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Berkshire Hathaway
Thoughts on Costco

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By djman99
December 19, 2002

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I bought a very small amount of Costco at $28.50 ahead of the conference call. At $28.50 I was very hesitant about buying. I really like the company, it's just that at this price this is not exactly a fat pitch. What I want a more meaningful discount to intrinsic value. I was hoping that the conf call would be a disaster and that I would be given a chance to buy a healthy position at a truly attractive price. Alas it did not happen so I will hold onto my small position and see what happens.

I did a DCF analysis and I value COST at $32.50. So $28.50 is a marginal buy.

A few points:
1) I do not think any new competitors will be entering the warehouse club market. Only a masochist would want to start from scratch and try to get inside Costco's gross margins while bearing startup costs.

2) Sam's may be WMT's poor cousin but they are not going to stop expanding. I am in Ontario and Sam's recently announced that they are entering the market. Up until now COST has been the only warehouse in Canada -- they have 60 stores in the country. If COST had the same penetration in the US they would have twice as many US stores as they currently have. It will be interesting to see how Sam's does when trying to push into COST territory.

3) COST's ability to juice comps by rolling out ancillary services will drop. All of the low hanging fruit has already been picked. Pharmacy, optical, gas, food, photo, printing, hearing aids, even payroll processing. What else can they add? More furniture is possible, maybe furnaces and windows, expand automotive to include brakes and exhaust but I can't think of too much else. Maybe roll out some travel agencies to sell vacation packages. (Supposedly they already do some travel, but the 3 COSTCOs where I have been don't seem to have it.)

4) According to a TheStreet.com article 50% of American families belong to a warehouse club. I don't know if this is really true, but it is worrisome. A certain number of families will never join a club (they live in remote rural areas, have no money, hate big box stores etc). If the 50% figure is really true then it does seem like COST growth is starting to run out of runway.

5) COST will be expensing options, but until then subtract about $60 million from GAAP earnings.

6) Warehouses don't depreciate that fast compared to retailers with trendy decor, so I believe that COST is depreciating assets faster than the assets are actually losing value. Of course there are some infills and teardowns which minimize this effect.

7) Membership fee will probably go up five bucks in Q4 of 2004. I'm guessing it will be a 10 buck increase for executive members. This will drop right to the bottom line.

8) I'm not that worried about rising SG&A due to workers comp and health costs. WMT, Sams, Grocery stores and anybody else you can name will have the same problem. It's only an issue of COST shows rising SG&A while other are falling.

9) COST management is among the best. Still there is risk that once COST becomes a mature company and it is in the interest of shareholders to declare a dividend and slow expansion, there could be some empire building and ego gratification resulting in the creation of uneconomic stores. I know that CM is on the board, but it does happen and I will be watching for it. Nobody wants to admit that they no longer have a growth company.

11) As COST does become mature, FCF will rise. Pre-opening costs will drop and brand new stores which take a bit of time to become profitable will no longer be an issue.

12) Given FCF for 2002 of about $700m, I'm trying to predict growth in owner earnings over then next 15 years. Possible growth rates are 11, 11, 12 (membership fee increase), 11, 10.5, 10, 9.5, 9, 8.5, 8, 7.5, 7, 6.5, 6 , 5.5 for the next 15 year. I'm using 5% perpetual growth to calculate terminal value. My discount rate is fairly low (this isn't exactly a bio-tech startup) but my growth rates are probably too conservative.

dave


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