Fluent Essays

our task is to develop a detailed Financial Statement Analysis for Costco Wholesale in the year provided in the case FY2001. You should include the following components in your analysis: Brief description of the company (Costco), its market, its competitors and its strategy. Analyze Costco’s Income Statement and Balance Sheet. Discuss any trends that emerged from 1997 to 2001 (see Exhibits 5 and 9). Analyze Costco’s financial ratios. Assess the company’s financial performance in regards to its profitability and financial risk (see Exhibits 10 and 11). Briefly compare Costco’s financial statements with the main competitor’s financial statements (see Exhibits 6, 7, 8, and 11). What are Costco’s strengths and weaknesses compared to the competition? Based on your analysis, provide a forecast for the company’s financial performance in the upcoming five years (in very broad terms). Focus on the company’s future profitability and potential future financial risks. Also discuss how Corporate Social Responsibility (CSR) initiatives may help Costco to achieve its financial goals. Format of Paper: There is no strict minimum or maximum length. The majority of well-structured Financial Statement Analyses in the past were about 3 pages long. - Font size 12. Single-spaced. Font type: Times New Roman. CASE: A-186A DATE: 06/19/03 Brian Tayan prepared this case under the supervision of Professor Maureen McNichols as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 2003 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: [email protected] or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –– electronic, mechanical, photocopying, recording, or otherwise –– without the permission of the Stanford Graduate School of Business. COSTCO WHOLESALE CORPORATION FINANCIAL STATEMENT ANALYSIS (A) INTRODUCTION Margarita Torres first purchased shares in Costco Wholesale Corporation in 1997 as part of her personal investment portfolio. Between 1997 and 2002, she added slightly to her holdings from time to time when the company sold stock for what she felt was a reasonable valuation, and up to that time she did not sell any of her shares. Having watched Costco grow from 265 warehouses to 365 worldwide, and from sales revenue of $21.8 billion to $34.1 billion, she wondered what factors led to such successful growth. She also wanted to determine whether those factors would hold consistent going forward. At this point, Costco was one of a special breed of retailers called wholesale clubs. Unlike other retailers, wholesale clubs required that customers purchase annual memberships in order to shop at their stores. Costco operated a chain of warehouses that sold food and general merchandise at large discounts to member customers. The company was able to maintain low margins by selling items in bulk, keeping operating expenses to a minimum, and turning inventory over rapidly. Costco’s closest competitors were SAM’S Club (a division of Wal-Mart) and BJ’s Wholesale, which both operated as wholesale clubs. Other competitors included general discounters (such as Wal-Mart), general retailers (such as Sears), grocery store chains (such as Safeway), and specialty discounters (such as Best Buy). Torres first considered investing in Costco because she herself was a member. She was impressed by the company’s low prices and noticed in particular that her local Costco was always crowded. She decided to research the company and started, as always, with their annual reports. She discovered a company with tremendous growth potential, strong operational efficiency, and a dedicated management team – and a stock selling at a reasonable price. Now, in July 2002, having profited well from her investment, she decided it was time to update her analysis and determine whether the company was still operating efficiently. For the exclusive use of L. Zhang, 2021. This document is authorized for use only by Lyuliang Zhang in Accounting and Financial Reporting-Fall21 taught by SEB DEMIRKAN, Johns Hopkins University from Sep 2021 to Oct 2021. Costco Wholesale Corp.: Financial Statement Analysis (A) A-186A p. 2 INDUSTRY OVERVIEW – RETAIL Department Stores The retail industry in the United States was transformed in the late 1800s by the rise of department stores and general merchants. Companies such as R.H. Macy & Company (founded in 1858) and Bloomingdale Brothers, Inc. (1872) opened stores in New York City and subsequently began to expand across the country. Department stores became famous not only as places to shop, but also as destinations for the new pastime of window-shopping. These stores revolutionized retailing by offering a variety of products in one location and by developing a reputation for excellent customer service. Other innovations included free delivery of purchases and the ability for customers to make purchases using store credit. The most dominant department store for most of the 20th century was Sears, Roebuck and Company. Founded in 1893 as a mail-order company, Sears opened its first retail store in 1925. By 1945, Sears achieved $1 billion in sales. Throughout the 1950s and 1960s, the company expanded aggressively across the country, selling everything from clothing to appliances to televisions and home repair items. Trying to find success in ventures beyond retailing, the company had owned at one point Allstate Insurance (home, life and auto insurance), Coldwell Banker (real estate broker), and Dean Witter Reynolds (stock brokerage). Sears also launched the Discover credit card. From the mid-1970s through 2002, however, the company struggled, and all of these companies were being sold off. In 2001, Sears had sales of $41 billion and Federated Department Stores, which owns Macy’s and Bloomingdales, had sales of $16 billion.1 Discount Stores The 1960s witnessed a new breed of retailer, the mass discounter. These companies originally targeted lower income consumers with a broad product line similar to that of Sears and other department stores. Discounters, however, differentiated themselves by de-emphasizing the shopping experience and instead focused on delivering items at the lowest price. In 1960, discounters had combined sales of $2 billion. Over the next four decades, discounters prospered. In mid-2002, the largest discounter was Wal-Mart, founded by Sam Walton. Walton started his career as a management trainee at J.C. Penney and later as a franchiser of five-and-dime stores. In 1962, he opened the first Wal-Mart store in Rogers, Arkansas. The operating philosophy of Wal-Mart was simple: offer products to customers at the lowest price possible, locate stores in rural locations, where they can serve the average American, maintain a clean store environment where customers will want to shop, hire energetic employees who provide outstanding customer service, treat employees as “associates” and manage them with an open-door policy where they can express complaints or make suggestions freely. In fact, Walton was famous for allowing employees at any level to walk into his office with comments on how to improve Wal-Mart. Wal-Mart’s subsequent growth was unprecedented. Sales were $44 million in 1970. They had grown to $1.2 billion by 1980 and to $26 billion by 1989 when Walton retired as CEO. For the fiscal year ended January 31, 2001, Wal-Mart had sales of $218 billion. The company operated over 4,400 locations worldwide. 1 Federated sales for fiscal year ended February 2, 2002. For the exclusive use of L. Zhang, 2021. This document is authorized for use only by Lyuliang Zhang in Accounting and Financial Reporting-Fall21 taught by SEB DEMIRKAN, Johns Hopkins University from Sep 2021 to Oct 2021. Costco Wholesale Corp.: Financial Statement Analysis (A) A-186A p. 3 Wal-Mart also expanded its product offerings. Wal-Mart stores sold clothing, health and beauty products, prescriptions, electronics, sporting goods, music, and toys. In 1983, Wal-Mart opened its first SAM’S wholesale club to compete with Price Club. In 1987, Wal-Mart opened its first Supercenter, which included a full-sized grocery store along with the complete product line of a traditional Wal-Mart store. By 2000, Wal-Mart was also selling its products online through Walmart.com. During this era of Wal-Mart expansion, another type of discounter developed, specializing in the sale of only one category of product, such as electronics, hardware, or furniture. Dubbed “category killers,” these companies looked to beat discounters at their own game by achieving even greater efficiencies of scale. Although not all specialty discounters gained lasting success, several continued to dominate their respective categories, including Home Depot, Circuit City, and Walgreens. Discounters and specialty discounters had been very successful stealing sales from department stores. As a result, general merchandisers from Sears to J.C. Penney have been forced to reinvent themselves in order to stay in business. Whether they would succeed, however, was still in question. Montgomery Ward, a once-formidable competitor to Sears, was forced to shut down its stores in 2000 after 128 years of operations. Wholesale Clubs The early 1980s saw the introduction of a new trend in retailing – the wholesale club. Wholesale clubs are based on the same premise as discounters: offer the best value to shoppers. They delivered that value, however, in a different way. First, customers purchased an annual membership in order to shop in the stores. Second, the clubs carried a very limited selection of goods, generally 4,000 SKUs compared to 40,000 SKUs at most grocery stores. Whereas discounters and specialty discounters carried a broad product line, clubs generally carried one or two brands in each category. Third, the clubs sold items in bulk. By limiting the selection of goods and selling in bulk, clubs were able to negotiate discounts from vendors and pass on those discounts to customers in the form of lower prices. These two factors also allowed clubs to turn inventory over faster. Fourth, the clubs kept operating expenses to a minimum. Low operating expenses were essential in order for them to maintain profitability, because they worked on very low gross margins. Clubs achieved low operating expenses by running their stores in warehouse-style facilities and by reducing stocking costs. Wholesale clubs saw annual revenue and earnings growth of 12 - 15 percent during the 1990s compared to 5 - 6 percent annual growth for general retailers. Wholesale clubs expanded internationally with limited success. They gained traction in Canada and Mexico, but growth was not as effective in Europe, South America, and Asia. Although prices of wholesale clubs were attractive to international consumers, there were many challenges in growing internationally, including differences in consumer purchasing behavior, less space at home for consumers to store bulk items, high real estate costs for warehouses, government regulations, and difficulties in implementing a distribution system (see Exhibit 1). Online Retailers In 2000, online retailers were thought to be the next dominant player in retailing. Shipping items from centralized distribution centers, online retailers were thought to have a fundamental cost For the exclusive use of L. Zhang, 2021. This document is authorized for use only by Lyuliang Zhang in Accounting and Financial Reporting-Fall21 taught by SEB DEMIRKAN, Johns Hopkins University from Sep 2021 to Oct 2021. Costco Wholesale Corp.: Financial Statement Analysis (A) A-186A p. 4 advantage over brick-and-mortar retailers. However, consumers did not change behavior to make a substantial portion of their purchases online. As a result, by 2002, online retailers had not gained the sales volume necessary to realize efficiencies of scale. The high cost of shipping and the inability of customers to inspect goods before purchasing were thought to be two main impediments. Although customers adapted to purchasing certain categories through the Internet, such as electronics, software, books, and music, online retailers had not yet become a major threat to traditional retailers or discounters. INDUSTRY GROWTH Despite the fabulous growth in revenue for discounters and warehouse clubs, sales for the retail industry as a whole grew roughly in line with GDP. According to Survey of Current Business, retail and wholesale trade activities in the United States totaled $1.6 trillion or 16 percent of GDP in 20012. In 1960, retail and wholesale trade were substantially smaller ($68.8 billion) but still represented approximately 15 percent of GDP3. In this sense, retail was a mature industry with companies achieving growth in excess of GDP only by stealing sales from competitors or by expanding beyond the United States. GDP growth over the forty-year period 1960 to 2000 was 8 percent per year in nominal dollars. GDP growth from 1990 to 2000, when inflation was low, at 5.9 percent per year (see Exhibits 2 and 3). COSTCO AND THE COMPETITION Costco History In 1975, Sol Price opened the first wholesale club, named Price Club, in San Diego, California. Operating on a membership basis, the club sold goods in bulk to small business owners. Business owners could buy staple items including consumer product, canned foods and beverages, and tobacco products for resale in their own stores. Customers typically purchased products at Price Club for their personal use as well. Going public in 1980, Price Club expanded rapidly throughout California and the West, as well as select locations in Canada and Mexico. The company merged with Costco in 1993. Operating under the same business model as Price Club, Costco Wholesale was founded in 1983 by Jeffrey Brotman and James Sinegal. The company went public in 1985 and used proceeds to fund expansion in the Pacific Northwest and Canada. In 1985, merchandise sales were $336 million and membership fees just over $4 million. With the success of the wholesale club concept, competition soon followed. Wal-Mart entered the industry by creating SAM’S Club, Kmart opened Pace Clubs, and BJ’s Wholesale began operations in the Northeast. By the early 1990’s, the industry had too many players. In 1993, a wave of consolidation took place, as SAM’S purchased Pace Club and Costco purchased Price Club (creating Price/Costco, which later simplified its name to just Costco). The two main survivors, Costco and SAM’S, were left with 85 percent of the market. 2 U.S. Census Bureau, Statistical Abstract of the United States: 2001 (Washington, DC, 2001), p. 418. 3 U.S. Census Bureau, Statistical Abstract of the United States: 1962 (Washington, DC, 1962), p. 317. For the exclusive use of L. Zhang, 2021. This document is authorized for use only by Lyuliang Zhang in Accounting and Financial Reporting-Fall21 taught by SEB DEMIRKAN, Johns Hopkins University from Sep 2021 to Oct 2021. Costco Wholesale Corp.: Financial Statement Analysis (A) A-186A p. 5 Costco Strategy In 2001, Costco was the largest wholesale club in the industry with sales of $34 billion. The company, however, was smaller than SAM’S in number of warehouses (365 for Costco vs. 528 for SAM’S). Costco differentiated itself from SAM’S by targeting a wealthier clientele of small business owners and middle class shoppers (see Exhibit 4). Costco, through its history with Price Club, took great pride in having invented and developed the club warehouse concept. The company demonstrated its value to customers by refusing to mark up products more than 14 percent over the distributor’s price. By comparison, a typical retailer marked up products 25 percent to 40 percent. Although selling items in bulk allowed for many operating efficiencies, management’s main focus was on delivering the lowest per unit price on the products it sold. For example, a 100 fl. ounce container of Tide liquid detergent would sell at a general retailer for $8.99, or $0.0899 per fl. ounce. At Wal-Mart, a 100 fl. ounce container sold for $7.44, or $0.0744 per fl. ounce. Costco sold the same detergent in a 300 fl. ounce container at a price of $17.99, or $0.06 fl. per ounce. Costco was able to sell at such a low per unit cost precisely because of its bulk packaging. The size of the container, however, was not maximized in order to compel consumers to purchase more goods. Costco had a policy of not increasing the size of a container unless it resulted in a lower per unit cost. That is, they would not sell Tide detergent in containers greater than 300 fl. ounces unless the resulting price was less than $0.06 per fl. ounce. They believed that lowering the unit price of goods was what allowed them to deliver value to the customer. Selling through Costco was a mixed blessing for product manufacturers. On the one hand, Costco offered a broad distribution channel that brought increased revenues. In addition, Costco only purchased a handful of SKUs from its vendors. This allowed manufacturers to greatly reduce production costs. For example, when Costco ordered toilet paper from Kimberly Clark, it ordered one color, one print, and one ply. This allowed Kimberly Clark to set up the production line only once and run continuous batches of the same product, lowering per unit production costs. On the other hand, because Costco was a powerful purchaser, it could demand that production savings be passed on to itself in the form of lower prices. As a result, the manufacturer would see increased revenues, but increases in profits would be limited. Costco passed these savings on to its own customers. The result was lower profits throughout the supply chain. Costco created value for the customer through these savings. This drove the value of its membership and allowed Costco to raise fees over time. In 1986, Costco’s membership fee was $25. By 2002, it was $45. The more savings Costco was able to pass on to customers, the more it would be able to increase its membership fee over time. Costco also delivered value to customers by expanding its selection of name-brand products and by adding ancillary services. Costco offered such items as Levi’s jeans, Polo bed comforters, and Compaq computers. Through its proprietary brand, Kirkland, the company offered everything from cheese and ice cream to cookware and vitamins. Kirkland products were developed wherever Costco recognized a need for high quality, low cost items that did not exist in the market. In addition, Costco added photo development services, pharmacies, gas stations, and tire changing stations in many of its stores. The company also increased its fresh food department and added high-end wines and jewelry in an attempt to serve the needs of its For the exclusive use of L. Zhang, 2021. This document is authorized for use only by Lyuliang Zhang in Accounting and Financial Reporting-Fall21 taught by SEB DEMIRKAN, Johns Hopkins University from Sep 2021 to Oct 2021. Costco Wholesale Corp.: Financial Statement Analysis (A) A-186A p. 6 customers. In fact, with $500 million in wine sales in 2001, Costco was the largest retailer of wine in the United States. All of these services were aimed at increasing the number of visits that members made to Costco stores per year and increasing the total dollars spent per customer per year. Increased sales per customer translated into increased sales per store. Besides offering the lowest cost products, Costco claimed to have the best operating efficiency in the business.4 Operating efficiency was essential, given the company’s low gross margin. This efficiency was the result of a very cost-conscious culture. In fact, the company reported operating margins down to the basis point in its annual report. Expenses were minimized through various methods. Stores were run in no-frills warehouse facilities, reducing capital expenditures. Whenever possible, goods were not individually stocked on shelves; instead, a forklift delivered a pallet directly onto the warehouse floor, reducing labor costs. The company distributed goods to its stores through a cross-docking procedure, in an effort to reduce transportation costs. Instead of paying for half-full trucks to deliver products directly from the manufacturer to the warehouse, trucks met at distribution hubs called cross-docks. The manufacturers unloaded full truckloads of products at the cross-dock locations. Costco employees then consolidated and reloaded products into trucks bound for each specific store location. This ensured that trucks were always operating at full capacity, from the manufacturer to the store. Cross-docks never stored inventory, so that all of the items delivered were reloaded and shipped that same day. Costco profited richly from this strategy. In 1985, the company had a net loss of $3 million on product sales of $336 million. By 2001, the company’s profit had soared to $602 million on product sales of $34 billion (see Exhibit 5).5 SAM’S Club SAM’S Club, operated by Wal-Mart, was Costco’s largest wholesale club competitor. SAM’S outnumbered Costco in terms of number of warehouses and worldwide members. However, Costco had larger total revenues, sales per store, and operating income. A few factors limited SAM’S performance. First, SAM’S traditionally catered to a lower income customer than Costco. As a result, SAM’S customers tended to spend less per visit than Costco’s. Second, until 2000, SAM’S lacked a differentiated operating strategy in the Wal-Mart Corporation. Most SAM’S clubs were located adjacent to a Wal-Mart store, offering the same products at the same prices. Many shoppers patronized Wal-Mart without seeing the need to pay a membership fee to enter SAM’S. As a result, many of the cost savings that the two companies enjoyed in real estate development, product purchasing, and delivery were more than offset by decreased sales at SAM’S. 4 Wal-Mart would not break out detailed operating information on SAM’S for comparison. 5 Fiscal year ended September 2, 2001. For the exclusive use of L. Zhang, 2021. This document is authorized for use only by Lyuliang Zhang in Accounting and Financial Reporting-Fall21 taught by SEB DEMIRKAN, Johns Hopkins University from Sep 2021 to Oct 2021. Costco Wholesale Corp.: Financial Statement Analysis (A) A-186A p. 7 Third, SAM’S suffered large amounts of management turnover during the 1990s. SAM’S saw four different presidents come and go between 1994 and 1998. In contrast, James Sinegal and Jeff Brotman had been in charge of Costco since the company’s founding. In 2001, SAM’S began undergoing transformation. Its president, Thomas Grimm, was providing stronger leadership to the organization. He was pursuing an aggressive push to regain the lead from Costco by increasing the rate of expansion in warehouse stores. In fiscal year 2002, SAM’S was planning to open 80 new warehouses. The company had also outlined new plans to renovate older warehouses, add higher-end merchandise to appeal to wealthier clientele, and introduce ancillary product lines similar to Costco’s in order to increase customer visits. Most importantly, SAM’S and Costco’s expansion plans would pit the two warehouse clubs directly against each other in local markets. Traditionally, SAM’S and Costco did not have a large number of stores competing in the same markets. The majority of SAM’S Clubs were located in the South and most Costco’s were in the West. With plans for both clubs to enter each other’s markets, it was unclear how much cannibalism would take place. One indication came from a recent Costco store, which opened in the Dallas market in 2000. Although SAM’S already had 14 warehouses in Dallas, Costco claimed that their own first-year sales were in line with historical averages, approximately $55 million (see Exhibit 7). BJ’s Wholesale Club BJ’s Wholesale Club was a small but efficient competitor to Costco. BJ’s was founded in 1984 in Medford, Massachusetts. By 2002, the company had 130 warehouses, all located in the United States. 2001 sales were $5 billion, on a membership of 6.7 million. BJ’s strategy was similar to Costco’s: to target small business owners and middle-class customers, include high-value goods in the product line to increase sales per customer, and increase store visits through ancillary products. BJ’s strategy diverged from Costco’s in that its stores were smaller (110,000 square feet versus 148,000 square feet), it carried more SKUs (6,000 per store versus 4,000 per store), and it marked up select items more than 14 percent, which was Costco’s limit. Also, BJ’s spent more money on flooring, lighting, and signage in its warehouse facilities in an attempt to improve the shopping atmosphere. The results were mixed. In more recent years, BJ’s had achieved sales and profit growth greater than Costco’s. BJ’s customers visited its stores 12 times per year versus 9 times for Costco and SAM’S. BJ’s also reported gross margins of 9.2 percent, which allowed it to claim that its operations were even more efficient than Costco’s6. On the other hand, sales per store were only $55 million versus $101 million at Costco, and its membership fee was not as high as Costco’s ($40 for a basic membership versus $45) (see Exhibit 8). 6 A direct comparison of gross margins between the two companies is misleading in that BJ’s cost of goods sold figure includes procurement expenses. Costco excludes such expenses from cost of goods sold. Both methods are acceptable under GAAP. BJ’s accounting method results in shifting costs from operating expenses to cost of goods sold, decreasing its reported gross margins, decreasing operating expenses, but leaving operating profits the same. Information is not available in the BJ’s annual report to allow us to quantify the company’s procurement expenses. For the exclusive use of L. Zhang, 2021. This document is authorized for use only by Lyuliang Zhang in Accounting and Financial Reporting-Fall21 taught by SEB DEMIRKAN, Johns Hopkins University from Sep 2021 to Oct 2021. Costco Wholesale Corp.: Financial Statement Analysis (A) A-186A p. 8 REVIEW OF COSTCO OPERATIONS Torres had been following Costco’s progress for five years, but decided that it was time to run a more thorough analysis. From an operational standpoint, Costco had seen tremendous growth during this period. But how had the company been affected by growth? Had its operational efficiency changed? How had it financed the growth and how had its capital structure evolved? Torres typically evaluated her investments using two methods: ratio analysis and cash flow analysis. Ratio analysis involved comparing different line items in public financial statements to see how they change over time or how they compare to similar companies. Cash flow analysis involved analyzing a company in terms of the cash it generates from operating activities, investment activities and financing activities. The objective of cash flow analysis was to understand what cash requirements are needed to fund the business, the sources of that cash, and the use management makes of free cash flow. First, she decided to focus on ratio analysis and leave cash flow analysis for another time. She decided to organize her analysis into three parts: common-size financial statements for Costco over the past five years, a sustainable growth model of Costco over the same period, and a benchmark of Costco against its competitors in important industry ratios. Common-Size Statements Common-size income statements expressed the line items of a company’s income statement as a percent of revenues. Looking at Costco’s income statement, Torres noticed that there were two revenue lines: net sale of goods and membership fees. In creating her common-size income statement, she decided to use net sales of goods as the point of comparison (100 percent) and express other line items, including membership fees, as a percentage of net sales. Her rationale was that this allowed for a clearer reflection of gross and operating margins. Using this format, she was able to analyze the profit structure of Costco over time. Common-size balance sheets expressed the line items of a company’s balance sheet as a percent of total assets. Using this format, she was able to analyze the asset structure of Costco over time and understand how its assets were funded (see Exhibit 9). Sustainable Growth Model The sustainable growth rate was the rate at which a firm could grow while keeping its profitability and financial policies unchanged7. The sustainable growth model allowed an analyst to isolate the drivers that have led to changes in historical growth in order to isolate causes of change. This model could be decomposed into four steps. Step 1: Profitability and Earnings Retention At the end of each year, the return that a company realized on equity capital could either be reinvested back in the business or paid out to investors in the form of dividends and common stock repurchases. If no dividends or share repurchases were made and earnings were reinvested back into the business at the same incremental rate of return, the company’s return on equity 7 Sustainable growth model taken from: Palepu et al., Business Analysis & Valuation: Using Financial Statements (South-Western College Publishing, Cincinnati, 2000), …