Wednesday, December 5, 2012

This Wholesaler Is a Buy With a Special Dividend

Costco (NASDAQ: COST), a favorite of legendary investor Charlie Munger, has just announced a special dividend of $7 per share. The special dividend came before the expiration of the preferential tax treatment next year. This special dividend will be paid on December 18 to shareholders of record as of December 10. Right after the announcement, Costco jumped nearly 6.3%, from $96.51 to $102.58 per share. The special dividend seems to be juicy as it yields 6.82% for shareholders. Should investors consider Costco before December 10 for its special dividend?
Dividend source
On the same day of the special dividend announcement, Costco announced its debt (senior unsecured notes) offering to raise $3.5 billion in three tranches of around $1.1 billion - $1.2 billion per tranche due December 2015, 2017, and 2019 respectively. Costco will use around $3 billion of net proceeds from this debt offering to pay a special dividend. So, the special dividend would be financed by this new debt offering, not directly from Costco’s operations. It is like a type of dividend recap, in which the company issues debts to fund the dividend. As long as the leverage structure of the company is not so levered, it would be fine. As of August, Costco had $12.36 billion in stockholders’ equity, $4.85 billion in cash, and only $1.4 billion in long-term debt. If $3.5 billion were raised, then the long-term debt amount would increase to $4.9 billion. $3 billion cash would be paid out as dividends to shareholders, so the cash would increase just by $500 million. At that time, the D/E ratio would still be at a quite reasonable level, around 0.4x.
A Consistent Growing Wholesaler
In November, Costco reported both growing revenue and comparable sales. The comparable sales increased 6% overall in November, and 7% in the period of September to November, including the positive effect of increasing gasoline prices and stronger foreign currencies. The revenue for the first fiscal quarter in 2013 increased from $21.18 billion to $23.21 billion, a 10% year-over-year growth. Costco has been growing quite consistently for the last 10 years. Its revenue has experienced 8.83% annualized growth, from $42.5 billion in 2003 to $99.14 billion in 2012. The EPS increased from $1.53 to $3.89 in 10 years, marking a nice annualized growth of 9.78%. Costco is also a quite stable cash flow generator; with its free cash flow experiencing an 8.5% annualized growth rate in the last 10 years. That great consistent growth of Costco has reflected well in its stock price, making Costco a much better bet compared to Wal-Mart (NYSE: WMT) and Target Corporation (NYSE: TGT).
In the last 10 years, Costco delivered a nearly 230% total return (including reinvested dividends), whereas Target has grown only 105% and Wal-Mart has increased only 53.5%. I have written about Costco, indicating it as a wholesaler to hold forever, as Charlie Munger expressed his love for it: “If you get hooked on going to Costco with your family, you’ll go for the rest of your life…virtually none of the sins of modern capitalism are at Costco.”
Good Use of Capital 
By issuing low-cost debt to pay a special dividend, Costco has made a smart move to enhance shareholders’ value. The debt would be divided into three tranches, following the company’s new release:
  • $1.2 billion principal amount of 0.650% Senior Notes due December 7, 2015 (annual interest expense would be $7.8 million)
  • $1.1 billion principal amount of 1.125% Senior Notes due December 15, 2017 ($12.38 million interest expense)
  • $1.2 billion principal amount of 1.700% Senior Notes due December 15, 2019 ($20.4 million interest expense)
Compared to Costco’s return on invested capital, the coupon rate is considerably lower in this low interest environment. In the last 10 years, the lowest ROIC was 9.10% in 2009. Trailing twelve months, its ROIC was 12.25%. Before the debt issued, its interest coverage was as high as 29x. After the debt issued, the interest expense would increase by $40.58 million. If we used 2012 operating income, the interest coverage on the total debt (including the newly issued one) would still be at a very comfortable level, of 20.3x.  
Foolish Bottom Line
Valuation-wise, Costco seems to be quite pricey, with 18.8x forward earnings and 1.4x PEG. As Wal-Mart is trading at 12.4x forward P/E and 1.5x PEG, and Target is valued at 12x forward earnings and 1.3x PEG, Costco is much more expensive than its peers in terms of forward earnings, but quite comparable in PEG ratio. With the conservative capital structure, wise capital usage, consistent earnings and cash flow growth, Costco is still the best choice for investors’ long-term portfolios.  

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