Considering Costco (COST)

[AF: On 7-8-09, I  added some new material at the end of this post]

Costco is my favorite retailer: I find lots of bargains, lots of fashionable clothing, and lots of tasty food, all at low, low prices.  We only buy what we use so the large quantities that are part of the deal are no hardship.

Costco also has lots of free tastes to sample everyday, a kosher frank and soda for $1.50 (unchanged for 20 or so years), and an annual membership fee that pays for itself in savings with one or two big purchases.

Best of all, COST has a hassle-free return policy and adds one year to the standard one-year warranty for electronic products.  Even better, when I used the Costco American Express card to buy my laptop, I got a third year of warranty protection for free.

COMPANY BACKGROUND

– Costco Wholesale (COST) operates some 560 membership warehouse clubs, 403 in the U.S. and the rest in six other countries according to Value Line.   About 52% of its sales were from food and sundries.

– According to Wikipedia, Costco’s sales were $71B in 2008, up 12.5% due to an increase in same store sales and the opening of 24 new clubs.  COST is slowing its domestic expansion and focusing on international markets for future growth.  It plans to open 14 new international stores in 2009-2010.

–  Morningstar reported that COST has 55 million members, with 30% of its clubs in California, and seeks to add 6-9 clubs per year.  Its immediate strategy is to grow its ancillary businesses (such as gas stations, pharmacies, and optical services) to boost sales and to generate more frequent shopping visits.

** Despite tough economic times and recent disappointing performance, Morningstar also explained that Costco is strictly adhering to its policy of not marking up any item by more than 15%.  Charging low prices for quality merchandise and paying generous wages and benefits leads to slender profit margins: a 2.9% average Pre-Tax Profit Margin for the last 5 years and 2.8% in 2008.

** Morningstar predicted that Costco would expand to 750 warehouses by 2018 and estimated 5.0% annual sales growth for the next 10 years.

– I used Bob Adams’ one-click spreadsheet to analyze COST’s 2008 Annual Report which found: 9 Bullish results (good things), 8 Bearish results (not-so-goods), 3 red flags (Free Cash Flow and its Return are both low, Quick Ratio is also low), and 17 green flags (very good things) for an overall score of 61 out of 100.

** You can get a link to Bob’s free spreadsheet and a summary of its many features by going to my Favorite Links page: click here.

COST COMPARISONS <grin>:

 The table below compares the SSG by CalvinG, which I downloaded from Better Investing’s First Cut page, with two of mine and with Take Stock.

My two SSGs use the same judgments with one exception: Armin-2 projects growth from the last Fiscal Year while Armin-1 projects growth from the last Quarter of reported data.  Armin-2 is a SSG BUY, but Armin-1 is not. <grimace> 

Costco Wholesale (COST)	CalvinG	Armin-1	Armin-2	Take                 Stock
Date	6-12-09	6-18-09	Same	Same
Data	BI S&P             Online	BI S&P	Same	Morningstar-Hemscott
Price	$47.00	$46.24	Same	$46.24
52 week High &      Low Price	$74.89  &     $38.17	Same &         Same	Same &        Same	n/a
Last Q of Reported   Data	Q3 ending       5-09	Same	Same	Q2 ending             2-09
Software Used	BI Online SSG	TK 5	Same	Take Stock Online
Project Growth         From End of	Last FY            (No Options)	Last             Quarter	Last FY	Last FY                (No Options)
Sales Growth	8.00%	9.00%	Same	9.80%
EPS Growth	8.00%	9.00%	Same	9.10%
High PE	18.0	20.0	Same	24.4
High EPS	$4.28	$4.00	$4.48	$4.97
High Price	$77.04	$80.00	$89.60         12% > VL	$109.24               36% > VL
Value Line Estimated High Price = $65-80 at $47.07 as of 5-8-09
Low PE	15.0	14.6	Same	17.9
Low EPS	$2.91             (Last FY)	$2.7            (TTM)	$2.91	$2.72
Low Price	$43.65           (Low PE x         Low EPS,          No Options)	$30.20 (Recent        Severe Low)	Same	$48.69              (Higher than Current Price)
Upside/Down	8.88	4.2	5.5	Impossible to Calculate
Total Return	11.43%	12.1%	15.2%	20.1%
Final Recomm-endation	BUY	HOLD	BUY	n/a
SSG Buy Under	Not Included	$40.72	$46.43	$57.82
RV/PRV	Not Included	83.2/76.2	82.9/76.0	Not Included
Quality	n/a	A-	Same	3.20                   (Unacceptable)
PTPM – 5 yr ave	02.90%       Trend n/a	Same        Trend even	Same          Same	02.8%                 Trend n/a
ROE – 5 yr ave         End Equity	12.15%         Trend n/a	12.1%         Trend up	Same          Same	Not Included
ROE – 5 yr ave         Start Equity	Not Included	13.1%             Trend up	Same         Same	13.0%              Trend n/a
Debt to Equity – 5 yr ave	Not Included	14.4%             Trend up	Same         Same	Not Included

SSG by CalvinG [CG] :

– CG’s SSG is from BI’s First Cut where members can upload their stock studies on a two-page form that explains their judgments.  He also used BI’s Online SSG which is much more limited than SSG software. 

** The Online SSG only projects growth from the last Fiscal Year, has only one method for Forecasting the Low Price, and does not use the Relative Value-Projected Relative Value metrics.

– CG’s SSG is unremarkable for the most part and he makes conservative judgments throughout, but does not provide an explanation or reason for any specific decision.

– Two things are notable: his Forecast Low Price and his Final Recommendation:

** Calvin-G’s Forecast Low Price ($43.65) was very close to the current price for COST ($47.00) and explains why he got such a high Upside-Downside Ratio (8.88).  Sadly, the Online SSG offers no options for the Low Price whereas my SSG software provides four choices.

** First Cut asks for a final recommendation and CG’s was BUY even though his SSG did not satisfy the BUY criteria of at least 15.0% Total Return.

Armin’s  SSG-1 and SSG-2:

– When I did my SSG, Value Line’s 5.50% EPS estimate was atypically low compared to the other five analysts I checked: FactSet CallStreet via CNN Money was high at 13.00%, S&P was 12.90%, Zacks.com was 11.57%, Reuters.com was 11.46%, and Reuters-Thomson via YahooFinance was 11.30%.  The average of all six was 10.95% and, without VL, was 12.05%.

** I estimated 9.00% EPS, well below the analysts.  My resulting High EPS ($4.47) combined with my Projected High PE (20.0) gave me a Forecast High Price of  $80.00 that was at the top of VL’s $65-80 estimate.  I almost never want to substantially exceed VL, and then only if I believe I have a good reason.

** Unlike the Online SSG, I had the opportunity to chose the 52 week low as my Forecast Low Price ($30.20) which resulted in an Upside-Downside of 4.2 in Arrmin-1. I also had an open-ended option which allows me to enter any amount I choose.

– Armin-1 was not a SSG Buy because its 12.1% Total Return did not satisfy the minimum 15.0% criterion even though its 4.2 Upside-Downside passed muster.

– Armin-2 was a SSG Buy because its 15.2% Total Return and 5.5 Upside-Downside satisfied the minimum criteria.  The only judgment I changed in Armin-2 was that growth was projected from the last Fiscal Year instead of the last Quarter.

** Armin-2 illustrates an important point: projecting growth from the last FY in a recessionary market ignores COST’s last 9 months of declining performance and results in an unreliable and unrealistic analysis.

Take Stock:

Take Stock is a one-click computerized program at the StockCentral web site that allows no judgment by the user and is designed to produce a conservative result. 

–  Its Forecast High Price of $109.24 was $29/share or a whopping 37% greater than the high end of VL’s $65-80 High Price estimate.

– Its Forecast Low Price of $48.69 was higher than COST’s current price of $46.24 which Take Stock permits, but which seems like conceptual idiocy to me since a Low Price that’s not “low” makes no sense.

– Its Quality rating was 3.2, which is unsatisfactory, with 3.4 the minimum required to pass muster while a 6.7 is desired out of 10 maximum.  S&P, on the other hand, gave COST a grade of A- for quality, third highest out of 8 ratings.

QUESTIONS:

(1) Do you think Take Stock produced a conservative result, and why or why not?  Was that result reasonable in your judgment, and why or why not?

(2) Do you think COST is a SSG Buy, and why or why not?

(3) Which of the three different Projected High PEs (18.0, 20.0, 24.4) do you agree with and why?  Is there another figure you would use and why?

I’m trying to encourage some discussion and would appreciate your answers to one or more of these quations as a comment in the box below .

 

 -Armin

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The following comments were posted on the BI Discussion List which WordPress won’t let me publish as a comment so I am posting them here: 

 

Hey Ray:

You wrote: << It is my understanding that the Value Line “2012-2014 PROJECTIONS” are for the middle, 2013 (4 years)….if my understanding is correct, the Value Line Low & High of $65 & $80 at 4 years would be $71.50 & $92.00 at 5 years (expanding at annual rates of 10% (Low) & 15% (High).
 
I currently expand Value Lines High & Low another year (to 5 years) when checking with my SSG on a Company.  [AF emphasis]>>

 (1) VL manuals, free to the public, consistently say that its projections are for 3 to 5 years with no elaboration.  See: The Complete Overview of the Value Line Investment Survey and In Depth Guide to Reading a Value Line Research Report, both available at no charge from

 http://www.valueline.com/sup_howtoinvest.html

 – You take 3 to 5 years to mean 4 years while I construe it to mean 3 and 4 and 5 years, that is I believe VL projections relate to a three year period.

 (2) I think VL intends its projections to be like ball-park approximations because long-term estimates are notoriously inaccurate.  VL is deliberately imprecise and uses a dollar range (for COST, $65-80) and a date range (for the next 3-5 years).

 – What makes you think that VL projections are for four years?  Do you have any authority to point us to?

 (3) To compare your SSG for COST to VL, you expand VL’s $65 – 80 estimated High Price range by tacking on an additional year which works out to $71.50 – 92.00.

 – Do you do the same sort of expansion if you use VL’s estimated Tax Rate and/or shares outstanding as part of your SSG’s Preferred Procedure?

 ** Cy Lynch did NOT do any expansion when he used VL estimates in his recent PP articles in Better Investing magazine. See: http://www.betterinvesting.org/Members/Tools/Articles/Archives/PrintMagazine/Authors/LynchCy/0309grstks.htm

 ** Brian Altschul and Gary Ball did NOT do any expansion when Brian used VL estimates in his recent BI Online Stock Study of W. W. Grainger (GWW) and when Gary used VL estimates in his study of Danaher (DHR). See

 http://www.betterinvesting.org/Members/Tools/Stock+Studies/gww.htm

http://www.betterinvesting.org/Members/Tools/Stock+Studies/dhr.htm

** Bonnie Biafore did NOT mention any sort of expansion when she discussed VL in the BI-NAIC SSG Handbook (2003 edition, pp 39-45)

 – VL makes more than 20 estimates for next 3 to 5 years and I don’t think you can pick-and-choose which you will expand and which you won’t.  Moreover, I think these several applications and discussions support my understanding of VL’s 3-5 year projection period.

 (4) Because VL is silent, opinions can differ on whether VL can be interpreted to mean 4 years or 3 to 5 years.  But that is an issue separate from whether it is appropriate toexpand VL’s projections by adding an additional year.  In that regard, I know of no one who has ever added an extra year to VL projections and increased its High Price estimates.

(5) Maybe some of the gurus here might offer their thoughts if you start a new thread (such as: VL Question).  You could also ask VL for clarification and, if you get any answer, please share it with us.

 Armin

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Armin,

 It is my understanding that the Value Line “2012-2014 PROJECTIONS” are for the middle, 2013 (4 years).

 
Looking at COSTCO: Value Line May 8, 2009

 Current $47 to Low of $65 would be 11.5% Annual return in 2012 (3 years) & 6.5% Annual return in 2014 (5 years).

Current $47 to High of $80 would be 19.0% Annual return in 2012 (3 years) & 11.5% Annual return in 2014 (5 years).

That’s a spread of 19.0% to 6.5% of 12.5%, rather large spread for predicting future “Annual Total Return”.
 
Also if my understanding is correct, the Value Line Low & High of $65 & $80 at 4 years would be $71.50 & $92.00 at 5 years (expanding at annual rates of 10% (Low) & 15% (High).
 
I currently expand Value Lines High & Low another year (to 5 years) when checking with my SSG on a Company.
 
Thanx in advance for any different insight on this subject,

 Ray