Costco Wholesale Corporation - Zacks Investment Research

January 15, 2015

Costco Wholesale Corporation

(COST-NASDAQ)

Current Recommendation Prior Recommendation Date of Last Change

Current Price (01/14/15) Target Price

NEUTRAL

Outperform 12/07/2009

$139.31 $146.00

SUMMARY DATA

52-Week High 52-Week Low One-Year Return (%) Beta Average Daily Volume (sh)

Shares Outstanding (mil) Market Capitalization ($mil) Short Interest Ratio (days) Institutional Ownership (%) Insider Ownership (%)

$145.56 $110.18

20.87 0.52

1,757,821

441 $61,367

1.88 73 1

Annual Cash Dividend Dividend Yield (%)

5-Yr. Historical Growth Rates Sales (%) Earnings Per Share (%) Dividend (%)

$1.42 1.02

9.7 13.3 14.7

P/E using TTM EPS

28.9

P/E using 2015 Estimate

26.9

P/E using 2016 Estimate

24.5

Zacks Rank *: Short Term 1 3 months outlook

* Definition / Disclosure on last page

3 - Hold

? 2014 Zacks Investment Research, All Rights reserved.

SUMMARY

Costco continues to be a dominant retail wholesaler based on the breadth and quality of the merchandises it offers. Having delivered consistent comps growth, it is well positioned in the warehouse club industry. Costco s first-quarter fiscal 2015 results also hint the same, wherein top-line grew 7.4% to $26,866 million, and also came ahead of the Zacks Consensus Estimate. The quarterly earnings came in at $1.12 per share outperforming the Zacks Consensus Estimate by 2.8% and surging 16.7% from the prior-year period. This is the second consecutive quarter that the company has registered positive earnings surprise, after witnessing four consecutive quarters of earnings miss. However, we remain apprehensive if the company adopts aggressive pricing to counter competition, gain market share and drive traffic, as this may depress margins. Currently, we stay Neutral on the stock.

Risk Level *

Type of Stock Industry Zacks Industry Rank *

Low,

Large-Growth Retail-Discount

61 out of 267

ZACKS CONSENSUS ESTIMATES

Revenue Estimates

(In millions of $)

Q1

Q2

(Nov)

(Feb)

2013 2014 2015 2016

23,715 A 25,017 A 26,866 A 29,207 E

24,871 A 26,306 A 27,993 E

Q3 (May)

24,083 A 25,794 A 27,295 E

Q4 (Aug)

32,487 A 35,523 A 37,607 E

Year (Aug)

105,156 A 112,640 A 119,761 E 129,988 E

Earnings Per Share Estimates

(EPS is operating earnings before non-recurring items, but including employee stock options expenses)

Q1

Q2

Q3

Q4

Year

(Nov)

(Feb)

(May)

(Aug)

(Aug)

2013

$0.95 A

$1.10 A

$1.04 A

$1.40 A

2014

$0.96 A

$1.05 A

$1.07 A

$1.58 A

2015

$1.12 A

$1.18 E

$1.18 E

$1.70 E

2016

$1.22 E

The quarterly figures may not add up to annuals due to rounding off.

Projected EPS Growth - Next 5 Years %

$4.49 A $4.65 A $5.18 E $5.68 E

11



10 S. Riverside Plaza, Chicago IL 60606

OVERVIEW

Based in Issaquah, Washington, Costco Wholesale Corporation, (formerly Costco Companies Inc.) sells high volumes of foods, and general merchandise (including household products and appliances) at discounted prices through membership warehouses. It is the largest warehouse club operator in the U.S. The company s warehouses offer an array of low-priced nationally branded and select private labeled products in a wide range of merchandise categories. Costco offers three types of memberships to its customers: Business, Gold Star (individual), and Executive.

As of January 8, 2014, Costco operates 671 warehouses, comprising 474 warehouses in the United States and Puerto Rico, 88 in Canada, 34 in Mexico, 26 in the United Kingdom, 20 in Japan, 11 in Korea, 10 in Taiwan, 7 in Australia and 1 in Spain.

Costco generates revenue from two sources: 1) Store sales and 2) Membership fees and other revenue (MFI). Store sales accounted for 98% of fiscal 2014 revenue with MFI represented the remaining 2%.

Costco offers myriad varieties of food products as well as a vast range of household and lifestyle products, stationeries and appliances. The company also sells gasoline to customers at cheap prices. The company s products are classified under six broad merchandise categories, namely, 1) Sundries (including candy, snack foods, tobacco, alcoholic and nonalcoholic beverages), 2) Hardlines (including major appliances, electronics, health and beauty aids, hardware, office supplies), 3) Food (including dry and institutionally packaged foods), 4) Softlines (including apparel, domestics, jewelry, housewares, media, home furnishings, cameras), 5) Fresh Food (including meat, bakery, deli and produce) and 6) Ancillary and Other (including gas stations, pharmacy, food court, optical, one-hour photo, hearing aid and travel).

REASONS TO BUY

A Dominant Warehouse Retailer: We believe that Costco continues to be a dominant retail wholesaler based on its breadth and quality of merchandise offered. The company s strategy to sell products at heavily discounted prices has helped it to remain on a growth track as cash-strapped customers continue to reckon Costco as a viable option for low-cost necessities. Having continued to deliver consistent comparable-store sales growth, Costco is strongly positioned in the warehouse club industry. A differentiated product range enables Costco to provide an upscale shopping experience for its members, resulting in market share gains and higher sales per square foot. Moreover, the company continues to maintain healthy membership renewal rate. The company is also gradually expanding its E-commerce capabilities in the U.S., Canada, U.K. and Mexico. Ecommerce sales increased 20%, while comps grew 19% during first-quarter fiscal 2015.

Maximize Shareholders Return: Costco continues to make prudent use of its healthy free cash flow through share repurchases and dividend payments. This underlines its efforts to maximize shareholders return under trying economic conditions. Moreover, the company s current cash resources are reasonably adequate to support expenditures associated with its ongoing expansion initiatives.

Concentrating on Enhancing Global Footprint: We are also encouraged by the company s expansion strategy. Costco has one of the highest square footage growth in the industry and remains committed to opening new clubs in the domestic and international markets. The company opened 30 new locations in fiscal 2014, and plans to open nearly 31 new outlets in fiscal 2015. In our view, the company s diversification strategy is a natural hedge against risks that may arise in specific markets.

Equity Research

COST | Page 2

International comparable-store sales, excluding the effect of gasoline prices and fluctuation in foreign currencies rate, are growing at a healthy pace as evident from a 7% growth registered in first-quarter fiscal 2015.

REASONS TO SELL

Stiff Competition May Strain Margins: Costco faces stiff competition from BJ s Wholesale Club and Sam s Club, a division of Wal-Mart Stores. These two rivals follow similar business models as they market high volumes of merchandise at low prices in a membership-only warehouse clubs. Sam s Club, in particular, poses the biggest threat to Costco as both primarily target professionals and small-business owners who typically make bulk purchases.

Cannibalization a Threat: Another concern is Costco s over-expansion in new domestic markets, which invites the threat of cannibalization of existing stores. Moreover, club launches in new markets entail significant capital investments and promotional expenses which tend to strain margins.

Macroeconomic Headwinds: The company s customers are very sensitive to macroeconomic factors including interest rate hikes, increase in fuel and energy costs, sluggishness in the housing market, unemployment levels, and high household debt levels, which may affect their spending levels. Moreover, due to exposure to international markets, Costco remains prone to currency fluctuations. The strong U.S. dollar may adversely affect the top and bottom-line results.

RECENT NEWS

Costco Comparable-Store Sales for December Top Estimates January 8, 2015

Costco Wholesale Corporation posted its comparable-store sales results for the five weeks ended Jan 4, 2015 that fared better than analysts' expectations. The warehouse retailer announced comps growth of 3%, reflecting an increase of 5% at its U.S. locations but a decline of 1% at international locations.

Excluding the effect of deflation in gasoline prices and the impact of foreign currency fluctuations, Costco s comps for Dec 2014 rose 8%, reflecting an equivalent increase across its U.S. locations and international outlets.

Comps for the 18-week period increased 4%, buoyed by a 6% rise at its U.S. locations. Comps at international locations remained flat. Excluding the effect of gasoline prices and foreign currency fluctuations, comps for the period jumped 7%, reflecting an equivalent increase across its U.S. and international locations.

Costco s total net sales for December grew 5% to $12.12 billion from $11.53 billion in the year-ago period. Net sales for the 18-week period increased 7% to $40.85 billion from $38.33 billion in the prioryear period.

Equity Research

COST | Page 3

Costco Q1 Earnings Beat on Comps Growth, Revenues Rise December 10, 2014

Costco Wholesale Corporation commenced fiscal 2015 on a strong note, delivering better-than-expected first-quarter results. The company posted earnings of $1.12 per share that surpassed the Zacks Consensus Estimate of $1.09 and rose 16.7% from $0.96 reported in the prior-year period. Impressive comparable-store sales (comps) performance aided bottom-line growth.

Let s Unveil Further

The warehouse retailer s total revenue, which includes net sales and membership fee, climbed 7.4% to $26,866 million from the prior-year quarter, and came ahead of the Zacks Consensus Estimate of $26,831 million. Quarterly net sales rose 7.4% year over year to $26,284 million, whereas membership fee increased 6% to $582 million.

Costco s comps for the quarter increased 5%, buoyed by an increase of 6% at the U.S. locations and 1% at international outlets. In the year-ago quarter, the company delivered comps growth of 3%.

Excluding the effect of lower gasoline prices and foreign currencies, the company witnessed comps growth of 7%, with U.S. and international comps registering an equivalent percentage increase.

Costco s operating income rose 15.3% year over year to $770 million, whereas operating margin (as a percentage of total revenue) expanded 20 basis points to 2.9%.

Financial Aspects

Costco ended the quarter with cash and cash equivalents of $5,969 million and long-term debt of $5,034 million. The company s shareholders equity was $12,359 million, excluding non-controlling interests of $211 million.

Capital expenditures for the first quarter were $555 million. Management now anticipates fiscal 2015 capital expenditures to be in the $2.5 billion plus range.

Costco repurchased shares worth about $18 million at a price of $126.43 per share during the quarter.

Store Update

Costco currently operates 671 warehouses, comprising 474 warehouses in the United States and Puerto Rico, 88 in Canada, 34 in Mexico, 26 in the United Kingdom, 20 in Japan, 11 in Korea, 10 in Taiwan, 7 in Australia and 1 in Spain.

During the first quarter, the company opened 8 outlets, including 6 in the U.S., 1 each in Australia and Mexico. The company also relocated one location in Wayne, New Jersey to an expanded location.

The company has no store opening plan for the second quarter. However, management stated that during fiscal 2015 it plans to open 31 new outlets, of which 18 will be in the U.S., 3 each in Japan and Mexico, 2 each in Australia and Korea, and 1 each in Canada, U.K. and Taiwan.

Equity Research

COST | Page 4

VALUATION

Costco s current trailing 12-month earnings multiple is 28.9X compared with 40.6X for the industry average and 18.6X for the S&P 500. Over the last five years, Costco s shares have traded in a wide range of 19.2X to 29.5X trailing 12-month earnings. The stock is also trading at a premium to its peer group based on forward earnings estimate. Our target price of $146.00, 28.2X 2015 EPS, reflects this view.

Key Indicators

Costco Wholesale Corporation (COST)

P/E F1

26.9

P/E F2

24.5

Est. 5-Yr EPS Gr%

11.4

P/CF (TTM)

20.0

P/E (TTM)

28.9

P/E 5-Yr High (TTM)

29.5

Industry Average S&P 500

25.6 21.5

13.7

16.1 15.1

10.7

25.5 40.6 187.4 15.9 18.6 19.4

Target Corp (TGT)

23.4 19.6

9.1

9.6 22.9 22.9

Sears Holdings Corporation (SHLD)

115.7

716.4

TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow

P/E 5-Yr Low (TTM)

19.2

14.8 12.0

11.4 20.1

Costco Wholesale Corporation (COST)

Industry Average S&P 500

P/B Last Qtr.

5.0

P/B 5-Yr High

5.0

P/B 5-Yr Low

2.2

ROE (TTM)

17.4

D/E Last Qtr.

0.4

Div Yield Last Qtr.

1.0

EV/EBITDA (TTM)

13.7

6.2

6.2

6.2

8.4

1.2

0.7

50.3

5.1

9.8

3.2

24.8

2.0

Equity Research

COST | Page 5

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