Investment Manager’s Letter May 2004
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:
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.
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|
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.
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.
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.
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?
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.