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Roark, Question in Aisle 4

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By EightTrack2
July 14, 2005

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Apologies in advance for separating the Costco stock valuation aisle from the ketchup, dog food, hand soap, and toilet paper (which is located in the back of the store, sir).

Roark, I follow your math, but I don't follow your logic. What's wrong with my thinking? Basically, my disagreement/confusion references the differences between the aggressive financial behavior implicit in your COST economic modeling, and COST's actual very conservative approach.

(Of course, I would appreciate other comments besides any insights HR chooses to offer on this matter.)

Here are your two posts re COST economic returns:

http://boards.fool.com/Message.asp?mid=22738903

http://boards.fool.com/Message.asp?mid=22740971

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For example, Costco ended August 04 with $7.6b in equity and $1.3b in long-term debt, for roughly $9b in invested capital. It should do something more than $1.5b in EBIT this fiscal year, which should produce maybe a billion in NOPAT. Nothing special at 11%.

Okay, I follow the math and follow the logic. So far, mi comprehendo.

But it began the year with an amazing $3 billion in cash (and the interest is not included in NOPAT numbers, assuming I've gotten them right). Separate that cash that out, and suddenly Costco is investing only $6 billion of capital and producing $1 billion of NOPAT for a 16.7% return.

Costco ended FY04 in August with cash and cash equivalents representing 6.5% of their 04 annual sales. I understand the shortcut you made, for the purpose of illustration, to apply all the cash as a reduction in invested capital.

Clearly, COST has excess cash ... but how much and how should one treat it for the purposes of a ROIC calculation?

From FY1998 through FY2002, Costco's cash and equivalents ran about 2% of the year's sales ... +/- .25%. In 2003 it spiked to 3.63% and in 2004 it spiked to 6.5%.

I would suggest that at least 50% of that excess cash should be seen as permanent capital for the purposes of ROIC.

At the quarter ending May 05, COST had a cash balance of $4.05 billion. Of that balance, $626m consists of debit/credit card payment from the weekend sales prior to the quarter's end ... a little over 1% of COST's FY05 run rate. That's probably the absolute bare minimum cash needs for COST. 2% of sales may be a more acceptable number("1 week/52 weeks"), but with conservative COST, why not 3%?

COST has a $500m stock buyback program from Nov 2001, which was extended in 2004 (at that point, never utilized) up through Nov 2007. Although they purchased $47m in shares from May to June this year, combine it with a $55m quarterly dividend (recently raised), and it's difficult to see how COST can shrink that cash balance dramatically ... unless they expand operations dramatically, finish that 3 year $500m buyback program soon (and start and finish another soon), or boost the dividend big-time.

In fact cash could still be building up for the next few years (putting aside any possibility of a MSFT-style one-time dividend). Behavior in the out-years has to be dramatic to outweigh a decent discount rate in a DCF model, so ...

I'm confused. How should we treat excess cash? It seems a waste to apply a simple mullet haircut to every scalp if one has some barbering skills.

Then you have the fact that Costco owns both the land and building roughly 80% of its locations. This naturally depresses return on capital as real estate cap rates are going to be below excellent-business returns. If we assume that Costco could lease its stores like the majority of retailers and pay 8% or so, then return on capital for the core business would look a lot better than the 16.7% listed above.

Again, I follow the math but don't follow the reasoning.

True, Costco could lease it stores from third party REITs or other real estate investors. But they choose not to. Shouldn't we penalize or reward COST for their actual capital management?

Moreover, isn't COST (and others) paying 8% on store leases because their lessor is achieving acceptable cash-on-cash returns by owning a warehouse within a 65-75% LTV (loan to value) loan structure? Costco is doing the opposite (low debt, high equity) ... which is their choice.

Even if they engage in operating leases for more than 90+ of their 400+ warehouses, or conducted a sale-leaseback, such options would have left/will leave COST lots more cash on the balance sheet. So the problem returns ... and Costco's inability to reinvest cash quick enough in the business to prevent excess billions will be made even worse.

I have the same conundrum with ROIC calculations for ITT Tech (ESI). They own a lot of their schools, which depresses their return on capital. They've chosen at times to buy existing schools or construct new ones rather than purchase expensive stock, start a dividend, or grow the company faster. Really, they only seem capable of opening up X amount of schools in a given year ... at least successfully.

Perhaps COST has the same management limitations. I could absolutely plug in assumptions that management behavior will change and they will Lampert their balance sheet ... but they won't.

Well, all of this is a long-winded way of saying, "Huh"? As small passive investors, we can only react to management or try to predict their actions. I know in the case of Costco splitting the real estate and excess cash apple in half doesn't make a huge difference in their ROIC, but I'm really interesting in the logic of where, why and when to split the apple. There's no takeover prospect or management change on the horizon to provide a quick improvement to capital utilization.

Plus, my family left the country on vacation and I'm bored with Google Earth. I'm working and they're spending. Be a kind soul and help poor EightTrack make more money.

ET


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