When I was reading “The Economist” yesterday, I came across an interesting article that compared Amazon’s (AMZN) prices to the other major retailers in the United States. The research, which was completed by investment bank William Blair, looked at the prices of 100 randomly selected goods in an attempt to answer the most important question for many shoppers: who has the best prices?
As many know, Amazon is catching heat on sales tax, and recently agreed to start paying sales tax in California (if no national standards are in place at that time) in exchange for a one-year grace period. Regardless, even with Amazon’s current competitive advantage in the tax arena, the results may surprise you. In the electronics department, Amazon takes Best Buy (BBY) to the cleaners, with 87% of their goods coming in at a lower cost (still 78% with state sales tax accounted for). Against the discount retailers, Amazon is in line with the big box leaders, with Target (TGT) barely edging out a victory (43%) and Wal-Mart (WMT) coming in dead even at 50% (these figures include sales tax). However, when it comes to the warehouse, Amazon still hasn’t figured out a way to deal with the king: Costco (COST). Even without sales tax, Amazon only beat Costco’s prices 18% of the time; with tax included, the figure is a meager 13%.
When I read this, it reminded me that Costco is a great business and only getting stronger; with good managers and a growing base over which to spread fixed costs, Costco’s culture of relentlessly competitive prices will only strengthen the company in the coming years. In terms of valuation, if you back out roughly $3 billion in net cash on the balance sheet, the company is trading at 22.4x recently reported earnings. While that isn’t a screaming buy, it’s important to remember that they generated EPS growth of nearly 10% per annum over the past ten years, and still have plenty of room to grow both domestically and on a global scale. Either way, this is a company to keep an eye on, and to scoop up when the doomsday forecasters are dumping indiscriminately. Costco released their 10-K on Friday, and I figured I would run through it and highlight all the important developments of the past year for any interested readers:
The company separates net sales into six major categories: Sundries (including candy, snack foods, tobacco, alcoholic and nonalcoholic beverages and cleaning and institutional supplies), Hardlines (including major appliances, electronics, health and beauty aids, hardware, office supplies, cameras, garden and patio, sporting goods, toys, seasonal items and automotive supplies), Food (including dry and institutionally packaged foods), Softlines (including apparel, domestics, jewelry, housewares, media, home furnishings and small appliances), Fresh Food (including meat, bakery, deli and produce), & Ancillary and Other (including gas stations, pharmacy, food court, optical, one-hour photo, hearing aid and travel). The split between each category has been relatively steady over the past three years, with the split as such: 22% from Sundries, 17% from Hardlines, 21% from Food, 10% from Softlines, 12% from Fresh Food, and 18% from Ancillary and Other. The final category, Ancillary and Other, is the sole category that has materially increased as a percentage of net sales (18% compared to 15% in 2009); this is due to expansion in gas stations, pharmacies, and hearing-aid centers, which has outpaced the overall growth in store count.
The total number of warehouses continues to grow, and at an increasing rate. In 2009 and 2010, the company added 15 and 13 warehouses, respectively, bringing the total to 540; in 2011, after adjusting for the 32 warehouses in Mexico which are now reported in the total, the company added 20 net new locations in 2011. As noted on the Q4 call, the company expects to add 20 net new locations in 2012, with about half in the U.S. and half in international markets.
Of the company’s 592 locations, the geographic split is as such: 429 in the United States & Puerto Rico, 82 in Canada, 32 in Mexico, 22 in the United Kingdom, 9 in Japan, 8 in Taiwan, 7 in Korea, and 3 in Australia; in addition, the company owns both the land and building at the majority of these locations (79%). While the company continues to expand internationally, it is important to remember that their operations are still decidedly weighted to the United States and Canada: in 2011, these two regions accounted for 89% and 83% of consolidated net sales and operating income, respectively.
At the end of the year, the company had more than 35 million primary cardholders (up from 31.6M in 2010), and roughly 64 million total cardholders (6 million more than a year ago). At the end of 2011, executive members accounted for 38% of primary cardholders, up from 33% in 2009; this is a strong trend for Costco, because Executive members are the primary driver of the company’s revenues. For the year, member renewal rate was 89% in the U.S. and Canada, and approximately 86% on a worldwide basis, consistent with the past couple of years; membership fees increased to nearly $1.9 billion (second consecutive double digit percentage increase), a critical source of cash for the company’s bottom line.
As was noted on the Q4 call, the company announced that they are increasing the Gold Star and Business members rate from $50 to $55 per year (first increase since 2006), and the Executive Membership fee from $100 to $110 per year (the first increase since the program’s inception in 1997). As explained by CFO Richard Galanti, “we feel that the enhanced value of the Costco membership over the past 5 to 10 years far exceeds the modest $5 and $10 increase in the annual membership fee levels, and it will continue to allow us to bring our members even greater value on everything we offer.”
In Management’s Discussion and Analysis (MD&A), the first line reads:
“We believe that the most important driver of increasing our profitability is sales growth, particularly comparable sales growth (sales in warehouses open for at least one year).”
For the year, sales increased more than 14% to $87 billion, coming off an increase of 9.1% in 2010. Comparable warehouse sales, the key metric for retailers, continues to be strong; in the United States, the last five years (starting in 2007) have come in at 5%, 6%, (2%), 4%, and 7%. In international markets (with local currency), the same five years came in at 5%, 6%, 7%, 8%, and an impressive 10% in 2011. Due to international operations, the company is exposed to fluctuations in exchange rates, which they hedge via forward foreign exchange contracts; at the end of fiscal 2011, these contracts had a notional value of $247 million.
The MD&A continues: “The higher our comparable sales the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability.” With gross margins at less than 11%, controlling selling, general and administrative expenses is critical to Costco’s profitability; in 2011, SG&A decreased 31 basis points (as a % of net sales) to 9.97%, with 20 basis points attributable to gasoline price inflation. The remaining 11 basis points were driven by an improvement in warehouse operating costs, largely payroll.
At the end of 2011, cash and cash equivalents was equal to $4 billion and short term investments were worth $1.6 billion ($1.1 billion in U.S. Government & Agency Securities), compared to $2.6 billion in long term debt (including contractual interest payments); $900 million of that total is in the form of 5.3% senior notes that will be paid off in March 2012, a repayment that CFO Richard Galanti characterized in Q2 as “a nice change given that we're earning a lot less on our excess cash right now”. The significant majority of the company’s remaining debt (roughly 90%) beyond that issue comes in the form of $1.1 billion worth of 5.5% senior notes, due March 2017.
Net cash provided by operating activities totaled $3.2 billion in 2011, an increase of 15.1% compared to $2.78 billion in 2010. After adjusting for $1.3 billion in capital expenditures for the year, free cash flow came in around $1.9 billion. In 2012, management plans to spend around $1.5 billion for real estate, construction, remodeling, and equipment for warehouses and related operations.
Shareholders’ equity increased 10.8% during the year (11.5% on a per share basis, after adjusting for nearly 9 million shares repurchased in 2011 at an average price of $57.14), despite the effect of a $0.89 per share annual dividend to common shareholders. In regards to the share repurchase, the Board authorized $4 billion in additional repurchases in April of this year, of which $3.7 billion remains today; in the words of Mr. Galanti, “Long term, we continue to be buyers. On a regular basis, we're not going to predict up or down where the stock's going to go. But overall, we continue -- we currently believe in the outlook of the company and clearly, we've got enough cash to not only pay for ramped up expansion and an increasing dividend, but hopefully stock buybacks as well into the future.”
In regards to legal proceedings, the company has multiple class action suits which have been brought on behalf of present and former Costco members and employees; from my review of the proceedings, none of the cases appear to be particularly concerning, or at a point in the proceedings where concluding other would be premature.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.