCurrentAssets 228 268 272 272 272 272 272 272 272Short-TermInvestments 1,618 1,350 1,233 1,227 1,220 1,214 1,207 1,201 1,195CurrentAssets 16,779 15,218 17,317 19,771 24,781 29,307 35,144 41,648 47,238

Property,PlantandEquipment(Net) 15,401 17,043 18,161 19,583 20,745 22,058 22,956 23,917 24,946OtherAssets 837 902 869 869 869 869 869 869 869TotalAssets 33,017 33,163 36,347 40,223 46,395 52,234 58,969 66,434 73,054

LiabilitiesAccountsPayable 9,011 7,612 9,608 9,488 10,159 10,878 11,648 12,472 13,355AccruedLiabilities 4,550 4,860 5,162 5,162 5,162 5,162 5,162 5,162 5,162Other 1,695 2,003 2,639 2,639 2,639 2,639 2,639 2,639 2,639CurrentLiabilities 15,256 14,475 17,409 17,289 17,960 18,679 19,449 20,273 21,156

Long-TermDebt 6135 5161 6659 6659 5461 4963 3969 2679 2679OtherLiabilities 783 1195 1200 1200 1200 1200 1200 1200 1200TotalLiabilities 22,174 20,831 25,268 25,148 24,621 24,842 24,618 24,152 25,035

Equity:CommonStock 2 2 4 4 4 4 4 4 4RetainedEarnings 6,518 7,686 5,988 9,523 13,332 17,425 21,831 26,576 31,662AccumulatedOCI -1121 -1099 -1014 -1014 -1014 -1014 -1014 -1014 -1014OtherEquity 5218 5490 5800 5800 5800 5800 5800 5800 5800TotalEquity 10,617 12,079 10,778 14,313 18,122 22,215 26,621 31,366 36,452

Non-ControllingInterest 226 253 301 336 371 406 441 476 511TotalLiabilitiesandEquity 33,017 33,163 36,347 39,797 43,114 47,463 51,680 55,994 61,999

BalanceSheet-USDMillionsCostcoWholesaleCorporation

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2015 2016 2017 2018E 2019E 2020E 2021E 2022E CVAssets:CashandEquivalents 15% 10% 13% 17% 24% 29% 35% 40% 43%AccountsRecievable 4% 4% 4% 4% 3% 3% 3% 2% 2%Inventories 27% 27% 27% 25% 23% 21% 20% 18% 17%OtherCurrentAssets 1% 1% 1% 1% 1% 1% 0% 0% 0%Short-TermInvestments 5% 4% 3% 3% 3% 2% 2% 2% 2%CurrentAssets 51% 46% 48% 49% 53% 56% 60% 63% 65%

0% 0% 0% 0% 0% 0% 0% 0%Property,PlantandEquipment(Net) 47% 51% 50% 49% 45% 42% 39% 36% 34%OtherAssets 3% 3% 2% 2% 2% 2% 1% 1% 1%TotalAssets 100% 100% 100% 100% 100% 100% 100% 100% 100%

LiabilitiesAccountsPayable 27% 23% 26% 24% 24% 23% 23% 22% 22%AccruedLiabilities 14% 15% 14% 13% 12% 11% 10% 9% 8%Other 5% 6% 7% 7% 6% 6% ` 5% 4%CurrentLiabilities 46% 44% 48% 43% 42% 39% 38% 36% 34%

Long-TermDebt 19% 16% 18% 17% 13% 10% 8% 5% 4%OtherLiabilities 2% 4% 3% 3% 3% 3% 2% 2% 2%TotalLiabilities 67% 63% 70% 63% 57% 52% 48% 43% 40%

Equity:CommonStock 0% 0% 0% 0% 0% 0% 0% 0% 0%RetainedEarnings 20% 23% 16% 24% 31% 37% 42% 47% 51%AccumulatedOCI -3% -3% -3% -3% -2% -2% -2% -2% -2%OtherEquity 16% 17% 16% 15% 13% 12% 11% 10% 9%TotalEquity 32% 36% 30% 36% 42% 47% 52% 56% 59%

Non-ControllingInterest 1% 1% 1% 1% 1% 1% 1% 1% 1%TotalLiabilitiesandEquity 100% 100% 100% 100% 100% 100% 100% 100% 100%

CostcoWholesaleCorporationCommonSizeBalanceSheet

FigureA4:CommonSizeBalanceSheet