(Disclaimer: Excel file attached below the post)
Retail Industry
In anticipation of Costco's fist quarter results in the first week of December, I wanted to take the time and analyze the intrinsic value of the company based off of its most recent 10K issued on 09/03/2023. Before I proceed on to my analysis, if you are solely interested in the excel file, scroll all the way down and engage yourself with downloading it, but if you'd like to stick around for a while and allow me to run you through my analysis, well then, let's look at Costco's share price over the course of last year:
Source: Barron's CostCo Equity Page
Costco's pure dominance is vividly on display, but what is the true value of the company? Is the current share price $593.45 (as of the writing of this post) justified given its operations? I set out to assess the company based off its last 5 years' financial history.
Before I delve deeper into the valuation, I think it is prudent to take a few seconds and discuss the market, its dynamics, and Costco's operations both in the US and abroad.
Retail business, as one can imagine, is highly competitive, and companies have to not only spend capital to attain and retain consumers, but also have to be effective at finessing the general macro and economic environment. Slow growth in the near future- driven by inflation, high interest rates, and earnings- will keep the retail industry in check. According to Deloitte, GDP is forecasted to grow at 0.9% in '23, down from roughly 2% in '22. In the case of a recession, the economy could contract further giving rise to unemployment. In the current macro environment, inflation has lowered consumers' purchasing power despite gains in nominal income due to strong labor market and other factors. Retail and service businesses (mainly) suffered vastly due to consumer pullback and mandatory restrictions during the pandemic. Additionally, inflation and high rates, driven by extensive growth in money supply before and during the pandemic, are also chewing away at regular Joe's wallet. But, it isn't all dark in the retail industry; consumers have begun spending on services again, and have also started frequenting bars, restaurants, and various other social events and soirees. After that succinct overview of the industry and its outlook, lets peel the onion on Costco's operations.
Costco primarily engages in membership warehouses in the US and other parts of the world such as Puerto Rico, Canada, Mexico, Japan, UK, Taiwan, and China to name a few. The company also owns and operates e-commerce websites in various parts of its territories. As of the end of 2021, Costco had more than 800 stores worldwide. As of the end of 2023, the company had 316,000 employees under its employ; which, given its 242B revenue in FYE23, translates to approximately $766,740 per employee.
Costco is highly dependent on the efficiency of its US and Canadian operations; the operations in both the countries comprised 87% of net sales and 84% of operating income in '23. Given the company's vast real estate portfolio-the company owns 861 pieces of land and building worldwide, 184 of which are leased- Costco might be negatively impacted by the sector's poor projected performance in the future. Costco also competes with other competitors- Walmart, Target, Amazon, Sam's Club, and BJ's- in terms of identifying and obtaining suitable locations for its stores. Investing in brick and mortar is not the only avenue of growth for the company; consumers' behaviors and trends are also changing, and so heavily investing in online, delivering, and e-commerce shopping could be an additional path for growth along with memberships (renewal rate of 92.7% in US and Canada and 90.4% worldwide) and same store sales growth.
Valuation
As of the time of this valuation, Costco had a weighted average cost of capital of 8.91% (could be different for you depending on where you get your financial information from), and net debt of ($4.7B)- given its cash reserves and short term investments. Going back 5 years (FY2019-FY2023), Costco's top line grew from $152B to $242B, yielding a CAGR of 12.2% over the course of 5 years. Costco's revenue consists of net sales and membership fees, both of which were $237B and $4.5B respectively in '23. Net sales witnessed a modest growth of 6.7% while membership fees grew at a rate of 8.4% in '23. In my base case scenario, I project net sales to grow at a CAGR of 9.2% from $254B in '24 to $562B in '33; and membership fees to grow at a CAGR of 9.3% from $4.9B in 2024 to $14.4B in '33 yielding total revenues of $259B in '24 to $576B in 2033. I believe that my base case scenario runs parallel to the company's historic performance. Numbers, as one would expect, change drastically if we move to the weak case, which in my model serves to indicate a possible recession and consequently lower growth in both net sales and membership fees- feel free to download the file and have fun with the numbers.
My model predicts modest EBITDA margins of 4.3% throughout the projected years- '24-'33. As for the operating income (EBIT), base case scenario predicts EBIT to grow from $8.8B in '24 to $20.4B in '33, yielding a CAGR of 9.8%. Moving on to Net Operating Profit After Tax (NOPAT), the model predicts a modest growth throughout the future years; my analysis showcases a CAGR of 43.1%, growing from $6.5B in '24 to $15.1B in '33.
Moving on to other items in the analysis. Costco's CapEx (Additions to Property and Equipment) have been around 1.7% of total revenues for the last few historic years, and given its stage in the life cycle, I doubt that will change, and so in my base case, I have kept CapEx flat at 1.7% of total revenues: $4.4B in '24 to $9.8B in '33. I am assuming that over the course of the 10 years of this analysis, Costco will only be spending enough to update its existing PP&E. Therefore, I grow D&A (Depreciation and Amortization) from 53.2% of CapEx in '24 to 100% of CapEx in '33, which essentially means that the company will stop growing and will only have to spend enough to update its existing portfolio of property and equipment. Historic Net working capital (NWC) ranges from 4.0% of revenues to 6.0% of revenues from FY19-FY23, and so consequently, in base case, I have kept NWC at 4.5% of revenues throughout the projected years. My calculations tell me that Costco has pretty healthy Unlevered Free Cash Flows (UFCF) throughout the years (I promise it wasn't by design). I expect Costco's UFCFs to grow from $4.6B in '24 to $17.5B in '33. Taking the stub period into account, and leaving mid-year to reviewer's discretion, the sum of all of the PVs of future UFCFs comes out to $61.4B, discounted at a WACC of 8.91%.
As for the long term growth, I believe I have been generous because I think Costco will grow at 3% in perpetuity; generous because 2% is typically what economists expect a healthy nation's economy to grow at. I chose 3% because I believe Costco has a well defined position within the industry, and I expect that to persist, along with other factors such as consumer trends and the need for the retail industry as a whole. Given a long term growth rate of 3%, I calculate UFCFs of $18B in '34, and given a WACC of 8.91%, I calculate the the terminal value to be $306B. This gives us a present value of TV of $133B. My model and calculations yield a total value of Costco's operating assets (net of its operating liabilities) to be $194B. Costco has net debt of negative $4.7B, putting out an equity value of $199B. As per Costco's '23 10K, the company had 445,785,572 diluted shares outstanding, including unvested RSUs of 3,045 ( I couldn't find any options disclosure in the 10K), giving us an intrinsic value of $446.63 per share.
Conclusion
At the time of this analysis, Costco is trading at $593.45/share. Based on my assumptions and estimates, I feel that in my base case, Costco is trading 32.8% higher than its intrinsic value of $450.88/share. For my best case scenario, which essentially means that economy won't suffer from recession- mild or otherwise- Costco seems undervalued by about 13.2% with an intrinsic value of $672.22. Finally, My weak case, or recession scenario, predicts an intrinsic value of $307.76 per share. According to the weak case, Costco is trading 92.83% higher than its intrinsic value. With all that being said, There is a well known adage that gets tossed around in the valuation world: "DCF is entirely driven by assumptions." Some of you might or might not agree with my analysis and assumptions, and that is why I have attached the excel file for your review. So, feel free to download the file and play around with the numbers. Also, feel free to reach out with constructive feedback.
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