costco returns

Costco operates mainly in the US, Canada, the UK, Mexico, Japan, and Korea. It had $129 b revenues for (August) 2017, of which $94 b came from the US operations, and $19 b came from Canada. That's about 12% coming from its international operations. So it has some headway for growth out there. But will it fructify? 

Costco is a pretty straightforward business in wholesale and retail of merchandise. W. Craig Jelinek has been the President and CEO since 2012. In 2012, the market value of equity was $42 b (high) and now it is $81 b. A double in five years is nearly a 15% return; not bad. Earnings per share increased from $3.95 to $6.13. Expansion in the PE multiple from 25 to 30 was another reason. A 9% annual increase in EPS lead to nearly 15% in market value in five years. If you had picked the stock when the market capitalization was $34 b (low) in 2012, the returns would have been even better. Operating earnings increased from $2.7 b to $4.11 b; that's 8.30% annual increase.

In the meantime, the number of shares outstanding increased from 432 m to 437 m. Almost 17 m increase came from exercise of options and restricted stock units. To offset that Costco operated buybacks of 13 m shares. Had it not done that, the EPS in 2017 would have been $5.95 in 2017. In fact, Costco has been buying back its shares for long. In 2007 itself, it repurchased 36 m shares; then in 2008, 14 m more. From 2007 to 2017, Costco bought back 90 m shares. If shares were not repurchased, the total number of shares outstanding would have been 527 m, and that would have brought EPS down to $5.08. With the current multiple, the share price would be 18% lower at $152 instead of $186 now. Yet, due to higher number of shares outstanding, the market value of equity would be surprisingly similar to what it is now ($80 b). Of course, Costco would have retained cash of nearly $6 b assuming the buybacks were carried at low prices of each year, or it could have distributed to the shareholders.

So were those buybacks really worth it? To perform buyback, you need two factors: Excess cash, and low share prices compared to the intrinsic value. 

Where will Costco go from here? Revenues increased just over 5% annually during the last five years, and just over 7% during ten years. Assuming 7% increase in the next decade, we have revenues at year 10 of $254 b. With the current operating margins of 3.19% and net margin of 2.08%, Costco's EBIT would be $8 b and net earnings would be $5.3 b. Assuming no further dilution in equity, to get an annual return of say, 7%, the stock would need a PE multiple of, obviously, 30 at year 10. That is a rather rich pricing. When we use a multiple of 25, the rate of return would be 4.91%; at 20, the return would be 2.60%. When dividends are included, those returns would be 8.06%, 6.08%, and 3.90%. Well, why should Costco trade at a multiple of 30 or even 25, why not 20? Then there is dilution due to restricted stock units program.

When I do an intrinsic valuation of Costco based upon its free cash flows for the next decade and using a stable growth rate thereafter, I find that Costco is a 6% stock. I also converted its lease obligations into debt ($2.3 b) for the purpose of this valuation. But then for similar growth rates, the market has rewarded its shareholders nearly 15% return in the past. You can never tell what's with the markets.

Where is growth in revenues, earnings and cash flows going to come from for Costco? I think both Costco and Walmart should have some strategy to tackle the onslaught from Amazon. Online retail is here to stay and grow.