Costco Is a Mass Market Retailer, Focusing

Costco is a mass market retailer, focusing on a "warehouse club" business model. The company has a cost leadership strategy and this helps to characterize the firm's financial statements In terms of the critical ratios, the following table outlines the results for Costco for the 2012 and 2011 fiscal years:

Costco Financial Metrics

Liquidity Ratios

Formula

Current Ratio

current assets / current liabilities

Quick Ratio

(current assets - inventory) / current liabilities

Activity Ratios

Receivables turnover

Sales / Avg Accounts Receivable

Inventory turnover

COGS / Avg inventory

Debt Ratios

Debt ratio

Total liabilities / total assets

Long-Term debt to equity

Long-term debt / total equity

Profitability

Gross Margin

Gross profit / Revenue

Net Margin

Net profit / Revenue

Market ratios

P/E

Stock price / earnings

Price / Book

Price / shareholder's equity

These ratios tell the story of Costco. There are a number of aspects to this. The liquidity ratios highlight the degree to which the company can meet its financial obligations for the upcoming period. Firms that are in retail tend to have significant spreads between their current ratio and their quick ratio, because they have high inventory levels. Thus, the quick ratio is probably more important than the current ratio. The quick ratio for Costco is healthy, at 0.53. There is some concern that the trend is declining even while the current ratio is increasing, because that probably reflects inventory levels increasing. However, the inventory turnover ratio does not support that theory. However, it is good to know that Costco is a liquid company.

The activity ratios highlight how well the company is run. The receivables turnover and the inventory turnover figures are both healthy. The receivables turnover ratio is particularly healthy because it implies payment on sales in a little over 3 days. The inventory turnover ratio sits at just under a month, which is not great, but is expected for companies in retail. If Costco is purchasing goods on 30-day credit, for example, it is selling them and collecting that revenue by the time it has to pay its suppliers. In addition, management always wants to see turnover increase. While there has been a minor decrease in inventory turnover, this is offset by the increase in receivables turnover.

The next set of ratios are the debt ratios, which speak to the long-term solvency of the company. Costco has a low level of long-term debt relative to equity, and has low liabilities overall as a result. Thus, Costco is clearly well within the normal bounds of a solvent company and has little if any solvency risk. The profitability ratios are another type of ratio that can measure the health of the firm. Costco would be expected to have thin margins, because it is a low-cost retailer. The gross margin is around where you'd expect for a cost leader, and the net margin is as well. Firms with this strategy typically earn very tight margins and make profits based on very high volumes. Costco definitely takes this approach. It's 2% net margin is in line with other firms in the industry, include Wal-Mart.

The market ratios are another measure, this time relating the financial statement measures with the market response. These ratios are mostly useful if you accept the tenuous idea that markets are perfectly rational, which would at least imply the stock market price has real meaning. The market has actually priced the company, with its P/E being very stable for the past couple of years. The price/book ratio has increased in 2012, which reflects a modest increase in share price combined with a larger increase in the book value of the firm, something that derives from another year of profits and a decline in the debt ratio. The market does not see much more than moderate growth from Costco, but it also sees a fairly high level of stability in the company's growth trajectory.

This makes it relatively easy to project the 2013 financial performance. Costco will probably experience a slow, steady increase in revenues. The net margin is likely to remain the same, and there is no indication that Costco's other metrics are going to change much. It might try to turn over its inventory a little bit faster. The stock price is probably going to align with a P/E in the 24 or 25 range, since that has been fairly consistent. The exception would be if any aspect of Costco's operations were to change, but that is not likely given how well the company is run.

SWOT

Costco is one of the best-run companies in the world, so there are going to be a lot more strengths than weaknesses. The company needs to sell high volumes and maintain tight margins, and it does both well. The consistency of Costco's key ratios is one of its greatest strengths. This gives it predictability of performance. That also means that its stock price is unlikely to move much, or at least not in an unpredictable manner. It is hard to make money when a company performs exactly as expected, which is quite likely with Costco. The company's strong balance sheet, stable margins and operating metrics all point to high stability and good health.

If there is a weakness at Costco, the downward creep of inventory turnover is one. In Costco's business, turning over inventory is essential to profitability. If the company is happy with a 30-day turnover, that is fine but it should have an improving trend. Only by turning over inventory faster can the company enjoy better financial performance, and right now the inventory turnover is going in the wrong direction.

Opportunities abound for Costco, and with a P/E of nearly 25, the market clearly is optimistic that growth is still in the company's future. The Costco business model is excellent, but it has a lot of room for growth, in particular overseas. The market expects to see some growth for the company, but the assumption of growth is a reach given that the company has grown at a steady, measured clip for the past five years.

There are a few threats to the company. Its margins are thin, which constitutes a serious threat if anything changed to eat into those margins. However, Costco has been able to maintain these margins through a combination of bargaining power, tight operating controls and customer loyalty. Competition is not really a threat. Costco competes against some of the best-run companies in the world in retails (Wal-Mart, Target, Amazon, to name a few) and it has succeeded well against all of them. The key threat to Costco is probably internal, if the company were to materially change anything that it is currently doing to succeed.