Please assist with study questions 4-8 only. See attached case study.

CASE: A-186B DATE: 06/19/03 COSTCO WHOLESALE CORPORATION FINANCIAL STATEMENT ANALYSIS (B) INTRODUCTION Margarita Torres had just completed her analysis of Costco's financial performance over the previous five years. She had concluded that the company had grown at a manageable rate, using internally generated funds rather than debt or equity to finance expansion. In 2001, operations had suffered slightly from the rapid introduction of stores. Nevertheless, the financial ratios indicated that there was not a significant deterioration in operational efficiency. Asset and inventory turnover remained at steady levels, indicating that the company had not overbuilt capacity in relation to customer demand. Both gross and operating margins remained healthy. From an investment standpoint she was concerned about the future performance of the business. As an experienced investor, she knew that there were two components of judging the value of her stock holdings: the future performance of the business and the potential for continued returns from the current price level. She decided therefore that it was appropriate to evaluate her investment in two steps. First she would forecast the company's operations several years out to understand what the business would look in terms of number of stores, sales per store, and profitability. Second, she would value the business using a discounted cash flow model to get a better understanding of what rate of future return she should expect, given the current stock price. HISTORY OF COSTCO AS AN INVESTMENT Costco Wholesale went public in November 1985 at a price of $10 per share. At the time, it had 15 warehouses in operation. Investors who bought into the company at its initial public offering profited richly over the next 17 years. However, as with most investments, gains were not made evenly year over year. Brian Tayan prepared this case under the supervision of Professor Maureen McNichols as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright 2003 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: cwo@gsb.stanford.edu or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means -- electronic, mechanical, photocopying, recording, or otherwise -- without the permission of the Stanford Graduate School of Business. Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B p. 2 The years 1985 to 1992 were a time of extreme appreciation in the stock price, well in excess of the company's operational success. During the years 1992 to 1995, the company's stock price corrected itself to be more in line with reasonable valuations, and investors who held it from peak to trough saw a loss of 70 percent in their investment. This was also the time of the CostcoPrice Club merger, which caused short-term disruptions in operations. By the late 1990s, the company regained steam operationally, and the price of the stock increased almost ten-fold by May of 2000. By July 2002, the stock was off its all-time high, trading at around $35 per share. Investors who put $1,000 in Costco stock at the time of its IPO saw their holdings grow to $21,000 by July 2002, a compounded return of over 19 percent per year for almost 17 years. The company's stock traded on the NASDAQ under the symbol COST. FORECAST To determine a financial forecast for Costco, Torres went through the following four-step process: 1. She listed the fundamental factors that would drive growth. Keeping in mind Albert Einstein's statement that \"things should be made as simple as possible but not any simpler,\" she set an objective of isolating the four or five drivers that had the largest impact on Costco's future. She considered the constraints associated with each factor. 2. Second, she forecasted Costco's income statement and computed a rough estimate of free cash flow based on her determinations in step one. 3. Third, she ran a quantitative check on the numbers, comparing key ratios to the historical results to consider the feasibility of her projections. 4. Fourth, she ran a qualitative check on the numbers to understand whether her projections were conservative or aggressive. In carrying out her analysis, she relied on diverse sources of information: industry reports such as those compiled by Standard and Poor's, research analyst reports, web casts with company management archived on the investor relations section of company websites, and business periodicals. Growth Drivers The first factor she considered was the number of warehouses that the company would operate in the U.S. She had read in business periodicals that analysts thought the saturation point in the U.S. market was 1500 warehouses shared among all competitors. Costco management, in its third quarter 2002 conference call with analysts, said that it expected to operate between 500 and 600 stores in the U.S. by 20101. Management considered 500 conservative, 580 assertive, and 600 aggressive. With 289 U.S. warehouses in 2002, Costco had approximately a 30 percent market share. Torres knew that there was intense competition among Costco, SAM'S, and BJ's 1 Forward-looking comments made by management, here and throughout the case, taken from: Costco Wholesale Corporation, \"Audio Events: Q3 2002 Costco Wholesale Corporation Earnings Conference Call,\" May 30, 2002, http://www.costco.com (31 July 2002). Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B p. 3 to expand in the U.S. SAM'S had announced plans to aggressively increase its own new store openings. The second factor she considered was sales per store. In more established warehouses, Costco had U.S. sales per store of approximately $100 million, compared to $60 million for SAM'S, and $45 million for BJ's. All three companies felt that fresh food, luxury items such as fine wines and jewelry, and ancillary products helped to increase same-store sales over time. Costco management had stated that they would like to get U.S. store sales up to $125 million or even $150 million per store. Was that possible? Also, with the companies increasingly entering each other's markets, what pressure would be placed on Costco's store sales? Which company, if any, would come out dominant? The third important growth driver was the membership base. Costco located warehouses in areas with a population of around 500,000 in a 15-mile radius. They expected to sign up approximately 10 percent of those people as members. Torres was not sure whether membership per store would increase or decrease, especially given the effects of competition. She did feel, however, that Costco could raise the membership fee over time. The basic annual membership fee was $25 in the mid-1980s. By now it was $45. Costco also had an executive membership, which was $100. She felt that as customers spent more money on sales merchandise, the more valuable they would perceive the membership to be and the more, in turn, Costco could charge. Costco management reported that recent increases in the membership fee did not materially change membership renewal rates, which average 86 percent. The fourth important factor to consider was operating margins. Costco management had recently stated that they felt they deserved to make more money from their business, given the value they delivered to customers. Management noted that pretax margin had peaked at 3.3 percent in 2000 and fell to 2.9 percent in 2001. Costco wanted to increase their pretax margin to 3.4 percent to 3.6 percent over the next five years (Wal-Mart's pretax margin was almost 6 percent). Torres did not know how much of this increase would come from improved gross margin, resulting from a change in pricing strategy, and how much from improved operating margins, where operations were already very efficient. The fifth main factor she considered was international expansion. Management had already stated that its emphasis was on U.S. growth, but that it would grow internationally where it felt it could do so profitably. Plans were to open four to eight warehouses per year internationally over the next five years, and 10 to 15 per year over the subsequent five years. Forecast Financial Statements The next step was to forecast the financial statements based on her assumptions about the five main growth drivers, using 2010 as a terminal year. She built the model in the following steps: Merchandise Sales 1. Assumption: number of U.S. stores 2. Assumption: number of international stores 3. Assumption: sales per store 4. Output: merchandise sales Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B p. 4 Because the 20 stores Costco operated in Mexico were accounted for using the equity method (based on 50 percent ownership), she kept track of them separately. Pro rata share of earnings from the Mexican stores were disclosed on Costco's income statement under \"interest income and other\"; capital invested in these stores was listed on the balance sheet under \"other assets.\" Membership Revenue 1. Assumption: members per store 2. Assumption: revenue booked per member 3. Output: membership revenue Operating Ratios 1. Assumption: cost of goods sold as a percent of merchandise sales 2. Assumption: SG&A as a percent of merchandise sales 3. Assumption: pre-opening expense per store 4. Assumption: interest expense 5. Output: income statement line items After projecting the income statement for Costco, she projected year-end balance sheet amounts in the following simplified manner: Net Operating Working Capital 1. Assumption: net working capital required per store 2. Output: net operating working capital Net Operating Long-Term Assets 1. Assumption: net PP&A required per store 2. Assumption: other long-term assets required per store 3. Assumption: non-interest bearing long-term liabilities 4. Output: net operating long-term assets Invested Capital 1. Assumption: long-term debt 2. Output: shareholder's equity 3. Output: free cash flow She calculated shareholder's equity by subtracting net debt from total net assets. She calculated free cash flow to equity holders as net income, less the increase in operating working capital, less the increase in net long-term assets, plus the increase in long-term debt. Beyond the terminal year of 2010, she was not sure whether free cash would increase at the same rate as U.S. GDP, a higher rate or lower rate. This would depend on a variety of factors, including whether the saturation point for warehouses had been reached, whether the company would continue to steal market share from competitors, and whether the company would be able to grow outside the U.S.. For now, she assumed growth at 5 percent, her estimate of long-term nominal increase in GDP. Finally, she divided earnings and free cash flow by the number of shares outstanding. She had noticed that Costco's shares were increasing at a rate of 1 percent to 2 percent per year because Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B p. 5 of its employee stock option plan and assumed the company would continue earnings dilution at a similar rate. Quantitative Check To check her model quantitatively she compared her results with management's five-year targets: x x x Sales growth of 10 percent to 12 percent Earnings growth of 16 percent Earnings per share growth of 15 percent Other quick checks that she ran included: x Member count as a percent of the U.S. population x Sales per member x Return on equity Qualitative Check One final check of her model involved asking whether her assumptions about the future were realistic, aggressive, or conservative. She realized that retailing was very competitive and companies' financial results usually reverted to industry mean figures, particularly in margins and ROE. However, she knew that Costco had strong competitive advantages based on its lowcost business model. She was not sure when competitive pressures would catch up with them. She saw Wal-Mart as an example of a company that performed above average for a considerable time. Wal-Mart would be one of Costco's main competitors as the company grew. VALUATION Having completed a forecast for Costco, Torres found the task of calculating valuation to be relatively simple. She put together a discounted cash flow model using her projections of free cash. Discounted Cash Flow Model The discounted cash flow model involved listing free cash flow figures through 2010 and calculating a present value of the free cash flows after 2010 based on her long-term rate of growth assumption. She then discounted these figures back using an assumed discount rate. The most difficult step of the discounted cash flow model was determining this discount rate. Some analysts advocated using the weighted average cost of capital (WACC). They used interest rates on long-term corporate bonds to determine the cost of debt and assumptions about volatility and market rates of return to determine the cost of equity. Torres decided to postpone calculating the company's WACC and instead use a discount rate of 8 percent, slightly higher than the average historical yield on 30-year U.S. Treasuries. Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B p. 6 STUDY QUESTIONS 1. How appropriate are the five factors that Torres chooses to determine the future performance of Costco? 2. What other relevant factors might be included in a forecast of the business? To what extent are they covered in the factors above? 3. Review Torres' assumptions in Exhibit 2. Which assumptions would represent a change from Costco's historical performance? Do you feel her assumptions are appropriate, and if not, which ones would you change? 4. Review Torres' forecasted income statement and common-size income statement. Do you feel these are achievable results for Costco? 5. Review Torres' forecast in Exhibit 5. How does the rate of expansion (i.e. new store openings) affect the balance sheet and free cash flow? Do you agree with her terminal value assumptions? 6. How does Costco's use of the equity method to account for its ownership of the 20 warehouses in Mexico effect the income statement forecast, the balance sheet forecast, and the discounted cash flow model? 7. Review Torres' quantitative checks. Compare her projections with management's forwardlooking comments. Based on these and other constraints (e.g. the effect of competition, historical performance, etc.) do you feel that her forecast is realistic, conservative, or aggressive? What does the theory of reversion to the mean say about Torres' projections? Which do you agree with? 8. Would you recommend that Torres buy, hold, or sell her Costco's shares at the price of $35? Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B p. 7 Exhibit 1 Costco Wholesale Corp. Stock Price (1997 - 2002) 60 50 Price 40 30 20 10 0 Mar- Sep- Mar- Oct97 97 98 98 Apr99 Oct99 Apr00 Oct- May- Nov- May00 01 01 02 Source: DataStream Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Operating Ratios Cost of goods sold as a percent of sales SG&A as a percent of sales Pre-opening expense per new store ($mm) Interest expense ($mm) 89.55% 9.07% 50 18,800 39 2% 101 20 28 292 3 84 376 2002 1.5 (32) 89.63% 9.17% 50 17,095 39 99 Annual increase in store sales Sales per store ($mm, yr-end count) Membership Revenue Members per store (th.) Total members (th.) Revenue booked per member per year 20 27 264 7 81 345 2001 Number of Mexico stores, equity Merchandise Sales U.S. store openings during year Number of US stores, yr-end count Intl. store openings (excluding Mexico) Number of intl. stores, yr-end count Total stores, consolidated Assumptions 1.5 (32) 1.5 (32) 89.50% 8.97% 50 20,500 39 2% 103 20 28 320 6 90 410 2003 1.5 (32) 89.50% 8.87% 50 22,200 40 2% 105 20 28 348 6 96 444 2004 1.5 (32) 89.50% 8.77% 50 23,900 40 2% 107 20 28 376 6 102 478 2005 1.5 (32) 89.50% 8.67% 50 25,700 40 2% 109 20 30 406 6 108 514 2006 1.5 (32) 89.50% 8.60% 50 27,800 41 2% 111 20 30 436 12 120 556 2007 Exhibit 2 Margarita Torres: Assumptions Underlying Costco Forecast (2001 - 2010) Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B 1.5 (32) 89.50% 8.60% 50 29,900 41 2% 114 20 30 466 12 132 598 2008 1.5 (32) 89.50% 8.60% 50 32,000 41 2% 116 20 30 496 12 144 640 2009 p. 8 1.5 (32) 89.50% 8.60% 50 34,100 41 2% 118 20 30 526 12 156 682 2010 Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Interest expense Interest income and other Provision for merger and restructuring Income continuing ops before taxes Provision for income taxes Income before cumulative effect of acct. change Cumulative effect of acct., net of tax Income from continuing operations Discontinued operations Income (loss), net of tax Loss on disposal Net Income (loss) Income Statement (millions) Revenue Net sales Membership fees and other Total revenues Operating expenses Merchandise costs SG&A Pre-opening expenses Provision for impaired assets / closings Total operating expenses Operating income Other income (expenses) 37,948 726 38,674 2002 (32) 43 0 1,194 478 716 0 716 0 0 716 602 0 602 0 0 602 30,598 3,129 60 18 33,805 992 (32) 43 0 1,003 401 33,983 3,442 47 20 37,491 1,183 34,137 660 34,797 2001 0 0 826 826 0 826 (32) 43 0 1,377 551 37,776 3,786 51 20 41,633 1,366 42,208 791 42,999 2003 0 0 953 953 0 953 (32) 43 0 1,588 635 41,727 4,135 51 20 45,933 1,577 46,622 888 47,510 2004 0 0 1,069 1,069 0 1,069 (32) 43 0 1,782 713 45,820 4,490 51 20 50,381 1,771 51,196 956 52,152 2005 0 0 1,196 1,196 0 1,196 (32) 43 0 1,993 797 50,257 4,868 54 20 55,199 1,982 56,153 1,028 57,181 2006 Exhibit 3 Margarita Torres: Forecast Income Statement Costco (2001 - 2010) Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B 0 0 1,347 1,347 0 1,347 (32) 43 0 2,245 898 55,450 5,328 63 20 60,862 2,234 61,956 1,140 63,096 2007 0 0 1,467 1,467 0 1,467 (32) 43 0 2,445 978 60,832 5,845 63 20 66,760 2,434 67,969 1,226 69,195 2008 0 0 1,590 1,590 0 1,590 (32) 43 0 2,650 1,060 66,407 6,381 63 20 72,870 2,639 74,197 1,312 75,509 2009 p. 9 0 0 1,715 1,715 0 1,715 (32) 43 0 2,858 1,143 72,180 6,936 63 20 79,198 2,847 80,648 1,398 82,046 2010 Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 Interest expense Interest income and other Provision for merger and restructuring Income continuing ops before taxes Provision for income taxes Income before cumulative effect of acct. change Cumulative effect of acct., net of tax Income from continuing operations Discontinued operations Income (loss), net of tax Loss on disposal Net Income (loss) Income Statement (millions) Revenue Net sales Membership fees and other Total revenues Operating expenses Merchandise costs SG&A Pre-opening expenses Provision for impaired assets / closings Total operating expenses Operating income Other income (expenses) 100.00% 1.91% 101.91% 2002 -0.08% 0.11% 0.00% 3.15% 1.26% 1.89% 0.00% 1.89% 0.00% 0.00% 0.00% 1.89% 1.76% 0.00% 1.76% 0.00% 0.00% 0.00% 1.76% 89.63% 9.17% 0.18% 0.05% 99.03% 2.91% -0.09% 0.13% 0.00% 2.94% 1.17% 89.55% 9.07% 0.12% 0.05% 98.80% 3.12% 100.00% 1.93% 101.93% 2001 1.96% 0.00% 1.96% 0.00% 0.00% 0.00% 1.96% -0.08% 0.10% 0.00% 3.26% 1.31% 89.50% 8.97% 0.12% 0.05% 98.64% 3.24% 100.00% 1.88% 101.88% 2003 2.04% 0.00% 2.04% 0.00% 0.00% 0.00% 2.04% -0.07% 0.09% 0.00% 3.41% 1.36% 89.50% 8.87% 0.11% 0.04% 98.52% 3.38% 100.00% 1.90% 101.90% 2004 2.09% 0.00% 2.09% 0.00% 0.00% 0.00% 2.09% -0.06% 0.08% 0.00% 3.48% 1.39% 89.50% 8.77% 0.10% 0.04% 98.41% 3.46% 100.00% 1.87% 101.87% 2005 2.13% 0.00% 2.13% 0.00% 0.00% 0.00% 2.13% -0.06% 0.08% 0.00% 3.55% 1.42% 89.50% 8.67% 0.10% 0.04% 98.30% 3.53% 100.00% 1.83% 101.83% 2006 2.17% 0.00% 2.17% 0.00% 0.00% 0.00% 2.17% -0.05% 0.07% 0.00% 3.62% 1.45% 89.50% 8.60% 0.10% 0.03% 98.23% 3.61% 100.00% 1.84% 101.84% 2007 Exhibit 4 Margarita Torres: Forecast Common-Size Income Statement Costco (2001 - 2010) Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B 2.16% 0.00% 2.16% 0.00% 0.00% 0.00% 2.16% -0.05% 0.06% 0.00% 3.60% 1.44% 89.50% 8.60% 0.09% 0.03% 98.22% 3.58% 100.00% 1.80% 101.80% 2008 2.14% 0.00% 2.14% 0.00% 0.00% 0.00% 2.14% -0.04% 0.06% 0.00% 3.57% 1.43% 89.50% 8.60% 0.08% 0.03% 98.21% 3.56% 100.00% 1.77% 101.77% 2009 p. 10 2.13% 0.00% 2.13% 0.00% 0.00% 0.00% 2.13% -0.04% 0.05% 0.00% 3.54% 1.42% 89.50% 8.60% 0.08% 0.02% 98.20% 3.53% 100.00% 1.73% 101.73% 2010 Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 0 (230) 2001 Terminal Value Information Growth in free cash flow, perpetuity Discount rate Annual free cash flow, 2011 Earnings per share Free cash flow per share Annual increase in shares outstanding Shares outstanding, diluted basis 5% 8% 978 1.29 475,827 4,884 Shareholder's equity Free Cash Flow Net income (-) Increase in working capital (-) Increase in long-term assets (+) Increase in long-term debt Free cash flow to equity holders 860 115 Net PP&A required per store Other long-term assets required per store Non-interest bearing long-term liabilities Net operating long-term assets per store Net operating long-term assets Net long-term debt Minority interest 6,089 Net working capital required per store Net operating working capital Balance Sheet (millions) 1.49 (0.91) 1% 480,585 716 230 923 0 (437) 6,037 860 115 18 1 (0.35) 18.65 7,012 0 0 2002 1.70 0.40 1% 485,391 826 0 634 0 192 6,672 860 115 18 1 (0.35) 18.65 7,647 0 0 2003 1% 495,147 2.16 0.88 1.94 0.65 1,069 0 634 0 435 7,940 860 115 18 1 (0.35) 18.65 8,915 0 0 2005 1% 490,245 953 0 634 0 319 7,306 860 115 18 1 (0.35) 18.65 8,281 0 0 2004 2.39 1.05 1% 500,099 1,196 0 671 0 524 8,611 860 115 18 1 (0.35) 18.65 9,586 0 0 2006 2.67 1.12 1% 505,100 1,347 0 783 0 564 9,394 860 115 18 1 (0.35) 18.65 10,369 0 0 2007 Exhibit 5 Margarita Torres: Forecast Abbreviated Balance Sheet Costco (2001 - 2010) Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B 2.88 1.34 1% 510,151 1,467 0 783 0 684 10,178 860 115 18 1 (0.35) 18.65 11,153 0 0 2008 3.09 1.57 1% 515,252 1,590 0 783 0 807 10,961 860 115 18 1 (0.35) 18.65 11,936 0 0 2009 p. 11 3.30 1.79 1% 520,405 1,715 0 783 0 932 11,744 860 115 18 1 (0.35) 18.65 12,719 0 0 2010 Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 U.S. population (th.), 1% / yr growth U.S. members as % of the U.S. population Sales per member, U.S. ($) Return on equity Quantitative Check Sales growth Earnings growth EPS growth 2002 262,600 5.6% 2,599 11.9% 2001 260,000 5.0% 2,610 12.3% 6.0% 2,638 12.4% 2003 265,226 Model - Model - Mgt - thru 2010 thru 2006 thru 2006 10.0% 10.5% 10% - 12% 12.3% 14.7% 16% 11.0% 13.1% 15% 6.5% 2,679 13.0% 2004 267,878 6.9% 2,723 13.5% 2005 270,557 7.4% 2,766 13.9% 2006 273,263 Exhibit 6 Margarita Torres: Quantitative Check on Forecast (2001 - 2010) Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B 7.9% 2,842 14.3% 2007 275,995 8.4% 2,917 14.4% 2008 278,755 8.8% 2,992 14.5% 2009 281,543 p. 12 9.2% 3,066 14.6% 2010 284,358 Purchased by: Jonathan Reading JJREADING0909@POINTLOMA.EDU on March 25, 2014 18,659 41 15,900 35 Current Value Current market cap Current per share price 33 32,611 9 0.500249 16,314 2,346 2001 Model Value Present value of Costco Corp. Present per share value Terminal Value Value of perpetuity, $1 g=5%, r=8% Value of perpetuity, free cash flow Year Discount factor Present value of free cash Discounted Cash Flow Model Year Discount rate Discount factor Discounted free cash flow Present value of free cash, 2002 - 2010 2002 1 8% 0.92593 (405) 2003 2 8% 0.85734 165 2004 3 8% 0.79383 253 2005 4 8% 0.73503 320 2006 5 8% 0.68058 357 2007 6 8% 0.63017 355 Exhibit 7 Margarita Torres: Discounted Cash Flow Model, Costco (2001 - 2010) Costco Wholesale Corp.: Financial Statement Analysis (B) A-186B 2008 7 8% 0.58349 399 2009 8 8% 0.54027 436 p. 13 2010 9 8% 0.50025 466