Costco Wholesale Corporation (Costco)

Investment Rating
BUY

I. Investment Highlights
Company Profile
Costco is a low cost/discount retailer that operates through
417 warehouse style retail stores, and through Costco.com.
Access to Costco Warehouses is restricted to members who
pay a small annual fee for access. Started primarily as a
small business supply company, Costcos inventory focus has
grown to include high-end consumer goods including home
electronics and luxury items. Costco has succeeded by
focusing on the demands a specific customer group while
continues to provided for other profitable customers.

Pricing
Closing Price (10/11/05) $45.49
52-Week High
$50.46
52-Week Low$39.48
Valuation
FY
2003
2004
TTM
2005E

EPS
5.35
6.57
7.18
-----

P/E
17.2
11.3
12.5
11.8

Profitability & Effectiveness (5 yr)

ROA
5.99%
ROE
12.51%
Profit Margin
1.96%
ROCI
%

Growth Dynamics
Costcos quarterly sales growth is in tune with the rest of the
industry at ~ 10%. This is a very sustainable growth rate and
while not stellar, when combined with the lowest labor costs
in the industry, results in an excellent return.

Market Data
Revenue Est.
Current
Total Assets (000)
Quarter
Volume
Avg. Estimate 12.78B
Market Cap No.
(B) of An. 21.87 11
Avg Vol (000)3,017,520
Low Estimate 12.46B
EPS
2.07
High Estimate
13.07B
P/E
22.07
Year Ago
11.58B
Div & Yield
0.46(1.00%)

Next
Quarter
13.85B
11
13.39B
14.07B
12.66B

Current
Year
58.7B
13
57.17B
60.53B
N/A

Next Year

9.4%

N/A

8.9%

Sales
Sales Growth

10.4%

63.95B
11
61.13B
66.28B
58.74B

Source: finance.yahoo.com

Alex Arnote
Ahae5d@mizzou.edu

Since a great deal of Costcos growth comes from new store

openings, growth is somewhat limited by the availability of
new markets. Costcos management has recognized this and
has already begun an extensive and successful overseas
expansion plan while maintaining steady domestic growth.
Growth in older stores is spurred by the addition of additional
services included gas stations, pharmacy, and other service
oriented enterprises.

Earnings per share (MorningStar.com)

II. Executive Summary

Costco is an international discount retailer with 415 retail locations in six countries and
thirty seven states. Small business owners and professionals in the $100k salary range
are the primary customers due to their disposable incomes and demand for high-end
goods/services. The increased demand for designer goods has led to increased sales of
designer home furnishings including furniture and accessories.
Day to day office and home supplies, from paper to flour provide the economic saving of
bulk buying and bring customers in who can then make high dollar impulse buys
generating one of the highest dollars per square foot.
Low volatility and consistent growth combined with excellent leadership and corporate
policy make Costco an excellent stock for long term investing.
Recommendation: BUY
Costco is a buy for anyone who wants a low risk stock that will outperform the market
and wants long term stability with excellent growth and consistent dividends.
Target Price: ~ $45 the going market rate
Pros
-Highest sales/profit per square foot in the industry
-Lowest labor costs in the industry
-Steady/consistent growth
-Low risk
-Better than market returns
-Everybody likes low prices
Cons
-Heavy economic link luxury goods
-Big name competition - Wal-Mart
-Long-term growth limitations possible
Critical Factors
High dollar per square foot and low costs allow for some of the lowest prices in the
industry. This combined with high quality and low cost creates high value customers that
purchase large amount of high cost items, particularly impulse buys.

III. Company Description

From the Costco website:
Costco Wholesale Corporation operates an international chain of membership
warehouses, mainly under the "Costco Wholesale" name, that carry quality, brand name
merchandise at substantially lower prices than are typically found at conventional
wholesale or retail sources. The warehouses are designed to help small-to-medium-sized
businesses reduce costs in purchasing for resale and for everyday business use.
Individuals may also purchase for their personal needs.
Costco's warehouses present one of the largest and most exclusive product category
selections to be found under a single roof. Categories include groceries, candy,
appliances, television and media, automotive supplies, tires, toys, hardware, sporting
goods, jewelry, watches, cameras, books, house wares, apparel, health and beauty aids,
tobacco, furniture, office supplies and office equipment. Costco is known for carrying top
quality national and regional brands, with 100% satisfaction guaranteed, at prices
consistently below traditional wholesale or retail outlets.
Members can also shop for private label Kirkland Signature products, designed to be of
equal or better quality than national brands, including juice, cookies, coffee, tires, house
wares, luggage, appliances, clothing and detergent. The Company also operates selfservice gasoline stations at a number of its U.S. and Canadian locations.
Additionally, Costco Wholesale Industries, a division of the Company, operates
manufacturing businesses, including special food packaging, optical laboratories, meat
processing and jewelry distribution. These businesses have a common goal of providing
members with high quality products at substantially lower prices.
Leadership

IV. Economic and Industry Environment

Industrys Relation to the Economy
The discount retailer industry on a while is not very related to the economy. During poor
economic times, discount retailers tend to do better since people have less money to
spend. Costco is a high-end discount retailer, primarily serving small business owners
who are susceptible to economic swings of the economy in general. Overall I would say
there is a high correlation between Costcos industry and the economy in general, unless
Costco is able to shift is merchandise to follow the swinging economy.
At a local level, Costco has done several things that have increased the value of each
customer. Products are marked up a flat rate so customers know products are priced at a

very reasonable level. Products are high quality and the return policy is very customer
friendly. Lastly, a great deal of the inventory at Costco has inconsistent availability.
Products often sell out and may never be there again, this low availability combined with
low prices and high quality dramatically increase impulse buying, particularly of high
cost items.
Competition
Two major chains, Costco and Sams Club, a Wal-Mart Division, dominate the United
States warehouse wholesale market. BJs Wholesale Club is a regional player, located
only on the Atlantic seaboard of the US. Overseas there are many smaller competitors,
but most are focused on food and not retail merchandise.

DIRECT COMPETITOR COMPARISON

Market Cap:
Qtrly Rev Growth (yoy):
Revenue (ttm):
Gross Margin (ttm):
EBITDA (ttm):
Oper Margins (ttm):
Net Income (ttm):
Price/Book Value
EPS (ttm):
P/E (ttm):
PEG (5 yr expected):
P/S (ttm):

COST
21.87B
10.10%
51.37B
1.96%
1.97B
2.89%
1.01B
2.47
2.07
22.07
1.61
0.43

WMT
185.57B
10.20%
298.46B
23.06%
22.39B
5.94%
10.72B
3.85
2.536
17.00
1.03
0.60

BJ
1.78B
9.8%
7.68B
1.55%
104.22M
2.52%
121.41M
1.91
1.71
15.2
1.05
0.23

Industry
TGT
46.2B
291B
13.6%
10.0
49.57B
NA
4.82%
3.4%
5.28B
NA
7.92%
NA
10.72B
NA
3.45
3.4
2.536
2.66
19.62
18.4
1.03
291B
0.60
10.0

WMT = Wal-Mart Stores Inc.

BJ = BJs Wholesale Club
TGT = Target
Industry = Discount Variety Stores

V. Company Position
Market Information
Costco operates in 6 countries and 37 states. Regions with a large number of small
business owners and/or higher income professionals with a demand for high-end goods
are typical.

Product Development, R&D

As a discount retailer, there few R&D costs associated with Costcos operations. Costco
does maintain its own Kirkland brand which sells high-quality products at lower prices.
There are some costs associated with this development, but they are limited. Kirkland
branded products cover most products Costco sells, particularly food and clothing.
Demographics
Costco primarily target independent small business owners who typically have $100,000
in personal income. Costco started by providing bulk sales of the items these business
owners needed for day to day business operations, and then moved into supplying high
end luxury merchandise that this customer group was demanding. It is the focus on this
high-end demographic that differentiates Costco from other discount retailers, such as
Sams Club.
Threat of Substitution
Costcos demographics focus does limit the overall threat of substitutions. One common
substitute, Sams Club sells bulk food and dry goods as well al a limited selection of high
end merchandise. The increase in high-end sales has been a recent shift in an attempt to
compete with Costcos significantly higher dollar per square foot of $795 vs. $516 at
Sams and $411 at BJs Wholesale Club. In fact, Costco received $13,647 in profit per
employee last year, compared to $11,039 as Sams Club.
This focus on high-end clients, mixed with low prices has created a loyal clientele that
creates a significant barrier to entry.
Image
By having some of the best benefits in the industry, Costco has created a hard working
and intensely loyal group of employees. The excellent treatment of employees has
helped to create a very positive image among shareholders, customers, and suppliers that
few of their competitors can match.
Among its customers, Costco is seen as a high end/low cost store. Products are expected
to be high quality and among the cheapest available. This image of low-cost/high-quality
leads customers to make impulse purchases that would otherwise not occur. Sams Club,
on the other hand, is associated with bulk buying cheap/low-quality goods and items.
Management Quality
Costcos leadership has made excellent decision about store placement, expansion, target
market, and product selection. Most promotions come from within and employees that
generate exceptional results are rewarded and promoted within the firm. Management
quality appears to be excellent and should be into the faceable future.
One fact of interest is the significant shareholdings of the CEO, Chairman, Sr. VP, and
Executive VP (see Other Considerations). It is preferential for high-level executives with

large stakes in the companies they run since it gives them a stake in the success of the
company in the long run.
VI. Financial Statement Analysis
Financial Ratios
Trend Analysis (Costco vs. S&P 500)

Looking at the year to date chart for price changes we see that the S&P 500 has
outperformed Costco. However, when looking at the 5 year chart below, we see a very
different picture.

Stock: Costco Wholesale

Industry: Discount Stores

Index: S&P 500

Chart from www.morningstar.com

DIRECT COMPETITOR COMPARISON

Market Cap:
Qtrly Rev Growth (yoy):
Revenue (ttm):
Gross Margin (ttm):
EBITDA (ttm):
Oper Margins (ttm):
Net Income (ttm):
Price/Book Value
EPS (ttm):
P/E (ttm):
PEG (5 yr expected):
P/S (ttm):

COST
21.87B
10.10%
51.37B
1.96%
1.97B
2.89%
1.01B
2.47
2.07
22.07
1.61
0.43

WMT
185.57B
10.20%
298.46B
23.06%
22.39B
5.94%
10.72B
3.85
2.536
17.00
1.03
0.60

BJ
1.78B
9.8%
7.68B
1.55%
104.22M
2.52%
121.41M
1.91
1.71
15.2
1.05
0.23

Industry
TGT
46.2B
291B
13.6%
10.0
49.57B
NA
4.82%
3.4%
5.28B
NA
7.92%
NA
10.72B
NA
3.45
3.4
2.536
2.66
19.62
18.4
1.03
1.15
0.60
0.94

WMT = Wal-Mart Stores Inc.

BJ = BJs Wholesale Club
TGT = Target
Industry = Discount Stores

As we see here, Costco is outperforming its competitors, its industry, and the market as a
whole.
VII. Financial Forecasts (from analysts)
Avg. Revenue forecasts (from finance.yahoo.com)
Earnings estimate (next quarter Feb. 2006)
Revenue estimate (next quarter Feb. 2006)

$0.60
$13.83B
7

Sales Growth estimate (current)

9.5%

EPS trends
Earnings Trends
Current Estimate
7 days ago
30 days ago
60 days ago
90 days ago
Source: finance.yahoo.com

Current Quarter
$0.44
0.44
0.44
0.44
0.44

Next Quarter
$0.60
0.61
0.61
0.61
0.61

Current Year
$2.29
2.29
2.28
2.30
2.30

Next Year
$2.59
2.62
2.62
2.65
2.65

There appears to be very little variation of the analysts opinions over the course of three
month. This seems to indicative a level of stability and openness of the company.
Growth Estimates and Trend Analysis
Source: finance.yahoo.com

Growth Estimates
Current Qtr.
Next Qtr.
This Year
Next Year
Past 5 Years (per
annum)
Next 5 Years (per
annum)
Price/Earnings (avg. for
comparison categories)

COST
10.0%
11.1%
12.3%
13.1%

Industry
15.5%
14.6%
13.0%
15.9%

11.3% N/A

S&P 500
17.90%
16.10%
14.50%
11.50%
N/A

12.00%

14.72%

10.58%

19.3

18.53

1.49

Currently Costcos growth estimate for this quarter is 10.0%. Compared to the industry
and the S&P 500, this is significantly lower. The estimate for next few years shows
Costco increasing its growth rate to a level similar to the industry. It should also be noted
that Costcos Industry includes many companies that have very different business
models, making comparison difficult.
VIII. Analysis of Risk
From an actual risk standpoint, Costco is not expected to have financial problems
anytime in the near future. Morningstar has given it an A rating for financial health and I
see few problems, barring a major collapse in the US economy, on the horizon.
Costco is traded on the NASDQ Stock Exchange as ticker symbol COST. During the
last three months the average trading number of shares traded was 3,017,520 shares daily.
During the last 12 months the low share price was $39.48 and the high was $50.46.

The standard deviation, or relative risk, was measured at approximately 3.83 with a
correlation of 0.627(see chart below). The Beta is 0.84
Marketability
a. Trading Location NASDQ
b. Average Daily Volume (13 wk) 3,017,520
Total Risk
c. Range 52 week range $39.48 $50.46

d. Standard Deviation: 3.83

Systematic Risk
e. Correlation to market
Date
1-Sep-05
1-Aug-05
1-Jul-05
1-Jun-05
2-May-05
1-Apr-05
1-Mar-05
1-Feb-05
3-Jan-05
1-Dec-04
1-Nov-04
1-Oct-04
1-Sep-04

Close
43.09
43.4
45.97
44.73
45.38
40.63
44.18
46.59
47.27
48.41
48.6
47.94
41.51

Market
1237.91
1220.33
1234.18
1191.33
1191.5
1156.85
1180.59
1203.6
1181.27
1211.92
1173.82
1130.2
1114.58

2-Aug-04
1-Jul-04
1-Jun-04
3-May-04
1-Apr-04
1-Mar-04
2-Feb-04
2-Jan-04

41.17
40.71
41.18
37.9
37.5
37.61
38.86
36.94

1104.24
1101.72
1140.84
1120.68
1107.3
1126.21
1144.94
1131.13

Mean:

42.83667

1162.15

StDev
Mrkt. Corr.

3.831115
0.627443

Beta with market .84 (MSN Money)

IX. Fundamental Valuation

Estimation of Required Rate of Return
The required rate of return has been estimated from a series of data over the previous nine
years. We use the assumption here that what has happened in the past has a reasonable
change to continue in the future. The S&P 500 has been used as a proxy for the market.
Also, we use historical rates on the 1-year T-bill as an estimation of the risk free rate of
interest. For the periods 1995-2004 the historical equity premium on the market was
6.38%. This is a geometric mean average rate of return. The Capital Asset Pricing
Model was used to compute the required rate of return for Costco:
RE = RF+ (Equity Risk Premium)
RE = 4.3 + (.84) (6.38) = 9.6%
Financial Summary
A brief snapshot of financial performance and relevant ratios includes: (as of Oct. 11,
2005) Note: Information in table used for valuation, see page 1 for up-to-date figures.
General Information
Stock Price
Market Capitilization
Beta
EPS
DPS
P/E
Dividend Yield
Dividend Payout Ratio

45.49
21,810,000,000
0.84
7.180
0.46
22.01
1.00%
14%

10

Required Rate of Return

ROE
Forecasted Growth Rate

9.6%
12.45%
8.30%

Dividend Discount Model

0.46(1.06)/(0.096-0.06) = $13.54
Forecasted Growth Rate
g = (1-p)*ROE = (1-0.01)*12.45 = 12.33%
X. Other Considerations
Top Individual Holders
Holder

Relationship

SINEGAL, JAMES D.

Shares

Reported

CEO

655,674

6-June-05

Chairman

162,475

11-Mar-05

WALKER, THOMAS KIRK

Executive Vice Pres.

152,902

26-apr-05

DICERCHIO, RICHARD D

Sr. Executive Vice Pres.

107,408

1-Nov-04

BROTMAN, JEFFREY H

Top Institutional Holders

Holder

Shares

% Out

Value*

Reported

DAVIS SELECTED ADVISERS, LP

40,624,076

8.48

$1,794,771,677

31-Mar-05

BARCLAYS BANK PLC

34,560,690

7.21

$1,526,891,284

31-Mar-05

Top Mutual Fund Holders

Holder

Shares

% Out

Value*

Reported

DAVIS NEW YORK VENTURE FUND

18,051,900

3.77

$853,313,313

31-Jan-05

VANGUARD/PRIMECAP FUND

7,500,000

1.57

$363,075,000

31-Dec-04

Source: Major Holders http://finance.yahoo.com

*Value shown is computed using the securitys price on the report date given

As for Benjamin Graham, it is a tough call. Given the current market, I would say that
Costcos low Price/Book ratio of 2.5 beats the industry average of 3.4 and the market
average of 3.3 so it passes.
XI. Conclusion
There are few unfavorable conclusions about Costco. The limitations on continued
growth could be problems, but the overseas expansion and controlled domestic growth
have reduced this risk. A major economic downturn would hurt the company since the
demand for luxury goods would decline, but this could be offset by increased demand for
low-cost bulk buying.
11

The membership system not only an excellent source of income, but allows Costco to
know what each customer buys and to tailor the marketing and product selection
accordingly.
Recommendation
Buy. This stock will out perform the market and have a low level of risk due to the
excellent management and a specific target market that Costco serves perfectly. Steady
growth potential and success overseas will lead to excellent returns with very little actual
risk.

Disclaimer: This analysis does not necessarily reflect the beliefs of the University of
Missouri-Columbia or the College of Business. The insights and opinions are of the
students of Investment Funds Management and should not be used in personal investment
decisions. The University of Missouri and the authors of this analysis take no
responsibility for the validity of the valuation and analysis.

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Financial Resources:
Online
Yahoo Finance (finance.yahoo.com)
MSN Money (www.msn.com)
Morningstar (www.morningstar.com)
ADVFN (www.advfn.com)
Databases
Factiva
ABI/Inform
Fund Management Resources
Citigroup Inc Analysis Report
AutoZone Inc Analysis Report
Portfolio Committee Spreadsheet

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