A check of Costco balance sheet at the end of
the 2nd quarter of 2004 shows that the retailer is accumulating cash
at a rapid rate. Interestingly enough they are accumulating cash
faster than they are earning it, a good trick for a retailer. The
table below shows that in the 2nd quarter Costco's balance sheet
cash and short term investments increased to $2.287 billion from
$1.911 billion at the end of the 1st quarter. This represented an
increase of $376 million for the quarter. This is an interesting in
view of the fact that: 1) net income for the period was only $226
million and 2) the company spent almost $109 million on expansion.
Munger Accounting?
Must be a fluke right? Basic accounting tells us
that you can not earn $226 million, spend $109 million on new stores
and end up with $375 million more cash in the bank. The table,
however, shows that if it is a fluke, it has been going on for a
while. For the 12 months ending with the 2nd quarter of 2004, the
company accumulated a total of $1.118 billion in new cash after
spending $692 million on expansion, recording only $780 million in
net income. With Charlie Munger on the board, one is left to wonder
if this is an exercise in Munger Accounting, which is similar to
GAAP, but takes a consistently more pessimistic view of the future.
Costco Cash Levels
12 Months Ending February 28, 2004
In Millions of Dollars
| Quarter |
Cash & Short-term Investments
(millions) |
Increase in Cash from Previous Qtr. |
Net Income |
Capital Spending |
Cash Increase Plus Capital Spending |
| 2nd Qtr 2004 |
$2,287.6 |
$376.0 |
$226.7 |
$108.9 |
$484.9 |
| 1st Qtr 2004 |
$1,911.6 |
$366.2 |
$160.2 |
$222.0 |
$588.2 |
| 4th Qtr 2003 |
$1,545.4 |
$256.0 |
$239.4 |
$202.2 |
$458.2 |
| 3rd Qtr 2003 |
$1,289.4 |
$120.4 |
$153.7 |
$159.2 |
$279.6 |
| 12 Months |
|
$1,118.6 |
$780.0 |
$692.3 |
$1,810.9 |
During the 12 month period there was a small
increase in long term debt, but that increase was more than offset
by a $59 million reduction in short-term debt and $95 million
purchase of minority interests. Exactly where the cash is coming
from is hard to understand from the 10Q, but some is coming from an
increase in membership income ($55 million), some from increase in
inventories ($26 million), and also maybe as much as $200 million
from an increase in cash reserved for workman compensation claims.
There has also been an accounting change that has the effect of
switching rebates due to customers, from accounts receivable to
cash.
While a good share of this increase may be
nonrecurring, it is still highly unusual to see a retail operation
that is building stores aggressively and growing revenue by 18% per
year that still able to pile up excess cash. It is more typical to
see a retailer at this stage still piling on debt and building
stores as fast as they can.
Moat Building
Wall Street is getting bored with Costco because
their earnings are not growing fast enough, and now the popular view
is that Costco is too good to its customers and employees and is not
paying enough attention to its shareholders. But flat earnings can
be the result of a bad economy or they can be the intentional result
a conscious effort to dig a deeper moat. Warren Buffett likes to talk about durable competitive
advantage. From the 1998 chairman's letter we have the following
quote.
"GEICO's growth would mean nothing if it did
not produce reasonable underwriting profits. Here, too, the news is
good: last year we hit our underwriting targets and then some. Our goal, however, is not to widen our profit margin but rather to
enlarge the price advantage we offer customers. Given that
strategy, we believe that 1997's growth will easily top that of last
year."
It is interesting to read this quote in terms of
Costco's apparent current strategy. Perhaps their goal in keeping
their margins low is to enlarge the price advantage they offer
customer. Do they do this because they are only interested in the
customer or because they want to build a durable competitive
advantage over Sam's and BJ's?Costco and Sam's have been locked in a price
tussle, and Jim Sinegal says that Costco will not be undersold.
Costco wants the customer to know when he walks in their store, that
the price he sees at Costco is the best price he is going to see.
This is their moat, and if they have to suffer a few flat quarters
to build that moat, then they are willing to do so.
BJ'S
Costco ability to build their balance sheet
strength in the midst of a price war with Sam's may be a good
indication of the moat that they already have in place. A look at
BJ's results for the year ending January 31, 2004 show they
increased their cash by $46 million while their debt increased by
$90 million. While BJ's does not have much debt, it leases a much
higher percentage of its stores than does Costco. At the end of its
2003 year, Costco leased 85 out 397 stores or 21 % of its stores,
whereas, BJ's leases 92 of 150 stores or 61% of it's stores. Lease
obligations at BJ's amounted to $1.7 billion compared to $1.4
billion at Costco, whose revenue is almost 7 times larger than BJ'sThe impact of Costco and Sam's price war would
appear to much greater on BJ's than either Sam's or Costco. In the
12 months ending January 31 2004 BJ's net fell from $130 million to
$102 million or by 21%. During a similar period (12 months ending
2/15/04) Costco's net increased from $834 million to $925 million.
Keep in mind that in early 2003 BJ's price fell
to the point that its total market value was only a little over $600
million, so if the market weakens again and Costco keeps up the
price pressure it BJ's could be easy shark bait for Senegal. We, of
course, have no idea if Costco would have any interest in an
acquisition, but when you are in a three-horse race and you can
shoot one of the other two horses, it does tend to smack of moat
building.Of course we do not know how the FTC would feel,
and it might be cheaper to get rid of horse number three by just
continuing to cut prices. Also, I have no idea if the combination
would make business sense, but Costco does have all that cash, so it
does stir the curiosity a little.
Indeed the most intriguing question raised by
Costco's ability to build its cash is what they will do with it.
Clearly they could build stores a lot faster than they are
presently, a strategy that would likely to be more popular on Wall
Street, and garner a shot at a higher PE ratio. But currently they
seem content with their pace of building about 25 stores a year. A
third alternative for any excess cash, and my personal preference,
would be a share repurchase program. This would allow per share
earnings to grow faster than the bottom line.
Wal-Mart
Besides BJ's the only other player is Wal-Mart
with Sam's Club. Wal-Mart is bigger and they have more resources
than Costco, but they also have $24 billion in debt and capitalized
leases, so while their sales are about 6 times that of Costco, their
debt is 20 times that of Costco.Wal-Mart also has some tough decisions to make.
The Super Center business brings about 3.5% to the bottom line,
whereas the warehouse clubs are lucky to get 1.5% to 2.0%. So is
Wal-Mart going spend a lot of their capital building Sam's Clubs
when they can get a better return from Super Centers? Especially if
they think Sam's Clubs are cannibalizing their Super Center
business?
"Tahoma">Costco has not been a great investment for the
last three years, and it is starting to lose some of its following
on Wall Street. I probably would not be buying at today's prices,
but the value is getting better even with price moving sideways. And
if the bear returns, we might see prices that would provides a nice
margin of safety.