Costco Wholesale Corporation Financial Analysis

Phil Gamble

December 10, 2013

INTRODUCTION

This paper walks through the 10K Form for Costco Wholesale Corporation’s 2012

fiscal year ended on September 2nd. It is the collection of an entire semester’s worth of

accounting basics and financial analysis. All of the dollar amounts in this report are in

millions, except if stated otherwise. The report starts with an overview of the company and

its balance sheet, moving into the analysis of ratios that use time sequence and industry

comparison. Finally the report draws from all aspects of the financial statement, and

reports on the future prospects for Costco.

BACKGROUND INFORMATION

Costco Wholesale Corporation is incorporated in the state of Washington. Issaquah,

Washington is the location of Costco’s headquarters (1). Costco’s most recent fiscal year

ended on September 2, 2012 (1). The name of Costco’s independent outside auditor is

KPMG (35). Costco’s stock is sold on The NASDAQ Global Select Market (Morningstar). The

current stock price as of December 9th is $121.66 per share (Morningstar).

FINANCIAL OVERVIEW

Balance Sheet

Costco’s total assets at the beginning of its fiscal year were $13,706 million (42). At

the end of its current fiscal year, Costco’s total assets were $13,526 million (42). Costco’s

total liabilities at the beginning of its fiscal year were $ 12,050 million (42). The company’s

largest assets are merchandise inventories of $7,096 million and cash and cash equivalents

of $3,528 million (42). At the end of its current fiscal year, Costco’s total liabilities were $

12,260 million (42). Its largest liability is by far accounts payable of $ 7,303 million (42).

Accrued salaries and benefits is the second largest liability of $1,832 million, and third is

deferred membership fees of $ 1,101 million (42).

Income Statement

Costco’s total revenue for the current fiscal year is $99,137 million (43). For the

fiscal year ending on August 28, 2011, Costco’s total revenue was $88,915 million (43). The

total revenue was $ 77,946 million for the fiscal year ended on August 29, 2010 (43).

Costco’s net income for its current fiscal year is $ 1,709 million. In 2011 and 2010 Costco

earned $1,462 and $1,303 million respectively (43). The only two sources of revenue are

net sales of $97,062 million and membership fees of $2,075 million for the 2012 fiscal year

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(43). Costco’s largest expenses are merchandise costs of $86,823 million and selling,

general and administrative expenses of $9,518 million for the 2012 fiscal year (43).

Cash Flow Statement

Costco’s net cash flow from operating activities was $3,057 million for the 2012

fiscal year (44). For the fiscal year ending in August of 2011 the net cash flow from

operating activities was $ 3,198 million and for the fiscal year of 2010 it was $ 2,780

million (44). Costco definitely generates sufficient cash from operations to fund its

investing activities because the cash from operations is almost $1,800 million more than

the money used in investing activities (44).

STRATEGIC OVERVIEW

Basic Information

Costco operates in the wholesale industry in the United States and seven other

countries worldwide. Its main competitors are Wal-Mart Stores Incorporated, BJ’s

Wholesale Club Incorporated, and Target Corporation (8). Costco sells a limited selection

of nationally branded products and also operates under a private brand, Kirkland Signature

(12).

Business Model and Strategies

Costco’s business model is that of a low cost company that sells all of its products at

wholesale prices. Per unit Costco has prices that are hard to beat. However, all of the

products in the warehouses are only sold in large quantities. Also Costco carries a limited

number of top brands that ensures a good relationship with its suppliers. Costco can keep

prices so low due a strong bargaining position with supplier and the construction of its

stores. Its stores are warehouses with concrete floors, few employees, and all of its

products are packaged in boxes that allows for easy maneuvering with a forklift.

Customers also have to be Costco members and pay a $55 yearly fee to enter the store (6).

Costco’s membership renewal rate in the United States and Canada in the fiscal year 2012

was 87.9%, which indicates strong customer loyalty (MarketLine 4). In addition to strong

customer loyalty, membership fees also bring in additional revenue other than net sales.

The main strength of Costco is its very efficient low cost operating model

(MarketLine 4). Its warehouses offer a limited selection of national and private brands

across a wide merchandise range (Marketline 4). Inventory turnover is high due to the low

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prices Costco provides, which keeps inventory costs low (Marketline 4). This is crucial

because it allows Costco to receive payment from customers for goods before payment to

merchandise venders is due (Marketline 4). Costco can achieve favorable terms with

suppliers by paying cash during the discount period, and reduce interest expense using this

strategy.

One of the weaknesses that Costco has is a lack of online options to purchase its

goods. Costco has options to buy goods online, but consumers very rarely utilize this

purchasing path (MarketLine 6). This is a great concern because the US Census Bureau

reported that online retail sales increased 16% from $142 billion in 2009 to $224 billion in

2012 (MarketLine 7). Wal-Mart and Amazon are already dominating online shopping, and

Costco will lose customers if a user friendly online buying option is not provided. This

weakness can be turned into an opportunity with an update to the company’s website, and

creation of Android and Apple smartphone applications (MarketLine 7).

Another weakness Costco has is a limited selection of products; Costco only offers 3,300 to

3,800 products to sell at a particular time (MarketLine 6). Customers’ who prefer a one-

stop buying experience may forgo lower prices in exchange for a more seamless buying

experience (MarketLine 6).

Environment and Social Performance.

In order to protect the environment, Costco does not use plastic bags, but customers

use recycled boxes to carry goods to their cars. Also signs are posted in the warehouses

that urge customers to keep the doors of the refrigerators closed in an effort to not only cut

costs, but to reduce the carbon footprint of the warehouses. Even in a struggling economy,

Costco pays its workers an average of $21 an hour and gives eighty eight percent of its

workers health insurance (Stone 3). Costco’s new CEO Craig Jelinek believes that healthy,

happier workers contribute to increased profitability. He also wrote a letter to Congress

asking for an increase in the minimum wage (Stone 3). Jelinek stated that it has been

proven that providing employees with a living wage and health care puts more money back

into the company and minimizes employee turnover (Stone 3).

ASSESSING LIQUIDITY

Current Ratio

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The current ratio for Costco at the end of its fiscal year in 2012 was 1.16. At the end

of its fiscal year in 2012 it was 1.14 (41). In its 10K, Costco notes that the primary sources

of liquidity are “cash flows generated from warehouse operations and cash and cash

equivalents and short-term investment balances” (27). These ratios do not adjust for a

LIFO reserve. For 2011 and 2012 the LIFO reserve was $108 million and $87 million due to

inflation (49).

Industry Analysis

In order to evaluate the current ratios for 2011 and 2012, it is necessary to look at

past current ratios. Costco’s current ratio has remained very stable from 2003 to 2011,

varying from 1.05 to 1.16 (Morningstar). The lowest ratios occurred during the recession

from 2006-2009, but the company since then have been relatively more able to pay back

short-term obligations (Morningstar). Wal-Mart, another competitor in the general

merchandise retailer industry, had a current ratio of .87 in 2011 and .89 in 2012

(Morningstar). Also Target had a current ratio of 1.63 in 2011 and a current ratio of 1.71 in

2012 (Morningstar). Relative to the industry I think that Costco shouldn’t be concerned

with its liquidity, because it is very close to its competitors that also have found success in

the wholesale industry.

Effect of Current Ratio on Stock Price

Investors seem to have no problem with the liquidity of Costco, when looking at the

company’s stock in the past 10 years. While its current ratio has stayed relatively constant,

Costco’s stock went from $28.06 a share on September 30, 2003 to $115.17 a share ten

years later on September 30, 2013 (Prior 1). Wall Street appears to be very confident in

Costco’s ability to pay back short-term and other obligations.

ASSESSING PROFITABILITY

Revenue Recognition

Costco only has two sources of revenue: net sales and membership fees (45). Net

sales were almost entirely from merchandise sold and totaled $87,048 million in the 2012

fiscal year (45). Membership fees totaled $1,867 million in the same fiscal year. Revenue is

recognized “at the time the member takes possession of merchandise or receives services”

(34). When Costco receives revenue before the transfer of ownership of the merchandise

or before a service is performed it is recorded as a liability under deferred revenue (34).

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This seems appropriate because GAAP mandates that a company record revenue only after

it has been earned. Costco utilizes the matching principle by matching expense with

revenue.

Costco record no gains, losses, or non-operating items in the company’s income

statements from the past 3 years.

Gross Profit Rate and Profit Margin

At the fiscal year ended on August 28, 2011, Costco has a gross profit rate of .128

(45). A fiscal year prior in 2010 the gross profit was .130, and two years prior Costco

recorded a gross profit of .130 (45).

INVENTORY ACCOUNTING

Cost-Flow Assumptions

Costco uses the LIFO cost assumption when valuing merchandise inventories in the

United States (34). The company states in its 10K report that the LIFO method is used

because it “more fairly presents the results of operations by more closely matching current

costs with current revenues” (34). In order for Costco’s financial statements to be

compared with other companies that use the FIFO cost-flow assumption, Costco provides a

LIFO reserve in the footnotes (25). The LIFO reserve increase of $21 million in 2012

mostly resulted from higher costs for food, sundries, and gasoline (25).

LIFO is also used as a tax cutting mechanism. During periods of increasing prices,

Costco will report a lower pre-tax income using LIFO then if it had used FIFO. Increasing

prices suggests that the “last goods in” are more expensive than the “first goods in” and will

result in a higher cost of goods sold. A higher cost of goods sold will result in a lower pre-

tax income, and therefore a lower income tax. This saves Costco money, and allows it to

further offer lower prices to customers. It is also important to note that warehouses not

located in the United States use FIFO in order to conform to regulations set by the

International Accounting Standards Board (34).

Inventory Turnover

The inventory turnover for Costco in 2011 was 12.66 times in the 2011 fiscal year,

and 11.95 times in the 2010 fiscal year. Days in inventory totaled 28.82 in 2011 and 30.65

in 2010. Costco was looking to increase inventory turnover and decrease days in inventory

over the past two years in order to compete with Wal-Mart and its leading inventory

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system. Retailers want to keep minimum amounts of inventory on hand, but at the same

time keep its stores filled with goods that customers are looking for (Kimmel, Weygandt &

Kieso 2013).

INTERNAL CONTROL OVER FINANCIAL REPORTING

Identifying Internal Controls

Costco’s annual report on internal control over financial reporting specifies three

main areas regarding the reliability of its financial reporting (36). The first policy that

Costco enforces is that records are maintained in accurate details that rightly show

transactions and the composition of its assets (36). Costco also employs procedures that

record transactions in accordance with GAAP, and procedures that ensure cash receipts

and expenditures only occur following appropriate authorizations (36). The last internal

control policy that Costco has is providing reasonable assurance that the company prevents

and detects unauthorized use of assets that could have an adverse effect on financial

statements.

All of these policies and procedures are meant to assure outside decision makers

that Costco’s financial statements are as accurate as possible (36). Management

acknowledges the limitations of its system of internal controls, but has concluded that

internal control over financial reporting was effective as of September 2, 2012 (36). No

internal control weaknesses were identified (36).

Independent Auditor’s Opinion

KPMG, Costco’s independent auditor, plays a critical role in examining and testing

the evidence that Costco uses to determine the amounts in its financial statements (40).

The independent auditor also examines the information used to prepare disclosures

included in its financial reporting (40). In the opinion of KPMG, Costco “maintained, in all

material respects, effective internal control over financial reporting as of September 2,

2012” (40).

CASH

Costco records as cash and cash equivalents all highly liquid investments with

maturity of three months or less at the date of purchase (49). Also, cash and cash

equivalents can only include amounts due from credit and debit cards transactions, if those

amount “have settlement terms of less than one week” (49). From August 28, 2011 to

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September 2, 2012, Costco’s cash and cash equivalents increased 24.73%, from $3,214

million to $4,009 million (44). Costco’s cash and cash equivalents has increased at this rate

due to an increase in sales in the United States and a higher percentage of revenues coming

from international stores than ever before (How Does Costco Make Money?). From 2010 to

2011, Costco reported a 7% increase in the comparable store sales in the U.S. (How does

Costco Make Money?). Another primary source of cash and cash equivalents is due to

“revenue contribution of Coscto’s international business increasing from 18% in 2008 to

22% in 2011” (How does Costco Make Money?). Both of these factors increase cash and

cash equivalents because Costco’s revenue, in the fiscal year 2011, was 97.89% dependent

on net sales (45). Any increase in cash and cash equivalents is therefore going to be

primarily dependent on net sales.

EVALUATING ACCOUNTS RECEIVABLE

In the company’s annual report, Costco is very brief in its policies for bad debts and

allowance for doubtful accounts. This is because Costco does not have a store credit card.

Therefore, the risk of a customer not paying his or her credit card bill lies with the credit

card companies, not Costco. Costco still has a small allowance for doubtful accounts

balance of $2 million for 2012 and $3 million for 2011 (48). Write offs for the past 3 fiscal

years were immaterial (48). Accounts receivable are mostly in the form of volume rebates

or other purchase discounts from vendors, making accounts receivable and average

collection period not applicable (49).

PROPERTY, PLANT, AND EQUIPMENT

Balance Sheet Data

September 2, 2012 August 28, 2011

Land $4,032 $3,819

Buildings and Improvements 10,879 10,278

Equipment and fixtures 4,261 4,002

Construction in process 374 269

Accumulated Depreciation

and Amortization

(6,585) (5,936)

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Under property and equipment, Costco has listed on its balance sheet: land,

buildings and improvements, equipment and fixtures, and construction in progress (44).

Also, as a contra-asset, accumulated depreciation and amortization are included on the

balance sheet (44). The book values of these assets for the past two fiscal years are shown

in the table below (44).

Capital expenditures in the 2012 fiscal year totaled $1,290 million, in 2011 they

totaled $1,055 million, and in 2010 they totaled $1,250 million (80). The increase from

2010 to 2011 was due to Costco consolidating its 32 Mexico warehouse in 2011 (18).

Costco’s main capital expenditures are payments for increasing its warehouse spaces, and

the payments equipment, such as forklifts, used to stock their products (18). Costco’s

assets classified as held for sale were immaterial at the end of the last two fiscal years (50).

Losses included in the selling of assets were also immaterial (50). These trends indicate

that Costco’s long-term capacity is growing as the company spends more than a billion

dollars a year improving its assets. Also Costco is expanding by purchasing more

warehouses in order to increase its market share of the retail industry.

The company’s accounting policies regarding depreciation of property and

equipment are as follows: “depreciation and amortization expense is computed using the

straight-line method over estimated useful lives or the lease term, if shorter” (52). The

estimated useful life for buildings and improvements is 5-50 years, and for equipment and

fixtures, 3-20 years (52). Costco also evaluates long-lived assets for impairments

periodically when relocating or closing a warehouse (52). On the company’s consolidated

balance sheet, impairment costs are listed under “provision for impaired assets and closing

costs, net” (45). Deprecation expenses are not specifically listed, but would fall under

“selling, general and administrative” expenses (45).

INTANGIBLE ASSETS

Goodwill

Costco only has goodwill listed on its balance sheet under “other assets” (53). The

book values for goodwill in the fiscal years of 2011 and 2010 were $74 million and $71

million respectively (53). Costco uses a straight-line method of amortization of its

intangible assets over their useful lives, but it does not specifically name any assets as

intangible, only capital leases (52).

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Other Intangible Assets

Although goodwill is the only intangible asset listed separately on Costco’s balance

sheet, I think there are a few other intangibles that Costco left has out. Most of the

copyrights or patents that Costco could have recorded in its 10K report would be a part of

its private label brand, Kirkland Signature. For example, Kirkland Signature has a laundry

detergent called Ultra Clean that uses a “patented catch and release technology” (Costco

Connection). Costco is constantly trying to patent new products under its private label that

have average quality, but are far cheaper than the leading brands. A few examples of

Costco’s registered trade marks are: COSTCO BUSINESS CENTER, THE COSTCO

CONNECTION, COSTCO HOME, COSTCO ONLINE, COSTCO WHOLESALE CASH, GOLD STAR,

KIRKLAND SIGNATURE, PRICE CLUB, NO LINES ONLINE, EXECUTIVE MEMBER,

BALLANTRAE WINE MERCHANTS, CANINE CLUB, CHOCOLATES OF THE WORLD, COURT

CLASSIC, FUNHOUSE TREATS, and SEATTLE MOUNTAIN (Costco Terms and Conditions of

Use). United States GAAP doesn’t allow Costco to record these patents on its balance sheet

because their values are subjective and hard to determine.

RETURN ON ASSETS ANALYSIS

Using financial data found in Costco’s 10K report, the table below shows the profit

margin, asset turnover and return on assets for each of the past five years (20).

The return on assets decreased between the fiscal years 2009-2010 is due the increase in

assets caused by 24 new warehouses that were opened in 2009 (18). Average total assets

increased at a faster rate then net income due to the new costs incurred from opening the

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(dollars in millions)Sept. 2,

2012

Aug. 28,

2011

Aug. 29,

2010

Aug. 30,

2009

Aug. 31,

2008

Net Income $1,462 $1,303 $1,086 $1,283 $1,083

Net sales $87,048 $76,255 $69,889 $70,977 $63,088

Average total Assets $25,288 $22,897 $21,331 $20,145 $19,607

Profit Margin 1.68% 1.71% 1.55% 1.81% 1.72%

Asset turnover 3.44 3.33 3.28 3.52 3.22

Return on Assets 5.78% 5.69% 5.09% 6.37% 5.52%

large number of stores, therefore lowering the return on assets (20). Costco leaned in this

mistake, and only opened 15 and 13 new stores in 2010 and 2011, respectively (20).

LIABILITIES

Ratio Analysis

The two largest current liabilities in Costco’s 10K for the fiscal year ended on

September 2, 2012, accounts payable of $7,303 million and accrued salaries and benefits of

$1,832 (42). Costco’s debt to asset ratio and times interest earned ratio for the 2012 and

2011 fiscal years can be seen in the table below (42).

The debt to asset ratio suggests that over the past two years, Costco has kept the

percentage of its assets financed by creditors constant, only varying by .85% (42). Costco

is relying slightly more on debt to finance its activities in 2012 than in 2011 than resources

invested by owners (Kimmel, Weygandt & Kieso). The times interest earned ratio

increased in 2012 from 2011, signaling Costco having less difficulty meeting its interest

payments (42). This indicated that in 2011 Costco’s income before interest and taxes was

29.516 times the amount needed for interest expense (Kimmel, Weygandt & Kieso).

Long-Term Debt

Costco has specified only one type of long-term debt it uses to raise capital (61). In

2007 Costco issued $1,100 million of Senior Notes due March 15, 2017, at a contractual

interest rate of 5.5% (61). These notes were sold at a discount of $6 million, have a

carrying value of $1,097 and a fair value of $1,325 million as of September 2, 2012 (61).

Costco may redeem these notes before maturity by paying 101% of the principal amount

plus accrued and unpaid interest to the date of repurchase (61).

STOCKHOLDERS’ EQUITY

Common and Preferred Stocks

Shares Shares Issued Shares Par Value per

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Fiscal year ending on

September 2, 2012

Fiscal year ending on

August 28, 2011

Debt to Asset Ratio 53.9% 53.1%

Times Interest Earned Ratio 29.516 20.853

Authorized Outstanding share

Preferred Stock 100,000,000 0 0 $.005

Common Stock 900,000,000 432,350,000 434,266,000 $.005

In the stockholders’ equity section of Costco’s balance sheet, only two types of exist:

common stock and preferred. The table below provides the basic data concerning these

two stocks (42)

The number of stocks outstanding in 2012 decreased due to Costco repurchasing

more stock then the number of stock options that were exercised and the release of vested

Restricted Stock Units (44). This resulted in a decrease of 1,903 million shares outstanding

from 2011 to 2012. Additional paid-in capital decreased mainly due to purchasing a non-

controlling interest in Costco Mexico on July 10,2012 (22). Prior to the purchase, Costco

owned 50% of Costco Mexico through a joint venture (22). This purchase Costco to record

the net income from stores in Mexico under “net income attributable to Costco” in its

income statement, as opposed to “net income attributable to non-controlling interest” (22).

Retained earnings increased $723 million in 2012 due to a strong net income, partially due

to the acquisition of the Costco Mexico (22).

Treasury Stock

Costco does not have any treasury stock in its financial statements. This is due to its

policy on repurchased stocks: “Repurchased shares are retired, in accordance with the

Washington Business Corporation Act” (31). In 2012 the company bought back “7,272

shares of common stock, at an average cost of $84.75 per share, totaling approximately

$617 million” (22). Costco did not issue any new stock in 2012. Stock options exercised,

including tax effects in 2012, totaled 2,756 million shares, adding $142 million to additional

paid-on capital (44). Also, the release of vested restricted stock totaled 2,554 million shares

in 2012, decreasing additional paid in capital by $76 million (44). The company states: “the

fair value of restricted stock units (RSUs) is calculated as the market value of the common

stock on the measurement date less the present value of the expected dividends forgone

during the vesting period” (54).

Dividends

Costco’s quarterly cash dividends were paid out in 2012 at $0.24 during the first

and second quarter and $0.55 in the fourth quarter (19). The company increased the

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quarterly cash dividends from $0.24 to $0.275 in May of 2012 (29). This increased the cash

dividends for the year to $1.03 per share from $0.89 in fiscal year 2011 (29). Cash

dividends declared totaled $446 million in 2012 for the 432,350 shares outstanding held

by 8,154 stockholders of record (19).

The company’s payout ratio for 2012 was .261:1 and for 2011 was .266:1 (44).

Costco kept its payout ratio constant for the past two years to signal to investors that it is a

growing stable company. Not only is the stock a good buy in terms of future capital gains,

but Costco also rewards its shareholders with quarterly dividends in proportion with its

earnings for the quarter. Wall Street is not always happy with CEO Jim Sinegal’s decisions,

especial Costco’s average pay of $17 an hour (Greenhouse 1). An analyst at Deutsche Bank

complained in 2012, “it’s better to be an employee or a customer than a shareholder”

(Greenhouse 1). Costco’s stock price has risen more than 10 percent from August 2011 to

September 2012, because so many people love the treatment of employees, in addition to

the savings (Greenhouse 2).

Financial Strategy

After analyzing the liabilities and stockholders’ equity of Costco, I concluded that the

company is gradually adopting a financial strategy that leans more heavily on debt

financing than equity financing. This can be seen first and foremost in the company’s

yearly stock repurchasing program where, in the past three years, an average of 8.5 million

shares have been repurchased and retired each year (44). Also Costco’s debt to asset ratio

has increased in the last three years, as the company increases its notes payable (42). Total

stockholders’ equity has been steadily decreasing since 2005 as a percentage of total

liabilities and equity, making the company more reliant on debt (Morningstar).

CASH FLOWS

Summary

The cash flows for Costco in 2012 are listed in the table below (45).

Category 2012 2011 2010

Operating $3,057 $3,198 $2,780

Investing (1,236) (1,180) (2,015)

Financing (2,281) (1,277) (719)

Net Change in Cash $(481) $795 $57

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Not included in this table was the effect of exchange rate changes on cash and cash

equivalents (45). By only looking at the table above one could make only a few conclusions

about Costco’s cash flows. Costco created a large amount of cash from operating activities

in the past three fiscal years, but cash from financing activities has decreased at a high rate.

This resulted in a negative cash flow for 2012, a decrease of more than a billion dollars

from 2011 (45). Costco is a mature company that is paying back its long-term debts and

buying back stock (45). For these reasons the large negative cash flow from financing

activities, seems to be an acceptable number. 5.3% senior notes that were due March 2012,

and the purchase of non-controlling interest in Costco Mexico caused the dramatic

decrease in cash flows from financing activities (45).

Analysis

Costco’s primary sources of cash during its most recent fiscal year were net sales

and membership fees (20). If Costco had used the direct method to report cash from

operating activities, the values would be evident from these cash flows. However, because

the indirect method is used, it is necessary to derive from Costco’s business strategy how it

earns cash (45). The company spent the most cash on purchases of short-term investments

and additions to property and equipment for the last three fiscal years (45). Costco has

consistently spent cash in this way because of their business model as a general

merchandise retailer.

Net cash flows from operating activities have remained relatively constant in the

past 2 years, totaling in $3,057 in 2012 and $3,198 in 2011 (45). In 2010, net cash flows

from operating activities were much lower then the past two years at $2,780 million (45).

The primary reason that the net cash flows from operating activities differed from net

income the past 3 years are the adjustments to depreciation and amortization expense, and

increase in accounts payable (54). Depreciation and amortization increased steadily each

year as Costco opened 81 new warehouses in the United States and abroad (18). Accounts

payable fluctuated in the past 3 years, and had a inverse relationship with the third largest

cash flow from operating activities: increase in merchandise inventories (45).

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Illustrated in the table below are the percentage changes in Costco’s net sales

revenue, net income, and net cash flows from operating activities in each of the last three

fiscal years (20).

% change 2012-2011 2011-2010

Net Sales Revenue 11.50% 14.15%

Net Income 16.89% 12.20%

Net cash flows from

operating activates

-4.41% 15.04%

The main trend in these percent changes is that net sales revenue and net income

have been positively increasing during the past 3 fiscal years (20). I think that this is due to

the simple Costco business model of selling consumer goods to individuals and businesses.

The next highest revenue is membership fees, which is 2% the amount of net sales (20).

Costco is also a low cost provider, that needs to sell a large quantity of goods to make a

large gross profit, due to the low profit margin gained on each good sold. Net cash flows

from operating activities are trending in the opposite direction (45). The 2012 Form 10K

Report point to the main cause of the -4.41 decrease due to an “increase in our net

investment in merchandise inventories (change in merchandise inventories less changes in

accounts payable) of $314” (28). More cash was used to buy inventory then in the year

prior, possibly to cut down on interest expense by take advantage of the company’s $3.5

billion in cash (45).

2012 2011 2010

Interest $95 $116 $111

Income tax $1,000 $841 $731

Interest and income taxes for the last three fiscal years can be seen in the table

below (27). The interest expense is mostly related to the $900 million of 5.3% and $1,100

million of 5.5% Senior Notes issued in 2007 (27). Costco uses a provision for income taxes

methods due to the complexity of tax law, and states that significant judgments and

estimates are used (33).

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Cash Debt Coverage

Costco’s free cash flow, current cash debt coverage, and cash debt coverage can be

seen in the table below (42).

The figures presented in the table for each year have positive relationships. When

free cash flow is high, Costco is going to be more able to pay back debt with its cash flow

from operations. It is important to note that the authors of Financial Accounting for

Decision makers believe that if current cash debt coverage is under .40 or cash debt

coverage is under .20 then a company’s liquidity need to be further investigated (Kimmel,

Weygandt & Kieso). These two coverages apply to the company’s apply to a company’s

ability to repay liabilities form cash generated from operation, without liquefying

productive assets such as plants, property or equipment (Kimmel, Weygandt & Kieso). I

think that there is little cause for concern, however, because almost a fourth of Costco’s

assets are merchandise that are highly liquid and could be sold at a reduced price to gain

cash to pay back short-term debt (42).

Under noncash investing and financing transactions four items are listed: decrease

in accrued property and equipment, property acquired under capital leases, unsettled

repurchases of common stock, and distribution declared but not paid to non-controlling

interest (45). Distribution declared but not paid to non-controlling was $22 million and

refers to the agreement that Costco made with its joint venture partner, Controladora

Comercial Mexicana, when Costco acquired its 50% equity interest in Costco Mexico (22).

Cash Flow Summary

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2012 2011 2010

Free Cash Flow $1,131 $1,519 $1,387

Current Cash Debt

Coverage

.2515 .2901 .2850

Cash Debt Coverage .2069 .2292 .2231

I am not concerned about Costco not generating sufficient cash flow form its

operations to cover the replacement and growth of its long-term assets. Costco has been

very successful in generating operating cash flows, and has been investing this cash

immediately back into merchandise to take advantage of discount periods. Cash flow from

operations only decreased slightly in 2012, and the negative change in cash was mostly due

to bonds that had reached their maturing date, and the purchase of Costco Mexico. These

two transactions are not an annual expense, and are allowing the company to expand into

international markets. Costco still has $3,528 million of cash and cash equivalents at the

end of 2012, and did not issue new bonds or stock to raise additional case (45). Financing

from Costco come exclusively from senior notes that were issued in February 2007 (30).

SUSTAINABLE INCOME

Extraordinary Items

In 2012 Costco’s warehouse in Tamasakai, Japan was reopened (29). This

warehouse was severely damaged in the March 2011 Japan earthquake that demolished

parts of the island country (29). This is very important for Costco’s image internationally

because the company could have closed the warehouse for good, but instead made a

commitment to the people of Japan to rebuild.

Comprehensive Income

For the fiscal year 2012, Costco’s comprehensive income was $96 million less than

its net income (44). This was caused by foreign-currency translation adjustment and other

adjustments that are not specified (44). Comprehensive income includes all changes in

stockholders’ equity, during a year, except those changes resulting from investments by

stockholder sand distributions to stockholders (Kimmel, Weygandt & Kieso). Sustainable

income is the most likely level of income a company may obtain in the future (Kimmel,

Weygandt & Kieso). It is computed by adjusting for irregular items (Kimmel, Weygandt &

Kieso). Costco has no irregular items in the 10K report. Therefore, sustainable income is

equal to net income for 2012 of 1,709 million (44).

RATIO ANALYSIS

Price-earnings Ratio

The price-earnings ratio for all three companies was found using Morningstar. This

ratio is computed by dividing market value per share by earnings per share (Kimmel,

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Weygandt & Kieso). The number of shares cancels and the ratio is left as how much market

value a company has divided by net income. Costco is well above competitors with a very

strong P/E ratio (Morningstar). This is due to strong net income in the past 2 years relative

to market share (44).

2012 2011

Costco 24.0 25.1

Wal-Mart 18.4 18.9

Target 17.2 18.1

UPDATE

In the past 2 years, Costco’s stock price has risen from $75.68 to $122.65

(MorningStar). This is due to high consumer confidence in the company, and a 90%

membership renewal rate (Greenhouse 2).

SUMMARY AND CONCLUSION

Revenue

Costco’s revenue has risen about $10 million the past three fiscal years, totaling

$97,062, in 2012 (43). I fully expect revenue to continue to grow larger in the future, due

to Costco buying Costco Mexico, and expecting to open 32 warehouses in 2013 (64).

Revenue is based almost entirely on net sales, and as long as Costco keeps offering goods to

consumers at a high value, customers will renew memberships, and continue buying goods.

Profit

Costco’s business strategy is that of a lost-cost retailer. Profit from individual

products may be as low as 10-15%, as opposed to the 30-45% department stores offer

(Greenhouse 3). Gross profit has increased 9.4%, 12.7%, and 10.0% in 2010, 2011, and

2012, respectively. Wall Street is very confident in Costco’s ability to make profit, as seen

in their $120 stock price (Morningstar). I think that profits can increase even more as

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Costco offers more and more Kirkland privet branded products in their stores. The profit

margin from these products is higher because Costco does not have to share the profits

with large name brands that have high bargaining power.

Asset Investment Strategies

The main assets Costco invests in are merchandise and buildings (44). Their

business strategy moving forward is to expand internationally, and gain higher market

share. This is going to be done by finding good locations to place new stores, and properly

training employees.

Financing Strategies

Costco had a very large negative cash flow from financing activities in 2012 due to

paying back the principle on $900 million notes, and purchasing Costco Mexico (18). Also

the company buys back about 8 million bonds each year. I think that moving forward,

Costco will need to issue new notes to continue its financing strategy. Costco can obtain

low interest rates on these bonds due to its strong financial history.

Strong Aspects of Performance

I think the Costco did a great job in 2012 increasing gross profit, while not

decreasing revenue. This means that customers are willing to pay slightly extra for

Costco’s high value goods. Also they company did very well in making employees happy.

Costco pays its employees an average of $16 per hour which is far above minimum wage,

and as one employee puts “I want to retire here”(Greenhouse 3). Lastly the Companies

stock price has done very well this year which indicated confidence from stockholders and

Wall Street that Costco is on the path to success.

Weak Aspects of Performance

Costco did not expand into international markets as much as they should have in

2012. Only one third of new warehouses were opened in Canada and other international

countries in 2012 (18). Net income slightly decreased form 2011 to 2012, which could

signal an increase in costs that Costco has mishandled. Expenses rose at a faster rate then

revenues for Costco, and the company may have to reevaluate its supply chain to identify

the large expenses.

Future Prospects

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Through a semester of analyzing Costco, I firmly believe that if the company corrects

its weaknesses, it will remain a leader in the general merchandise retail industry for years

to come. The three financial statements and footnotes had no items that gave me concerns.

I believe with a rejuvenated economy in 2014 Costco will show large increases in revenue,

net income, and especially net cash flows.

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REFERENCE LIST

Printed Sources

Kimmel, Weygandt & Kieso. Financial Accounting. Hoboken: Wiley, 2013. Print

Internet Sources

Morningstar. 2013. Costco Wholesale Corporation. Available at:

http://quotes.morningstar.com/stock/s?t=COST&region=USA&culture=en-US.

(Accessed on December 9).

MarketLine. Costco Wholesale Corporation SWOT Analysis 1-9. Available at:

<http://web.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=e47f8c4d-33ea-4068-

8c09-3cbf50b57c91%40sessionmgr110&vid=4&hid=120> (December 9)

Greenhouse, Steven. 2010. How Costco Became the Anti-Wal-Mart. The New York Times.

Available at:

<http://www.nytimes.com/2005/07/17/business/yourmoney/17costco.html?

pagewanted=1&_r=1&> (December 9)

“Form 10-K” Form 10-K. 2012. Securities and Exchange Commission. Available at:

http://www.sec.gov/Archives/edgar/data/909832/000119312512428890/d3880

97d10k.htm#tx388097_28

"Costco Connection - February 2013." Kirkland Signature. Available at:

<http://www.costcoconnection.com/connection/201312#pg1>

Costco Terms and Conditions of Use. Available at: <http://www.costco.com/terms-and-

conditions-of-use.html>

Trefis. “How does Costco Make Money” Available at:

<http://www.trefis.com/stock/cost/articles/161496/how-does-costco-make-

money/2013-01-07>

Morningstar. Target Growth, Profitablity and Financial Ratios.

Stone, Brad. Costco CEO Craig Jelinek Leads the Cheapest, Happiest Company in the World.

Available at: <http://www.businessweek.com/articles/2013-06-06/costco-ceo-

craig-jelinek-leads-the-cheapest-happiest-company-in-the-world>

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Prior, Ana. 2013. WSJ Online. Costco Shines Amid Otherwise Lackluster Same-Store Results.

Available at:

<http://online.wsj.com/news/articles/SB10001424127887324123004579056961

676026596>

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