COSTCO WHOLESALE CORP annual report, FY2015

Business context and reporting period

Costco Wholesale Corporation operates membership warehouses and online businesses in the U.S. and international markets. Its model combines membership fees, high sales volumes, rapid inventory turnover, and relatively low merchandise margins. This 10-K covers fiscal 2015, the 52 weeks ended August 30, 2015. Fiscal Q4 was 16 weeks; figures below are in U.S. dollars, generally millions unless noted.

Financial and operating performance

Gross margin was $12,601, or 11.09% of net sales, versus 10.66% in FY2014. Management attributed most of the 43-basis-point increase to gasoline-price deflation reducing the sales denominator; excluding that effect, gross margin on adjusted net sales was 10.81%, up 15 basis points. SG&A was $11,445, or 10.07% of net sales, up 18 basis points; excluding gasoline-price deflation, the ratio improved seven basis points. Net cash after capital expenditures was approximately $1,892.

At year-end, cash and cash equivalents were $4,801 and short-term investments were $1,618, totaling $6,419. Total debt was $6,147, including $1,283 current and $4,864 long-term. No short-term borrowings were outstanding under $407 of bank credit facilities. Total assets were $33,440 and Costco stockholders’ equity was $10,617.

For the 16-week fourth quarter, net sales were $34,993 versus $34,755 in the prior-year quarter; net income attributable to Costco was $767 versus $697.

Material changes versus the prior comparable period

• Comparable warehouse sales rose 1%, compared with 4% in FY2014. Excluding foreign-exchange and gasoline-price effects, comparable sales increased 7% (versus 6%).
• Foreign-currency movements reduced reported net sales by approximately $3,344 and diluted EPS by $0.28. Lower gasoline prices reduced net sales by approximately $2,902; the average gasoline selling price per gallon fell 22%.
• Paid members grew to 44.6 million from 42.0 million. Renewal rates were approximately 91% in the U.S. and Canada and 88% worldwide.
• Costco opened 23 net new warehouses, ending the year with 686, versus 29 net openings and 663 warehouses in FY2014.
• Operating cash flow increased, while investing cash outflow rose to $2,480 from $2,093, mainly reflecting capital spending. Financing cash outflow was $2,324, including dividends and share repurchases.
• Accumulated other comprehensive loss increased to $1,121 from $76, primarily reflecting a $1,045 foreign-currency translation adjustment for the year.

Outlook, management commentary, risks and unusual items

• Management emphasized comparable-sales growth, membership loyalty, competitive pricing, cost control, and warehouse expansion as key performance drivers. It planned up to 32 new warehouse openings and up to five relocations in FY2016, with expected capital expenditures of approximately $2.8–$3.0 billion. These are plans, not guaranteed results.
• In February 2015, Costco issued $1.0 billion of senior notes and paid a special dividend of $5.00 per share, approximately $2.2 billion. Total FY2015 dividends declared were $6.51 per share, including the special dividend; the quarterly rate increased to $0.40. A $57 tax benefit related to the special dividend increased diluted EPS by approximately $0.13.
• Costco repurchased 3.456 million shares for approximately $494 million during FY2015. A new $4.0 billion authorization was approved in April 2015; $3.699 billion remained available at year-end.
• Costco agreed to a ten-year co-branded credit-card program with Citibank; it expected Citi to acquire the existing portfolio from American Express by April 1, 2016, with Visa cards expected in summer 2016. Benefits include lower card-acceptance costs and potential royalty and other revenues; rewards and some economics remained subject to determination.
• Key risks include dependence on U.S. and Canadian operations (88% of sales and 85% of operating income), competition and low margins, currency and commodity-price volatility, labor and healthcare costs, expansion and cannibalization, supplier/product-quality disruption, and technology, privacy, and cybersecurity risks. A July 2015 breach at the third-party host of Costco’s online photo center affected information of some members.
• Legal proceedings include gasoline-temperature class actions, state unclaimed-property examinations, and DEA inquiries regarding controlled-substance prescription fulfillment. No accrual was recorded for the matters described; management said outcomes could nevertheless cause a material charge in an individual quarter, though it did not expect pending matters in aggregate to materially affect financial position.
• Management reported effective disclosure controls and internal control over financial reporting. KPMG issued unqualified opinions on the financial statements and internal controls.

Important facts for investors to verify

• Whether underlying sales momentum and margin performance remain strong after separating currency and gasoline-price effects.
• Whether membership growth, renewal rates, and Executive-member penetration support recurring fee revenue and sales.
• Whether planned FY2016 openings and $2.8–$3.0 billion capital spending are achieved without excessive cannibalization or pressure on returns.
• How the credit-card transition affects acceptance costs, member rewards, and royalty revenue once program terms and results are clearer.
• Potential cash needs from debt maturities, contractual commitments, tax examinations, legal proceedings, and self-insurance liabilities.
• Follow-up disclosures on the photo-center security incident and the company’s broader information-security controls.