-------------------------------------------------
To: Margarita Torres, Investor in Costco
-------------------------------------------------
From: MSF Analyst
-------------------------------------------------
Date: 6th November 2013
-------------------------------------------------
Subject: Evaluation of Costco Operational Forecasting

Purpose:
The purpose of this memo is to provide an analysis and valuation of Costco’s forecasted operational performance over the next 10 years.

Appropriation of the Five Factors:
Given that the market is highly competitive, the forecast undertaken for the number of warehouses was a conservative approach along with a 5% increase in the no. of US stores. Refer to Appendix 1.

Sales per store are considered a significant factor in determining profitability and shareholders’ equity. According to the forecast stated by Margarita Torres, the management expectations might be overestimated ($118m in the forecast, $125m-$150m).

The membership per store is a relevant factor in determining the future performance of Costco, given that Costco’s goal is achieving low gross margins. The membership base will contribute directly to the net income and promotes a sustainable income for each store. The pre-tax margin defined by the management is achievable; hence the forecasts in the common size analysis state that the pre-tax margin will be range from 3.12% to 3.53% in 2002 and 2006 respectively.

The international expansion should be conservative, given the challenges faced upon the historical expansion (Costco A); the retailers should consider that they’re investing in less effective markets with additional risks.

In general the overall factors seem appropriate except for the membership fees which will be constant over the period.

Additional Factors to be consider:
Upon our review, we recommend the consideration of the following factors: * Firm specific Factors: a few additional factors that will contribute for a further evaluation of Costco’s future performance: Total asset turnover: forecasting the future asset turnover will contribute to further analyse the feasibility of the growth rate of Costco. The management should define the ROE & ROA targets to foresee its effectiveness in future performance.

* Industry specific factors: The forecast lacks a common analysis forecast that will determine or define whether the analysis is too aggressive or conservative for example. Having a general idea of the effect of the competitors’ actions/plans will help in defining the overall expectations.

* Few economic indicators that affects the overall results of Costco. An economic forecast of the overall performance of the US/internationally will contribute to define how much of the pre-tax income it can keep. Additionally the economic forecast will define inflation that will affect its overall revenues, however at a lesser extent.

The considered factors of the analysis are appropriate; however they cannot complete a constructive conclusion on an investment unless the ROE/ROA is considered as well as the aforementioned additions.

Assumptions review:
There are a few observations regarding the changes from the historical data to the change in Margarita assumptions forecast (2001 – 2010) keeping in mind for a 10 year period consider to be a long period and a lot of changes can occur in the market , changes are as the following:

* Membership growth: the growth rate of the members was increasing from 8% to 16% during 1997 and 2001 respectively. In comparison with the forecast, the growth rate tends to slow down from 16% in 2001 to 7% in 2010. The drop in the growth rate of the memberships could be supported by the expansion of warehouses in the international level (Refer Appendix1).

* Cost of goods sold: in reference to the historical data, the overall COGS are decreasing overtime carrying on from the 1997-2001. It is observed from the forecast that Costco on 2003, maintaining a stable rate up to 2010 which might be hard to maintain with all changeable market conditions.

* SG&A: The SG&A have taken a different form from historical data, as the historical data states that SG&A were increasing over time. The forecast of the SG&A was decreasing over the 10 year forecast, from 9.17% in 2001 to 8.6% in 2010.

* Interest expense: The interest expense was forecasted at a stable ($32m) from 2001 to 2010 which seems to be unrealistic.

* Preopening expenses: the preopening expenses were trending upwards from 1997 to 2001; however in the forecast the preopening expenses were stable at $1.5m. This assumption is only supported by the increase in efficiency.

Review of the forecast:
By looking to the balance sheet side it can be observed that the net operating long term assets has increase to almost the double between 2001-2010 (6,089 MM to 12,719MM), also the shareholders equity increased by more than the double during the same period (4,884 MM to 11,744) . Moreover, by looking to the free cash flow we can notice a deficit on 2002 which we believe that it consider to be normal forecast specially for a company that find it expansion internally (using returned earing) however this number started to increase from 2003 with 192 MM all through 2010 where Margarita forecast to be 11,744 MM, as a consequence earning per share was increasing as will reached until 3.30 on 2010. The terminal value information shows that margarita assumed growth at 5% since she was not sure whether free cash would increase at the same rate as US GDP ( COSTCO A (Exhibition 1) was 5.9%) , as she’s being more conservative, Moreover, Margarita use discount rate of 8% which is slightly higher than the average historical yield on 30- year U.S. Treasuries, knowing the fact the that Costco operating in a considerably low risk industry this estimation might be fine, however, we think that Margarita should considered the WAAC for COSTCO as more accurate proxy.

Quantitative check
A quantitative check was applied on the forecast of the 2001-2010 and its historical data. We come to conclude that Margarita was conservative in her forecast in comparison with management; we came to a conclusion upon assessing the following factors:

* The sales growth rate set by the management was 10-12%, in our analysis we agree with such a target because the average growth rate of sales during the period 1997-2001 was 12%. * The 15% EPS growth rate defined by the management was achievable; hence the historical (Between 1997 and 2001) average yearly growth rate was 19%. However, we note that the basic EPS growth rate tends to fluctuate in a yearly basis, which are a concern and a cause to investigate the reasons. * The historical 5 year average growth rate was 22% relative to the 16% earnings growth target, margarita is being conservative in most ratios due to the increasing competition between the suppliers. * She has applied the rule of reversion to the mean in setting the ROE targets in his quantitative study, by applying the 13% 5 year historical average throughout his forecast. The 10 year analysis of the ROE averages out at 13% revolving around the historical mean.

Recommendation:
In general whether to recommend that Torres buy, hold, or sell her Costco shares at the price of $35 depend on Torres risk appetite, more information to be provide as well as what we already mentioned in Costco A (if she’s willing to hold the shares now for potential future returned) , Furthermore Costco B provide more detailed information regarding Costco management future growth ( internal expansion more warehouses, increase sale per store and so on) by linking this with the result of the estimated analysis that have been done (increase in earing P/S, FCF to equity holder) the decision of buying more number of share now at $35 and hold or resell in the next couple years when the price get even more high would probably result on getting positive return.