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
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
-- 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 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