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The Science of Hitting
The Science of Hitting
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A Review of Costco's 2nd-Quarter Results

An update on the company following another strong quarter

March 12, 2019 | About:

Costco (COST) last week reported financial results for the second quarter of fiscal 2019. For the quarter, revenues increased 7% to $34.6 billion, driven by solid mid-single digit comparable store sales growth (largely due to a roughly 5% increase in traffic). In addition, e-commerce reported a 20% increase in revenues (up 25% adjusted for currency headwinds). Despite the membership fee rate increase taken in June 2017, the company continues to report solid renewal rates with the U.S. and Canada at roughly 91% (the worldwide renewal rate in the quarter was 88%). Total cardholders reached 96.3 million, an increase of more than 2 million cardholders since the start of the fiscal year.

The company currently operates 770 warehouses around the world, with 535 in the U.S. and Puerto Rico. That’s a net increase of 21 units over the past 12 months (roughly 3% growth). The company plans to open another 15 warehouses over the next six months, including its first location in China. (On a side note, if somebody can get photos from opening day at that new warehouse, I will be forever grateful – have a feeling that will be a sight to see.)

As it relates to International expansion, CFO Richard Galanti gave an interesting answer on the call that speaks to the company’s long-term focus and its capacity to suffer:

“Whenever we go into a new country, you're going to lose money for the first few years, even if that first location or two contributes a small amount of profitability. Because you still have the central expense and the whole thing, the infrastructure. I look back at Japan. When we first went into Japan, we opened six units in the first five years and the goal was to be at breakeven at the end of year five and I think we beat it by about ten months. But at the end of the day, fast forward another ten to twelve years past those five years, and we now have in the high twenties [number of warehouses] and we'll grow from there faster and more profitable than it was in that mid-term when we were opening several units on a small base. But it takes time.”

While building warehouses in new markets like Spain, France, Iceland and (now) China may not contribute to profitability from day one, it’s clear from the numbers that the returns on investment for Costco are attractive over the long run (the company has roughly $17 million in shareholders equity per unit, on which it generates roughly $180 million in sales and more than $4 million in earnings).

This chart shows how per-unit sales and profitability has changed over time.

Net income in the second quarter was $889 million, or roughly $2 per diluted share. Through the first six months of the fiscal year, diluted earnings per share (EPS) has increased 23%. The outsized growth relative to revenue growth reflects a roughly 20 basis-point increase in the company’s operating margin to 3.5%. Considering the company’s long-term track record, it's probably reasonable to assume that at laest some of this margin expansion will be eventually passed on to customers in the form of lower prices.

In the second quarter, Costco spent $117 million to repurchase 516,000 shares (at an average cost of $209 per share). The company continues to allocate a relatively small amount of money to repurchases, with management commentary on the call suggesting that dividends are the more likely source of capital returns for shareholders (both recurring quarterly dividends and periodic special dividends). This would align with its prior actions: Since 2012, the company has returned roughly 80% of earnings to shareholders through dividends.

Conclusion

As I noted in a recent update on Costco, I think the stock price reflects great confidence in the company and its long-term prospects:

“At $215 per share, Costco trades at roughly 30 times trailing earnings. That’s a significant premium to retailers like Walmart and Dollar Tree, which trade at roughly 20 times trailing earnings on my numbers (with some adjustments for Dollar Tree). The question is whether Costco’s long-term growth prospects, which are clearly superior to Walmart and Dollar Tree, justify such a large premium.

In my model, I assume continued unit growth of roughly 4% per year. I also assume low-to-mid single digit comp store sales growth, which collectively drives high-single digit revenue growth. Even with continued unit growth, Costco has a fair amount of free cash flow left over. I assume those funds are used towards dividends (with a payout ratio of roughly 40%) and repurchases (with the diluted share count declining by roughly 1.5% per year).

With those and a few other assumptions, I end up with earnings five years out of roughly $11 per share. With a terminal price-to-earnings multiple of 20 to 26 times earnings and a 9% discount rate, we’re left with a fair value today of $150 to $200 per share. In summary, unless you’re willing to make assumptions beyond 2023 (which you could either do explicitly or by applying a higher terminal multiple), it’s tough to make the case that Costco shares are undervalued at current levels.”

Since I wrote that, the stock has climbed another 78% to over $230 per share. The same conclusion still applies: I think you need confidence beyond 2023 to invest at these levels (said differently, you need to think it deserves to trade at a material premium to the broader market). I don’t own the stock at this point (actions speak louder than words), but I definitely think you can make a strong case that this company has a runway that expends many, many years into the future. I’m not a buyer at these prices, but I would consider accumulating shares of Costco if it fell much below $200 per share.

Disclosure: None.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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