SIMON GRADUATE SCHOOL OF BUSINESS

Costco: Forecasting and Valuation Case

SUBMITTED BY Bhadra Menon Sanjeev Prakash Sanchit Sarin Venkata P Sastry Susarla

Q1. Assess Costcos business, operating and expansion strategies and identify the key features of its business model. In addition, what are the keys to success and what are the expected financial statement consequences of the strategies?
Business Strategy: Costco was the largest wholesale club in the industry with sales of $34 billion in 2001 and it differentiated itself from its closest competitor Sams by targeting a wealthier clientele of small business owners and middle class shoppers. The company valued its customers by adhering to the strict policy of marking up its products up to maximum of 14% over the distributors price whereas a typical retailer marked up products 25% to 40%. Costco managed its supply chain very effectively. It offered a broad distribution channel that brought increased revenues and purchased limited SKUs from its vendors. It passed the saving from the manufacturers low production cost to its own customers. As a result, it had low gross margin per sale but high volume of sales compensated for the low operating margin. The operating margin ranged between 2.70% to 2.91% from 1997 to 2001. It also charged an annual membership fee for the values provided to its customers and the membership fee increased its revenue by 1.82%-1.93% from 1997 to 2001. The company also offered various products through its own proprietary brand, Kirkland, to target the service or product sectors where it felt a need for high quality, low cost items that did not exist in the market. It increased its store sales by increasing sales per customer. Operating Strategy: The Company maintained the operating efficiency by reducing its capital expenditure through various methods. It reduced labor costs by using forklift for the delivery of pallets onto the warehouse floor. It implemented cross-docking procedure for the distribution of goods to its stores and maintained low inventory cost. Expansion Strategy: In 1993, Costco purchased Price Club to spearhead the wholesale club industry along with Sams. With the merger, it increased its sales from $6.6 billion in 1992 to $15.5 billion in 1993. Since 1997, it increased its number of stores in domestic market by 32% and in international market by 36.5% in five years. Till 2000, it avoided direct competition with Sams by limiting the number of stores in the same markets. The company benefited from its high inventory turnover ratio, low A/R days and high A/P days. The low cash cycle days contributed to its high Asset Turnover ratio and that in turn, contributed to its high Return on Equity. Costco has also maintained its current ratio close to 1 for several years despite expanding into domestic and international market and that shows its operating efficiency.

Q2. What are the major risks Costcos faces in the future when trying to execute its strategy?
Major Risks that Costco faces in the future due to its strategy are: 1. Risk of losing customer due to : Lack of choice Costcos strategy of concentrating only on a few items and sell them in bulk might go well with small business owners for now, but as Costco expands and acquires more customers, they will have to satisfy a wide array of people with different choices and this strategy of limiting variety for the sake of cost might reduce Costcos reach among the buyers who would not hesitate to pay little extra for the product that they want. 2. Risk of losing customers due to : Rigid container size Though Costco gives its customers lowest per unit price, Costco usually sells stuff in bigger containers than would be available elsewhere. This strategy is detrimental in two ways; first it keeps customers who do not want to buy large quantities but are ready to pay larger amount per unit for a smaller quantity. Secondly, bigger containers mean less convince and larger transportation costs for the consumer. Many customers might feel that the saving at Costco are not worth the inconvenience and extra transportation costs and might keep away from Costco. 3. Risk of losing customers due to : No customer service and lack of order From the case we understand that Costco, to save costs, keeps customer service at a minimum and also the goods are not ordered on shelves but are placed on the warehouse floor as a pallet or stack. This can be a great inconvenience for the customer, for example, if the customer is looking for jeans of a particular color and/or make, he/she would have to go through the entire stack of the jeans before they find/give up looking for it. This also might keep customers away from Costco. 4. Risk from the 14% markup strategy

Since 14% markup is a well-publicized differentiating strategy of Costco, If market conditions change and Costcos costs increase (for e.g. Rise in gas prices causing transportation charges to increase, or real estate prices or labor charge etc), Costco would be hurt if they raise their markup (Loss of differentiating strategy and also go against customer expectations) or they dont raise the markup (Loss due to cost increases). 5. Risk from being in a saturated industry Since retail is a saturated market, as the number of players in the market increases, the market share of Costco would come under pressure from the competitors.

Q3. The case contains information about Costcos potential competitors. a) Identify and justify the firm or firms you would define as Costcos closet competitor. b) What are the 4 most important observations you would make to differentiate them?
a) We would define SAMS Club and BJs Wholesale as Costcos closest competitors. We consider these two firms to be closest competitors to Costco because all three Costco, SAMS Club and BJs Wholesale operated on same business model in retailing the wholesale club. For all three of them customers had to purchase annual membership and all three stores Sold items in bulk amounts Had high inventory turnover ratios Had low operating expenses Operated on very low gross margins Ran stores in warehouse style facilities Attempted to offer best value to customers by offering lowest prices Carried a limited selection of goods 4,000 SKUs as compared to 40,000 SKUs at most grocery

b) The four most important differentiators amongst Costcos, SAMS Club and BJs Wholesale are as follows: 1) Costcos targeted a wealthier clientele of small business owners and middle class shoppers whereas SAMS Club catered to lower income groups. BJs policy was similar to that of Costcos in targeting small business-owners and middle class buyers. 2) Costco did not mark up its products more than 14 percent over the distributors price whereas BJs marked up select items more than 14 percent. Also, BJs stores carried more SKUs than Costcos 6,000 per store versus 4,000 per store 3) When it came to location most SAMS clubs were located adjacent to a Wal-Mart store, offering the same products at the same prices while this was not the case with Costco. Also, the majority of SAMS Clubs were located in the South and most Costcos were in the West.

4) BJs stores were smaller than Costcos stores 110,000 square feet versus 148,000 square feet and BJs spent more money than Costcos on flooring, lighting, and signage in its warehouses in an attempt to improve the shopping atmosphere.

Q4. What are the 5 most important factors likely to affect Costcos future growth

1. Increasing membership fee/value (Grow membership): . The companys membership base is growing and they are able to retain their customers. Virtually, they do everything to retain their customers. One of the key uniqueness and strength is that they sell membership to their customers that not only generate the fixed revenue every year but also increase the brand loyalty and awareness of the customers towards Costco. However, Costco can increase its customer base by tapping more of the middle class and lower income people. 2. Improving gross margins through the following methods (The company has low gross margin per sale) a. Offering more upscale products: In the core of their strategy, Costco sells limited numbers of products in fewer varieties to keep the cost down and they rely on high volume sales. The company can increase its clientele by offering more range of products. b. Growing private label: The Company needs to expand its own proprietary brand, Kirkland so that it can increase its clientele. 3. Growing sales per warehouse: The sales per warehouse is a figure that can be increased with effective management of warehouses. This can be done through better inventory management and more efficient supplier funding. 4. Employing creative cost cutting measures: For example, to achieve the price leadership they reduce handling and storage cost, they should maintain in-stock positions without being overstocked and transition seasonal merchandise, they should utilize just-in-time principles when ordering merchandise to minimize the cost of inventory, keep best value pack product to assure low prices through volume buying, expense reduction and low gross margins etc. In addition to this, Costco doesnt spent a lot in advertising and use word of mouth advertising for marketing which is not only one of the cheapest way to advertise but it is one of the most effective ways of advertisement.

5. Domestic and international expansion: Costco has to keep opening stores so that it can compete with Sams clubs warehouse numbers. This is essential for survival as both Costco and Sams are vying for big expansion into each others territories and thus would continue to add new warehouses in the process.

Q5.Estimate Costcos cost of equity capital as of the valuation date. Assume a longrun market risk premium from 6.5% to 7.5%.

Cost of equity Risk-Free Rate (rf) Market Risk Premium (rm-rf) Raw (observed) beta Cost of equity

3.00% 7.00% 1.1081077 10.76%

Risk free rate was taken as 3 month Tbill as of 2001 (30 yrs US treasury bond was discontinued in 2002. That is why we have taken the Tbill). We did a regression on the weekly returns of Costco and S&P 500 from 1996 to 2001 to obtain a beta of 1.11. Then using the CAPM formula, we get Cost of equity = rf +beta*(rm-rf)=10.76% The regression and raw data is available in the excel sheet

Q6.For some finite horizon you deem appropriate, project Costcos performance beginning with the fiscal year 2002. Be sure all of your I/S and B/S forecasting assumptions are explicitly stated and justified.
We have taken a 20 year horizon considering that it is a growing market. The terminal growth rate has come down to 6.0%.
Sales Assumption:

We have taken same store sales growth as 4.0% and the net number of stores opened (we have not separately calculated the opening and closing of stores) per year as 32 till the total reached 1000. WE assume that Costco will keep opening stores until it equals to Sams clubs warehouse numbers (which have been projected to increase at 12 per year). We believe this assumption is valid as the both Costco and Sams are vying for big expansion into each others territories and thus would continue to add new warehouses in the process

We have taken the income from members to be growing at 4% and the number of members to grow at 1.75 million. This was because the companys strategy seems to be focused on growing its members and also increasing its membership fee. It aims to do that by creating more value to its members.
Income Statement Drivers / Assumptions COGS as % of Revenue Provision for impaired assets/closings as a % of revenue SG&A as % of Sales 88.0% An average of the previous 3 years' ratio

0.1% 9.0%

Previous year's figure Previous year's figure This is the average percentage of preopening expenses to number of stores Average An average of the previous 3 years' ratio An average of the previous 3 years' ratio (An average of the previous 3 years' ratio) 1.73% 0.53% 0.70% 7.89% 0.74% 29.85% 15.33% 1.05% 8.20% 0.68% 1.86% 48.08% 0.82% 9.97% 0.29% 1.34% 0.43%

Preopening Expenses as a % of number of new stores Tax Rate Interest Expense as a % of average long term debt Interest Income as a % of net sales

184.3% 40.0% 4.44% 0.15%

Balance Sheet Drivers / Assumptions Cash / Sales Short - Term Investments / Sales Accounts Receivable / Sales Merchandise Inventories / Sales Other Current Assets / Sales Accumulated Depreciation & Amortization / Average Net PP&E Net PP&E / Sales Other Long-Term Assets /Sales Accounts Payable / COGS Short-Term Debt / Assets Accrued Liabilities / Sales Deferred Membership Income / Membership Fees Other Current Liabilities / Sales Long-Term Debt / Assets Other Long-Term Liabilities /Sales Minority Interest / Assets Other accumulated / Sales

Q7. Based on your projections in (6) perform a DCF valuation of Costco.

Present Value beyond 20 years Present Value in the first 20 years Forecast Equity Value Before Time Adj Forecasted Value as of Valuation Date -Value of contingent equity claims +Excess cash at Valuation Date Value Attributable to Common Equity Common Shares Outstanding at BS Date

$8,801.8 $4,138.8 $12,940.5 $13,587.5 0 $0.0 $13,587.5 449.631

Forecast Price/Share

$30.22

Please refer to the excel sheet for detailed calculations

Q8. Based on your analysis in (6) perform a Residual Income valuation of Costco.

PV beyond 20 years PV for 20 years Common Equity as of the year 12/31/2001 Forecast equity value before time adjustment Forecasted value as of valuation date - value of contingent equity claims + excess cash at valuation date Value attributable to common equity Common Shares Outstanding at BS date

$3,872.4 $3,538.3 $5,230.2 $12,640.9 $13,272.9 $0.0 $0.0 $13,272.9 $449.6

Forecast Price/Share

$29.52

Please refer to the excel sheet for detailed calculations

Q9. Set up an Abnormal ROE valuation of Costco as the valuation date. Beyond the basic elements of the valuation, your set up must show what the PV of Cumulative Residual Income (i.e., Abnormal ROE) is at the end of the first 3 years.

Terminal value of Abnormal ROE Total present value of Abnormal ROE Plus "One" Indicated Market to Book ratio (Sum of last 2 rows) Book value of equity at valuation date Indicated market value of equity before time adj (Product of last 2 rows) Market value of equity after time adj Plus: Excess Cash Common Shares Outstanding at BS date

74.0% 64.7% 1.00 2.39 $5,230.2 $12,484.9 $13,109.2 $0.0 $449.6

Forecast Price/Share
Please refer to the excel sheet for detailed calculations

$29.16