The ratings on Issaquah, Wash.-based leading discount club retailer Costco reflect our view of the company’s “strong” business risk profile. The ratings also reflect our re-evaluation of Costco’s financial risk profile to “modest” from “minimal” following the issuance of the notes to fund the dividend. We anticipate these profile assessments will not change in the next year.
The proposed transaction adds a moderate amount of debt to Costco’s balance sheet and its credit metrics are less robust. Pro forma for the addition of $3.5 billion of debt, total debt to EBITDA increases to 1.7x as of Sept. 2, 2012, from about 0.8x before the transaction, and funds from operations (FFO) to total debt ratio weakens to about 43% from 88% for corresponding periods. EBITDA coverage of interest remains relatively unchanged at about 17%, given only a modest increase in interest expense on the incremental debt. These measures are characteristic of a modest financial risk profile. We do not expect debt reduction in the upcoming year, but estimate that operational gains will propel EBITDA growth leading to total debt to EBITDA improving to 1.6x at the company’s fiscal 2013 year-end, and FFO to total debt strengthening to about 46%. We also project EBITDA coverage of interest will improve to about the mid-18% area.
We assess Costco’s business risk profile as “strong,” reflecting its leading position as the largest membership warehouse club in the U.S., its narrow but stable operating margins, strong membership renewal rate, and our expectation for profitability gains over the next year. Despite charging membership fees to allow for shopping at its warehouses, Costco successfully competes not only with other large discounters such as Wal-Mart or Target, but also with supermarkets and many specialty retailers. The company’s narrow, but carefully selected offering of branded products, its strong private-label Kirkland Signature, and a wide array of ancillary businesses that allow for a one-stop shopping experience, provide value to customers and encourage members to shop more frequently.
Costco’s profitability highly depends on new membership acquisition and its membership renewal rate, at slightly over 50% of its EBITDA for fiscal 2012, came from membership fee income. Historically, Costco enjoyed a healthy renewal rate of nearly 90%, and we believe that positive fundamentals in the discount segment, along with the company’s leading position in the industry will continue to support healthy renewal rates and drive operational gains. As such, our projected performance for Costco in fiscal 2013 includes the following assumptions:
-- Revenue growth of about 10% resulting from mid-single digit same-store sales growth, incremental revenue from new warehouses, and strong membership renewal rate of over 80%.
-- EBITDA margin remaining at about current 4% as benefits of sales leverage offset inflationary pressures.
-- Capital expenditure of slightly over $2 billion to support opening of nearly 30 new warehouses.
-- About 1.4 billion in free operating cash flow.
-- Continuous return of capital to shareholders in the form of dividend and share buyback activities consistent with the past.
Liquidity is strong for Costco and the short-term rating is ‘A-1’. Relevant aspects of the company’s liquidity profile, in our view, are as follows:
-- We expect that the company’s sources of liquidity over the next 12 months will exceed its uses by 1.5x or more.
-- We expect that net sources would be positive, even with a 30% decline in EBITDA.
-- In our view, the company’s financial policies are conservative and no additional debt issuances are contemplated in the next two years.
-- We also believe Costco has a high standing in the credit markets.
The company’s consistently solid operating performance generates good cash flow and the company’s strong balance sheet affords it good flexibility to access the public debt and bank loan markets as needed.
Pro forma for the transaction, Costco had nearly $5.3 billion of cash and short-term investments on Sept. 2, 2012. Given its large cash position, Costco maintains several small bank facilities in its foreign markets and a domestic letter-of-credit facility. Although some of these mature in the near term, we expect the company to renew these facilities at their respective maturity dates. The total amount of these facilities was about $438 million on Sept. 2, 2012, with no short-term borrowings outstanding. We anticipate that Costco will generate about $1.4 billion of free operating cash flow in 2013.
The outlook is stable. We expect Costco to continue to demonstrate good operating performance and generate healthy levels of cash flow, despite the competitive environment in which it operates. Although unlikely, we could consider a lower rating if total debt to EBITDA increases to about 2x as a result of a significant deterioration in operating performance, specifically, if EBITDA drops by 19% from the Sept. 2, 2012, level and debt remains constant at the pro forma level. Higher leverage could also result from a more aggressive financial policy, where Costco continues to use debt to finance its share repurchase program or pay another dividend to its shareholders. In this example, an incremental increase of about $2.3 billion of debt and our projected EBITDA for 2013 would likely result in total debt to EBITDA exceeding the threshold for a downgrade.
Although we do not expect to raise our ratings on Costco over the next year to two years, an upgrade could be contingent upon our reassessment of the company’s financial risk profile to minimal. In this example we would expect total debt to EBITDA to decline to below 1.5x and FFO to total debt ratio strengthen to over 60%. In addition, an upgrade is subject to our comfort level with future debt-financed shareholder initiatives and our belief that the company will sustain its credit metrics at the levels indicated above.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Use Of CreditWatch And Outlooks, Sept. 14, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
-- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008
-- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
Costco Wholesale Corp.
Senior Unsecured A+
Ratings Affirmed; CreditWatch/Outlook Action
Costco Wholesale Corp.
Corporate Credit Rating A+/Stable/A-1 A+/Watch Pos/A-1
Costco Wholesale Corp.
Senior Unsecured A+ A+/Watch Pos
Subordinated A A/Watch Pos