[Editor's Note: The chart in this article was revised on 4/4/2002 to correct a math error.]
Whew! We've come a long way since we began retooling the Rule Maker Criteria in January! We're almost done, and today we'll finish up with some valuation work on Costco (Nasdaq: COST).
First, I'm going to show you the short cut I promised last week -- because there is this simple reality when evaluating public companies: You don't want anything to do with the vast majority of them. In fact, the whole Rule Maker construct itself is a short cut. You are limiting your focus from the outset to a universe of the biggest, most important companies, thus eliminating some 95% of the potential destinations for your investment dollars. And that's a good thing, because no one is physically capable of evaluating 9,000 different companies at the same time.
This short cut works pretty simply. We've got this report card, right? Well, you don't really have to fill the whole thing out in all instances. If you find one or two items about a company that are distasteful to you, stop and move on to the next company.
Let's use Yahoo! (Nasdaq: YHOO) as an example, which will also give you a good idea of one of the first transactions for the Rule Maker Portfolio. Yahoo! was not that long ago valued at well over $100 billion compared to today's $10 billion, and it has provided the Rule Maker with what can be euphemistically described as a nice future tax offset. But what we want to know today is whether this is a company we would buy (or not sell) today. To do so we start at the top and work our way down. I will describe each item superficially, because we've got other stuff to cover here.
Sustainable Competitive Advantage -- Yahoo! is still far and away the dominant real estate on the Internet, with one of the most recognized names. A company wanting to take this space from Yahoo! would have to expend enormous resources.
10-year Cash King Margin over 10% -- Yahoo! has not been public long enough to qualify. But it has produced positive free cash flow for each of the last three years, which is a good thing.
10 years of revenue growth -- Again, not enough time as a public company to qualify. Even so, its growth rate has been tremendous over the run of its time as a public company.
Consistent Profitability -- Nothing has been consistent about Yahoo! It is currently unprofitable.
Honest, Shareholder-centric Management -- Whatever else its management does, there is something I cannot get around -- and that is its ridiculous stock options program. At the end of 2001, more than 23% of the company's share float, 136 million shares, had been granted as options. In 2001 alone, the percentage was 10.5%. In 2000, it was 4.9% of the float, in 1999 7.3%. In 2001, of course, there were more than 26 million shares cancelled, but the net dilutive potential of options activity was well over 5%. To me, this is unacceptable for any investment.
So I'm finished with Yahoo! I found an item that was so egregious that I could simply eliminate the stock from consideration. What's my price target for Yahoo!? When I think its management gives a damn about shareholders, I'll consider taking a stab at that question. Next!
See? Short cut.
Back to Costco
At the end of last week we had determined that Costco had a pretty nifty economic model, a sterling balance sheet, and a sustainable competitive advantage, evidenced by the company's 85% annual member renewal rate. In an old Forbes article, Wesco (Amex: WSC) Chairman and Costco Board Member Charlie Munger had this to say about Costco: "It's hard to think of people who've done more in my lifetime to change the world of retailing for good, for added human happiness for the customer."
The issue in valuing Costco centers around the fact that, though it currently earns more than $1.3 billion a year in operating cash flow, it is plowing all of it back into the company to open new outlets. So, we're trying to do a discounted cash flow on a company that has none. How to work around this? As a rough cut -- since it is a company we have vetted as being a stable, dominant player in its market -- we look at the components of the capital expenditures and remove what is discretionary. Costco's last 10-K shows that it used about $1 billion in fiscal 2001 to open new stores, which means that, of the total net $1.337 billion in capital expenditures, only $337 million was non-discretionary. If the company grows at its average 10-year rate of 9%, the operating cash flows for 2002 will be approximately $1.12 billion, with a non-discretionary amount of $367 million, for a total amount of adjusted free cash flow of $753 million.
What we do from here is project growth. Your role is to determine in advance what rate of growth you demand from a Costco investment to compensate you for the risk of holding it. I will pick the S&P 500's long-term growth rate of 11% -- but if the company's cash flow were less stable, my rate of expected return would increase.
And so we have the following:
($ in millions) OCF-NDCapEx Growth Rate Discount NPV Base Yr $753 9% 11% $753 (not added in) 1 $820 9% 11% $739 2 $894 9% 11% $726 3 $975 9% 11% $713 4 $1062 9% 11% $700 5 $1158 9% 11% $687 6 $1262 9% 11% $675 7 $1376 9% 11% $663 8 $1500 9% 11% $651 9 $1635 9% 11% $639 10 $1782 9% 11% $627
Add to this the terminal value, which I will assign as the 10th year Adjusted FCF amount of $1.782 billion with a multiple of 20x, then again discounted back to today. The present value of this amount is $12.556 billion. Add this to the total Net Present Value (NPV) for the first 10 years, and you get a total implied value for Costco of $19.378 billion. Costco's current total market cap is $17.686 billion, which means that the current value of Costco is a slight discount to these assumptions.
I will discuss this in more detail over the coming week on the Rule Maker Strategy discussion board. Be sure to come over!
Bill Mann, TMFOtter on the Fool Discussion Boards