SIMON GRADUATE SCHOOL OF BUSINESS
Costco: Forecasting and Valuation Case
Financial Statement Analysis ACC 411
SUBMITTED BY Bhadra Menon Sanjeev Prakash Sanchit Sarin Venkata P Sastry Susarla
In addition. The company benefited from its high inventory turnover ratio. operating and expansion strategies and identify the key features of its business model.
. contributed to its high Return on Equity. Costco has also maintained its current ratio close to 1 for several years despite expanding into domestic and international market and that shows its operating efficiency.6 billion in 1992 to $15. Assess Costco’s business. As a result.5% in five years. Kirkland.70% to 2. Costco purchased Price Club to spearhead the wholesale club industry along with Sam’s.Q1. It reduced labor costs by using forklift for the delivery of pallets onto the warehouse floor. The operating margin ranged between 2. Operating Strategy: The Company maintained the operating efficiency by reducing its capital expenditure through various methods. It offered a broad distribution channel that brought increased revenues and purchased limited SKUs from its vendors. it had low gross margin per sale but high volume of sales compensated for the low operating margin.91% from 1997 to 2001. The company also offered various products through its own proprietary brand. Expansion Strategy: In 1993. Till 2000. it increased its number of stores in domestic market by 32% and in international market by 36. It passed the saving from the manufacturers’ low production cost to its own customers. to target the service or product sectors where it felt a need for high quality. Costco managed its supply chain very effectively. It also charged an annual membership fee for the values provided to its customers and the membership fee increased its revenue by 1.5 billion in 1993. it increased its sales from $6. what are the keys to success and what are the expected financial statement consequences of the strategies?
Business Strategy: Costco was the largest wholesale club in the industry with sales of $34 billion in 2001 and it differentiated itself from its closest competitor Sam’s by targeting a wealthier clientele of small business owners and middle class shoppers.82%-1. The company valued its customers by adhering to the strict policy of marking up its products up to maximum of 14% over the distributor’s price whereas a typical retailer marked up products 25% to 40%. Since 1997. With the merger. It increased its store sales by increasing sales per customer. low cost items that did not exist in the market. It implemented cross-docking procedure for the distribution of goods to its stores and maintained low inventory cost.93% from 1997 to 2001. low A/R days and high A/P days. The low cash cycle days contributed to its high Asset Turnover ratio and that in turn. it avoided direct competition with Sam’s by limiting the number of stores in the same markets.
Rise in gas prices causing transportation charges to increase. Risk from being in a saturated industry Since retail is a saturated market. Risk of losing customers due to : No customer service and lack of order From the case we understand that Costco. as the number of players in the market increases. but as Costco expands and acquires more customers. This strategy is detrimental in two ways.g. Secondly. Many customers might feel that the saving at Costco are not worth the inconvenience and extra transportation costs and might keep away from Costco. they will have to satisfy a wide array of people with different choices and this strategy of limiting variety for the sake of cost might reduce Costco’s reach among the buyers who would not hesitate to pay little extra for the product that they want. Risk of losing customer due to : Lack of choice Costco’s strategy of concentrating only on a few items and sell them in bulk might go well with small business owners for now. 5. to save costs. for example. 2.
. keeps customer service at a minimum and also the goods are not ordered on shelves but are placed on the warehouse floor as a pallet or stack. bigger containers mean less convince and larger transportation costs for the consumer. This also might keep customers away from Costco.Q2. This can be a great inconvenience for the customer. Risk from the 14% markup strategy
Since 14% markup is a well-publicized differentiating strategy of Costco. 3. first it keeps customers who do not want to buy large quantities but are ready to pay larger amount per unit for a smaller quantity. or real estate prices or labor charge etc). Costco would be hurt if they raise their markup (Loss of differentiating strategy and also go against customer expectations) or they don’t raise the markup (Loss due to cost increases). he/she would have to go through the entire stack of the jeans before they find/give up looking for it. 4. the market share of Costco would come under pressure from the competitors. if the customer is looking for jeans of a particular color and/or make. If market conditions change and Costco’s costs increase (for e. Costco usually sells stuff in bigger containers than would be available elsewhere. Risk of losing customers due to : Rigid container size Though Costco gives its customers lowest per unit price. What are the major risks Costco’s faces in the future when trying to execute its strategy?
Major Risks that Costco faces in the future due to its strategy are: 1.
000 SKUs at most grocery
b) The four most important differentiators amongst Costco’s.Q3. offering the same products at the same prices while this was not the case with Costco. SAM’S Club and BJ’s Wholesale are as follows: 1) Costco’s targeted a wealthier clientele of small business owners and middle class shoppers whereas SAM’S Club catered to lower income groups. b) What are the 4 most important observations you would make to differentiate them?
a) We would define SAM’S Club and BJ’s Wholesale as Costco’s closest competitors. For all three of them customers had to purchase annual membership and all three – • • stores • • • • • Sold items in bulk amounts Had high inventory turnover ratios Had low operating expenses Operated on very low gross margins Ran stores in warehouse style facilities Attempted to offer best value to customers by offering lowest prices Carried a limited selection of goods – 4. 2) Costco did not mark up its products more than 14 percent over the distributor’s price whereas BJ’s marked up select items more than 14 percent.000 per store 3) When it came to location most SAM’S clubs were located adjacent to a Wal-Mart store. Also. Also.
. We consider these two firms to be closest competitors to Costco because all three – Costco.000 per store versus 4. the majority of SAM’S Clubs were located in the South and most Costco’s were in the West. BJ’s stores carried more SKUs than Costco’s – 6. The case contains information about Costco’s potential competitors.000 SKUs as compared to 40. BJ’s policy was similar to that of Costco’s in targeting small business-owners and middle class buyers. SAM’S Club and BJ’s Wholesale – operated on same business model in retailing – the wholesale club. a) Identify and justify the firm or firms you would define as Costco’s closet competitor.
Q4. and signage in its warehouses in an attempt to improve the shopping atmosphere. However. Improving gross margins through the following methods (The company has low gross margin per sale) a. they should utilize just-in-time principles when ordering merchandise to minimize the cost of inventory. The company can increase its clientele by offering more range of products. 3. b. keep best value pack product to assure low prices through volume buying. expense reduction and low gross margins etc.4) BJ’s stores were smaller than Costco’s stores – 110. What are the 5 most important factors likely to affect Costco’s future growth
1. Costco doesn’t spent a lot in advertising and use word of mouth advertising for marketing which is not only one of the cheapest way to advertise but it is one of the most effective ways of advertisement.
. they do everything to retain their customers. Growing sales per warehouse: The sales per warehouse is a figure that can be increased with effective management of warehouses. Virtually. Costco sells limited numbers of products in fewer varieties to keep the cost down and they rely on high volume sales. Costco can increase its customer base by tapping more of the middle class and lower income people. Offering more upscale products: In the core of their strategy. In addition to this.000 square feet and BJ’s spent more money than Costco’s on flooring. Employing creative cost cutting measures: For example.000 square feet versus 148. they should maintain in-stock positions without being overstocked and transition seasonal merchandise. Increasing membership fee/value (Grow membership): . The company’s membership base is growing and they are able to retain their customers. 4. This can be done through better inventory management and more efficient supplier funding. to achieve the price leadership they reduce handling and storage cost. 2. Growing private label: The Company needs to expand its own proprietary brand. Kirkland so that it can increase its clientele. One of the key uniqueness and strength is that they sell membership to their customers that not only generate the fixed revenue every year but also increase the brand loyalty and awareness of the customers towards Costco.
project Costco’s performance beginning with the fiscal year 2002.For some finite horizon you deem appropriate. We believe this assumption is valid as the both Costco and Sam’s are vying for big expansion into each other’s territories and thus would continue to add new warehouses in the process
. Assume a longrun market risk premium from 6. The terminal growth rate has come down to 6.76% The regression and raw data is available in the excel sheet
Q6.1081077 10.5% to 7. WE assume that Costco will keep opening stores until it equals to Sam’s club’s warehouse numbers (which have been projected to increase at 12 per year). Domestic and international expansion: Costco has to keep opening stores so that it can compete with Sam’s club’s warehouse numbers. we get Cost of equity = rf +beta*(rm-rf)=10.Estimate Costco’s cost of equity capital as of the valuation date.0%.
We have taken same store sales growth as 4.76%
Risk free rate was taken as 3 month Tbill as of 2001 (30 yrs US treasury bond was discontinued in 2002.5%.00% 1. That is why we have taken the Tbill).0% and the net number of stores opened (we have not separately calculated the opening and closing of stores) per year as 32 till the total reached 1000.
Cost of equity Risk-Free Rate (rf) Market Risk Premium (rm-rf) Raw (observed) beta Cost of equity
We have taken a 20 year horizon considering that it is a growing market.
Q5. We did a regression on the weekly returns of Costco and S&P 500 from 1996 to 2001 to obtain a beta of 1.11. Be sure all of your I/S and B/S forecasting assumptions are explicitly stated and justified.5. This is essential for survival as both Costco and Sam’s are vying for big expansion into each other’s territories and thus would continue to add new warehouses in the process.00% 7. Then using the CAPM formula.
0% An average of the previous 3 years' ratio
Previous year's figure Previous year's figure This is the average percentage of preopening expenses to number of stores Average An average of the previous 3 years' ratio An average of the previous 3 years' ratio (An average of the previous 3 years' ratio) 1.85% 15. This was because the company’s strategy seems to be focused on growing its members and also increasing its membership fee.74% 29.44% 0.53% 0.15%
Balance Sheet Drivers / Assumptions Cash / Sales Short .Term Investments / Sales Accounts Receivable / Sales Merchandise Inventories / Sales Other Current Assets / Sales Accumulated Depreciation & Amortization / Average Net PP&E Net PP&E / Sales Other Long-Term Assets /Sales Accounts Payable / COGS Short-Term Debt / Assets Accrued Liabilities / Sales Deferred Membership Income / Membership Fees Other Current Liabilities / Sales Long-Term Debt / Assets Other Long-Term Liabilities /Sales Minority Interest / Assets Other accumulated / Sales
Preopening Expenses as a % of number of new stores Tax Rate Interest Expense as a % of average long term debt Interest Income as a % of net sales
Income Statement Drivers / Assumptions COGS as % of Revenue Provision for impaired assets/closings as a % of revenue SG&A as % of Sales 88.73% 0.97% 0.70% 7.82% 9.33% 1.68% 1. It aims to do that by creating more value to its members.We have taken the income from members to be growing at 4% and the number of members to grow at 1.3% 40.1% 9.08% 0.20% 0.29% 1.75 million.0% 4.89% 0.86% 48.34% 0.05% 8.
587.940.272. Based on your projections in (6) perform a DCF valuation of Costco.Q7.6
$29.8 $4.0 $0.
Free cash flow to Common Equity +Cash from Operations -Increase in Operating cash +Cash from Investing +Increase in Debt -Dividends Paid on Preferred +Increase in Preferred Stock =Free Cash Flow to Common Equity Present Value of FCF
Present Value beyond 20 years Present Value in the first 20 years Forecast Equity Value Before Time Adj Forecasted Value as of Valuation Date -Value of contingent equity claims +Excess cash at Valuation Date Value Attributable to Common Equity Common Shares Outstanding at BS Date
$8. Based on your analysis in (6) perform a Residual Income valuation of Costco.4 $3.138.2 $12.631
$30.5 449.230.587.9 $0.538.272.9 $449.0 $13.value of contingent equity claims + excess cash at valuation date Value attributable to common equity Common Shares Outstanding at BS date
$3.5 0 $0.3 $5.872.5 $13.
PV beyond 20 years PV for 20 years Common Equity as of the year 12/31/2001 Forecast equity value before time adjustment Forecasted value as of valuation date .9 $13.640.0 $13.22
Please refer to the excel sheet for detailed calculations
Please refer to the excel sheet for detailed calculations
. your set up must show what the PV of Cumulative Residual Income (i.109.e.0 $449.230.6
Please refer to the excel sheet for detailed calculations
$29.0% 64.39 $5. Beyond the basic elements of the valuation.Q9.484.2 $12. Abnormal ROE) is at the end of the first 3 years.00 2.9 $13.16
. Set up an Abnormal ROE valuation of Costco as the valuation date.7% 1.2 $0.
Terminal value of Abnormal ROE Total present value of Abnormal ROE Plus "One" Indicated Market to Book ratio (Sum of last 2 rows) Book value of equity at valuation date Indicated market value of equity before time adj (Product of last 2 rows) Market value of equity after time adj Plus: Excess Cash Common Shares Outstanding at BS date