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A Stock for Dad represents the opinion of one Fool and in no way should be taken as the opinion of either the Motley Fool, Inc., the company in question or representative of anyone or anything else other than that specific Fool's thoughts.
Happy Father's Day, Dad. This year I've got an idea you might really like. Check out discount wholesaler Costco (Nasdaq: COST), the premier company in its business.
There are more than 320 Costco stores spread across 28 states, Canada, Mexico, the U.K. and Asia. Wheel one of its big shopping carts up and down the aisles. It's a harvest of savings. Sure it sells jewelry, computers, TVs, and wine, but for you -- since you like cooking -- you should check out the selection of meat and produce. I just bought an eight-pound pork loin at Costco for $2.05 per pound. I buy Hawaiian-grown Dole pineapples for $2.30 apiece, compared to $5 at my local supermarket. Costco is a lot more than five-pound jars of mayonnaise and spaghetti sauce.
It's worth taking some time to understand how Costco rewards shareholders. Like many big retailers, Costco has terrible margins so it relies on high volume. Its net margins are in the 1.5% range, which means it earns about $0.01 for every dollar of sales. But there are two ways to generate attractive returns for shareholders: high profit margins or high return on assets. The latter is basically a measure of how efficiently a company manages assets, and managing items like inventory and accounts receivable is critical for a retailer since most of what they own is tied up in current assets.
One component of asset efficiency is total asset turnover ratio (sales divided by average total assets), which measures how well a company turns assets into sales. Specifically, it tells an investor how much in sales is generated by each dollar of assets employed. A look at Costco's most recent 10-K shows a turnover ratio of $3.99, meaning it produced almost $4 in sales for every dollar of assets employed. That's well ahead of Wal-Mart, which generated an impressive $2.74. It's hard to find retailers that perform as well as these two giants.
Next up, let's talk cash. Cold, hard cash is what makes a business run, and Costco has grown its cash from operations 238% since 1995 -- an average annual growth rate of 36%. Better yet, cash flow growth has significantly outpaced net income growth and earnings per share. Since net income and earnings are widely influenced by accounting conventions and management estimates, and cash is just plain old cash, Fools like to see the green stuff growing faster than that lawn I never cut.
Here's a look at the numbers:
Year CFO Net Income* Diluted EPS
1999 $941 million $545 million $2.36
1998 $738 million $446 million $1.96
1997 $590 million $390 million $1.66
1996 $426 million $249 million $1.22
1995 $278 million $217 million $1.05
% Growth 238% 151% 125%
CFO: Cash Flow from Operations
* Excluding one-time charges and extraordinary items
Not only has cash growth outpaced net income and earnings, but the spread has increased, which means Costco has grown in profitability. In 1995, net income represented 78% of operating cash flow. By last year net income represented just 58% of cash flow.
However, It's not all good news. To be honest, Dad, I hope you had a better fiscal third quarter than Costco. As Whitney Tilson, a columnist who writes for the Fool's Boring Portfolio, recently pointed out, Costco's comparable-store sales growth and cash flow from operations took a turn for the worse. In Q2, cash flow from operations (CFO) dropped to $408 million from $424 million as changes in receivables and other liabilities took a bite out of cash inflows. Then in Q3, management guided investors to expect EPS growth in the 11% to 13% range, rather than the 15% it had targeted.
The changes throw a wrench in the works, but it's not unusual to see fluctuations in Costco's working capital accounts, or even to see CFO decline in a given quarter. In the second quarter of last year, CFO fell to $424 million from $434 million as inventories increased. By the next quarter inventories were back in line and cash flow zoomed to $644 million from $510 million a year earlier.
I'm not so worried about slightly slower earnings growth either since management recently said it could hit the 15% mark if it slowed new store openings, which would reduce expenses. As a long-term investor, I don't want to see a company managing earnings for Wall Street at the expense of future growth, and I'd give Costco's management a little slack since it has created so much value. From 1995 through 1999 its shares climbed an average of 56% annually. That kind of increase isn't sustainable, but all we're looking for is a market-beating return over the long haul, say 15% average annual price appreciation. As long as cash flow continues to increase rapidly and comparable-store sales growth doesn't slip below the 8% range forecast by management, I don't think you have to worry about slightly slower EPS growth.
Finally, the recent drop in the price of Costco's stock makes things very interesting. Costco trades at a forward P/E of around 23, way down from over 40 a few weeks ago. Right now it's priced as though it can grow earnings 12% annually for 20 years, discounted at 9%. That gives the company a net present value of $33.41 per share. The shares closed June 9 at $32.31, so it sold at a slight discount to that value.
Of course, discounted cash flow models are more art than science. You could argue it should be discounted at a higher rate, or that growth will drop below 12% long before the 20-year mark. In my opinion it's in the right ballpark.
But just to let you see the risk, Dad, let me show you how much success is priced into that model. There's not much margin of safety. It means Costco would be earning about $6 billion annually in 20 years. Wal-Mart, the world's largest retailer, earned $5.57 billion last year. So paying $33.41 per share for Costco means you're betting the company will be about as successful as Wal-Mart, a company with $165 billion in annual sales and over 3,000 stores. Is it a reach? What can I say, Dad, you're old enough to make your own decisions.
Have a great Father's Day.
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