Philippine Markets Daily

Charging customers to get through this wholesale retailer’s stores is how it amassed a loyal following and Uniform ROAs of 10%+

June 3, 2021

Subscription-based business models, while commonly used by software companies, can be adopted by companies in other industries as well.

This wholesale retail giant, for example, was able to amass loyal customers through its membership program, which gives them access to the company’s wide range of discounted products plus other perks and services.

However, looking at as-reported metrics, it appears that this business model has only generated muted profitability over the past decade. In reality, Uniform Accounting displays its true earning power, with returns that have expanded to new highs.

Also below, Uniform Accounting Embedded Expectations Analysis and the Uniform Accounting Performance and Valuation Tearsheet for the company.

Philippine Markets Daily:
Thursday Uniform Earnings Tearsheets – Global Focus
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Previously, we talked about the retail industry’s change in landscape with the rise of e-commerce. However, even as consumers gravitate towards online shopping, certain brick-and-mortar retailers like Dollar Tree (DLTR:USA) have thrived due to their unique business model.

Another discount retailer that has been immune to the online retail revolution is Costco Wholesale Corporation (COST:USA).

While Dollar Tree specializes as a dollar store, Costco is a wholesale retailer known for its membership-only business model.

This business model is similar to the Software-as-a-Service (SaaS) model. To recap, the SaaS model is basically a rental service where the user periodically pays for the authorization to use a software. It’s used by some of the biggest tech companies such as Adobe (ADBE) and Atlassian (TEAM).

However, these types of subscription-based models aren’t strictly exclusive to software companies. Gaming companies such as Activision Blizzard (ATVI) have adopted this model as well, and now, Costco.

Specifically, Costco offers a basic or executive membership plan for consumers and businesses, which costs $60 and $120 per year, respectively.

With subscription-based models, businesses will likely be able to reduce volatility in their revenues and enjoy customer loyalty, mostly because they’re essentially tied to the company’s product for a set period—Costco gets these benefits.

The company’s fee of just $60 per year (or $5 per month) provides a barrier of entry that’s low enough for customers to pay regardless of whether or not they’ll regularly use it.

Furthermore, while the membership gets their customers’ foot through the door, Costco’s wholesale products are what keeps them in. Members, especially families, enjoy shopping in Costco stores because they sell their merchandise in bulk quantities, and more importantly, at discounted prices.

Costco has a wide range of products, from high-quality food to appliances to brand-name merchandise. The company also offers its own label, Kirkland Signature, to its customers, which produces a variety of segments grocery items, organic food, hardware, and health products, among others.

Currently, Costco has more than 800 warehouses worldwide and about 105 million memberships, reaching a renewal rate of 91% in the US and Canada and 88% worldwide at the end of 2020.

The company continues to enjoy a loyal following because, other than everyday grocery products, members are also entitled to the different services that Costco offers. Members not only have access to Costco’s stores, but also to its pharmacy, gasoline stations, photo center, car rentals, and even insurance.

Even as the company has recently been enhancing its e-commerce platform, thanks to its membership (that customers will likely use so it doesn’t go to waste), plus its discounted bulk products and additional services, members continue to shop in its brick-and-mortar stores.

That said, it would appear that Costco’s multi-million membership model has just been generating stagnant returns at best, with return on assets (ROA) that have sustained 5%-8% levels annually.

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In reality, Costco’s profitability and growth are more accurately portrayed by Uniform Accounting, with Uniform ROA improving to a peak of 14% in 2020. This shows just how effective its business model is, especially combined with the perks that come with it.

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What as-reported metrics fail to consider is how current liabilities are factored into the ROA calculation. Traditional ROA calculations for measuring a firm’s earning power only include current and long-term assets as part of the cost of investment.

However, a company’s ability to receive goods and services in advance of payments—the current operating liabilities—ought to be factored in as well.

Current liabilities (excluding short-term debt) are necessary for operations. Items such as accounts payable, accrued expenses, and others are used to maintain the firm’s current capital position. On the other hand, long-term liabilities are mostly just used to finance the business.

If a company has a ton of cash to service its current liabilities and we only factor in its cash, it would make the company look inefficient. In reality, the company is just being responsible by building liquid assets to meet short-term obligations.

As such, net working capital (current assets minus current liabilities) is used for the firm’s ROA calculation. This shows a company’s real cash management ability and thereby, its true earning power.

In the case of Costco, as-reported metrics’ asset base for ROA calculation is at $55.6 billion in 2020, leading to an 8% as-reported ROA.

However, when subtracting current operating liabilities and applying other needed adjustments, we arrive at Costco’s $40 billion Uniform assets, resulting in a 14% Uniform ROA.

Costco’s earning power is actually more robust than you think it is

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As-reported metrics distort the market’s perception of the firm’s recent profitability. If you were to just look at as-reported ROA, you would think the company is a much weaker business than real economic metrics highlight.

Costco’s Uniform ROA has actually been higher than its as-reported ROA in the past sixteen years. For example, Uniform ROA was at 14% in 2020, while as-reported ROA was only at 8%.

Specifically, Costco’s as-reported ROA has ranged from only 5%-8% in the past sixteen years while Uniform ROA has ranged from 7%-14% levels in the same timeframe.

Uniform ROA maintained 9%-11% levels from 2005 to 2019, excluding 7% and 12% outliers in 2009 and 2019, respectively, before expanding to a peak of 14% in 2020.

Costco’s Uniform earnings margin is weaker than you think, but its Uniform asset turns make up for it

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Trends in Uniform ROA have been driven primarily by incremental improvements in Uniform earnings margin, coupled with stable Uniform asset turns.

From 2005 to 2020, Uniform margins gradually improved from 2% to 3%. Meanwhile, Uniform turns have ranged from 4.8x-5.4x levels since 2005 and currently sits at the high end of that range.

At current levels, the market is pricing in expectations for both Uniform margins and Uniform turns to reach new peaks.

SUMMARY and Costco Wholesale Corporation Tearsheet

As the Uniform Accounting tearsheet for Costco Wholesale Corporation (COST:USA) highlights, the Uniform P/E trades at 33.3x, which is above the global corporate average of 23.7x but around its historical Uniform P/E of 32.4x.

High P/Es require high EPS growth to sustain them. In the case of Costco, the company has recently shown a 27% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that provide very poor guidance or insight in general. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Costco’s Wall Street analyst-driven forecast is an 18% and 6% EPS growth in 2021 and 2022, respectively.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Costco’s $378 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to grow by 14% annually over the next three years. What Wall Street analysts expect for Costco’s earnings growth is above what the current stock market valuation requires in 2021 but below its requirement in 2022.

Furthermore, the company’s earning power is 2x the corporate average. Also, cash flows and cash on hand are about 3.5x higher than its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals a low credit and dividend risk.

To conclude, Costco’s Uniform earnings growth is in line with its peer averages, and the company is trading above average peer valuations.

About the Philippine Market Daily
“Thursday Uniform Earnings Tearsheets – Global Focus”

Some of the world’s greatest investors learned from the Father of Value Investing or have learned to follow his investment philosophy very closely. That pioneer of value investing is Professor Benjamin Graham. His followers:

Warren Buffett and Charles Munger of Berkshire Hathaway; Shelby C. Davis of Davis Funds; Marty Whitman of Third Avenue Value Fund; Jean-Marie Eveillard of First Eagle; Mitch Julis of Canyon Capital; just to name a few.

Each of these great investors studied security analysis and valuation, applying this methodology to manage their multi-billion dollar portfolios. They did this without relying on as-reported numbers.

Uniform Adjusted Financial Reporting Standards (UAFRS or Uniform Accounting) is an answer to the many inconsistencies present in GAAP and IFRS, as well as in PFRS.

Under UAFRS, each company’s financial statements are rebuilt under a consistent set of rules, resulting in an apples-to-apples comparison. Resulting UAFRS-based earnings, assets, debts, cash flows from operations, investing, and financing, and other key elements become the basis for more reliable financial statement analysis.

Every Thursday, we focus on one multinational company that’s particularly interesting from a UAFRS vs as-reported standpoint. We highlight one adjustment that illustrates why the as-reported numbers are unreliable.

This way, we gain a better understanding of the factors driving a particular stock’s returns, and whether or not the firm’s true profitability is reflected in its current valuations.

Hope you’ve found this week’s Uniform earnings tearsheet on a multinational company interesting and insightful.

Stay tuned for next week’s multinational company highlight!

Regards,

Angelica Lim
Research Director
Philippine Markets Daily
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