Portfolio manager’s Letter July 2003
Costco released their earnings for the third Quarter of 2003 last week, and they were good but not spectacular. Net was $1.02 per share, up 6.4% from $.96 last year. Sales increased 9.0%, not great, but pretty good for a period that included the latest Gulf war and was a disaster for a lot of retailers.
But a quick look beneath the surface shows fun things are happening under the covers. For instance, the Costco’s companies total reported earnings for the period was $481.5 million; this is about the same as the net increase in cash as shown on the Balance Sheet ($483.9 million). Total cash on hand at the end of the period was $1.289 billion or about the same as the companies total debt level.
That’s interesting. How did they manage that?
Elsewhere in the report we see that Costco opened 33 new stores so far this year, and that those stores cost $608 million. So how do they add an amount larger than after tax earnings to the cash line on the balance sheet and pay for new 33 stores? Maybe they borrowed the money? But, a check of the balance sheet shows that they actually paid off debt in the period, to the tune of $25 million.
The secret of course is cash flow, and Costco has a little extra magic when it comes to cash flow. The cash flow statement lists total net cash provided by operating activities of $1,076 million up 26% from $850 last year. I like that number a lot better, but you have to be careful with cash flow it can be like pre-forma earnings or EBITDA. But Costco has Charlie Munger (I’m an old man, I’m already Rich and I don’t like to be nervous) on the board and we all know how Charlie Munger feels about optimistic accounting.
$37.4 million of the increase in cash flow came from an increase in depreciation, 28.9 million from the increase in after tax income, and $30.7 million from deferred taxes. The balance or 129.5 millions comes from float like items (cost-free cash they hold but do not own).
Costco gets float from their Vendors who deliver goods before they receive payment and from customers in the form of membership fees and sales rewards. The largest item in this category is from accounts receivable. Because Costco turns its inventory so rapidly (8.7 times in the 36 week period). Costco sell their inventory and receive the cash from the customer before they have to pay the vendor. (Usually 30 days).
This means that as Costco opens new stores they generate a positive cash flow from their vendors and their customers. Nice trick, this. And it is something that other retailers can only dream about. Costco turns their merchandise 12.1 times last year, versus 10.5 times at BJ’s, and much slower rate at other traditional retailers.
In the first 38 weeks Costco’s generated $84,9 million in cash flow from this inventory build up. In addition Costco generated 44 million of increased float from member fees which are recorded as a liability when paid, and then prorated as income over the term of the membership, and the two per cent reward credit that is given to executive members. This charge is deducted from revenue when the sale is completed, but is not credited back to the customer until the end of the year.
I do not know exactly how to figure Costco owner earnings, but I would pick a number that is bigger than earnings per share because the $482 million is in the bank, 33 stores have been built, and debt was paid down. Nine of these stores were replacements of existing facilities, but that leaves us with 24 net, new stores, a pace of construction that will not provide spectacular growth, should provide substantial consistent and sustainable growth for quite a few years, and at the same time leave substantial fee cash flow to buy back stock, pay a dividend or (God Forbid) make acquisitions.
The second Quarter has ended on a positive note with the composite for all Losch Management Company’s accounts up 12.21% for the first half, vs. a gain of 10.7% for the S&P 500. For the last three years our company’s composite has shown a positive return of 15.82% per year, compared to a negative 12.50% per year for the S&P 500. For a difference 28.32% per year in our favor, three years ago I would have said that level of out performance was impossible over a period of three years. It turns out that this record was not only possible, but fairly easy; all you had to do to out-perform the averages was to avoid the obvious mistakes.
While I am happy with this record, it is more a reflection of the extreme over valuation in some sectors of the market three years ag While I am happy with this record, it is more a reflection of the extreme over valuation in some sectors of the market three years ago. Than any sort of stock picking genius. Indeed our record would have been even better if were not for my prejudice against paying taxes. My decision to sit on some of our overvalued positions in Home Depot and Charles Schwab in order to avoid huge tax penalties has turned out to be a false economy. Our record now, would be better if we had taken our punishment then.
The current market looks to me like cyclical (short term) bull market within a secular (long term) bear market. How long this bull will continue is anybody’s guess, but we would like to get as much mileage as I can from the rally. The problem is, I never been much good at picking market tops, and therefore tend to exit early. So it will not take much to scare me out of some of our long positions.
One thing that I am reasonably sure of is that interest rates cannot get much lower, and it is this belief that is behind the recent purchases of the Rydex Juno fund. This fund is designed to move in the opposite direction of long term government bonds. In other words if interest rates start to increase the price of the fund will go up. Granted interest rates are just about as hard to predict as the direction of the stock market.
The thing that I like about this trade is that there appears to be limited down side risk. Short term interest rates can only go down to zero, and even in a depression it is not likely long term rates would go below 2.5%. On the other hand there is lots of room for them to move higher.