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Fitch: Costco's 'A+' IDR Unaffected by $3.1B Special Dividend
April 26, 2017 / 4:26 PM / in 7 months

Fitch: Costco's 'A+' IDR Unaffected by $3.1B Special Dividend

(The following statement was released by the rating agency) CHICAGO, April 26 (Fitch) Costco Wholesale Corporation's (Costco; NYSE: COST) 'A+' Issuer Default Rating (IDR) is unaffected by the $7 per share $3.1 billion debt-financed special dividend declared on April 25, 2017, according to Fitch Ratings. Fitch projects leverage will increase by roughly 0.5x as a result of the action. The Rating Outlook is Stable. Costco had $4.7 billion of cash, $1.2 billion of short-term investments and $5.1 billion of debt at Feb. 12, 2017. The company intends to fund the special dividend primarily through additional borrowings. Fitch anticipates Costco could look to pre-fund $1.1 billion of 1.125% notes maturing December 2017 when accessing the market to finance the special dividend. Costco's ratings reflect its top three market position in North America food retailing with over 700 high-volume warehouses that generate nearly $119 billion in revenue, industry-leading comparable sales (comps), robust cash flow, and low financial leverage. Total adjusted debt/EBITDAR was 1.2x for the latest 12 month (LTM) period ended Feb. 12, 2017. Pro for the $3.1 billion dividend, total adjusted debt/EBITDAR is 1.8x. Fitch affirmed Costco's ratings on April 7, 2017, contemplating a potential special dividend due to Costco's demonstrated willingness to periodically issue debt to return cash to shareholders. Costco previously paid a $5 per share special dividend in fiscal 2015 and a $7 per share special dividend in fiscal 2013. Fitch projects total adjusted debt/EBITDAR will approximate 1.8x in fiscal 2017 (August), 1.5x in fiscal 2018, and be sustained in low to mid 1.0x range thereafter. KEY RATING DRIVERS Growing Membership, High Retention: Fitch expects Costco's growing membership, which currently consists of 48.3 million paid members, and high retention rate to support future sales and operating income growth. Costco's member base has grown at a 6% compound annual growth rate (CAGR) over the past five years. Renewal rates have approximated 90%, providing a stable stream of fee-based revenue. In fiscal 2016, membership fees totalled $2.6 billion, representing a modest 2% of Costco's $118.7 billion of revenue but 72% of its $3.7 billion of reported operating income. Effective June 1, 2017, Costco will raise annual membership fees in North America by 9% for both standard and Executive status or to $60 and $120, respectively. The last fee increase was 10% back in November 2011. Membership renewal and growth has historically shown little sensitivity to fee increases. Fitch believes this is due to Costco's membership base consisting of households with higher incomes than the U.S. average and enhanced rewards and savings that generally follow fee increases and therefore does not expect the pending increase to negatively impact membership growth or renewal rates. Costco continues to upgrade members to the more profitable Executive membership, which offers additional savings and benefits. Executive members represented 39% of paid cardholders at the end of fiscal 2016. Comps Slow But Lead Industry: Costco's comps, excluding the impact of fuel and currency, have slowed from 6% to 7% during fiscal 2011 to fiscal 2015 to 4% in 2016, 3% in the quarter ended Feb. 12, 2017, and 5% in March but continue to lead peers. Guest shopping frequency continues to be a positive contributor to sales but food and merchandise deflation, which reduces average ticket size, and new store cannibalization have negatively impacted comps. Growth in on-line sales has varied between the high single-digit to mid-teens rate over the past several years but is not making a significant contribution to comps because e-commerce only represents about 4% of Costco's net sales. Fitch projects comps (excluding fuel and foreign exchange) will pace near current levels in fiscal 2017 and fiscal 2018 as food deflation moderates and Costco continues to price competitively. Efficient Operations, Continued Investments: Costco offers a wide array of products but limits specific items in each product line to fast-selling models, sizes, and colors to enhance its operating efficiency and support its ability to invest in price. Warehouses maintain an average of 3,700 stock keeping units (SKUs) and are highly productive, generating more than $160 million of average annual sales each year. During fiscal 2016, 57% of sales were food-related products, 15% were from ancillary businesses, 16% consisted of hardlines, and 12% were softlines. Costco has increased capex to about 2.2% of sales from 1.8% in fiscal 2014 to support mid-single digit square footage growth and investments in distribution logistics and website functionality to enhance the on-line member experience. Low but Steady Margins: Costco's high volume warehouses and operating efficiency allow the company to operate profitably with low but relatively stable gross margins in the 12% to 13% range and EBIT margins in the 3% range. Profitability should benefit from the company's new co-branded credit card arrangement with Citibank, N.A., which became effective in June 2016; due to lower merchant fees, royalties earned on external spend, and a bounty on new signups through Costco, as well as the pending membership fee increase. However, Fitch projects margins will remain near current levels given that Costco generally passes along savings to members to remain price competitive. Solid Cash Flow, Range-Bound Leverage: Over the past five years, Costco has generated an average of $3.6 billion of cash flow from operations (CFO) and nearly $900 million of free cash flow (FCF; CFO less capex and dividends) allowing the company to invest in its business and return cash to shareholders. During most years, total adjusted debt/EBITDAR has remained range-bound in the low-to-mid 1.0x range. Fitch projects total adjusted debt/EBITDAR of 1.8x in fiscal 2017 versus 1.3x in fiscal 2016, and 1.5x in fiscal 2018. Fitch's projection reflects the repayment of $1.1 billion of 5.5% senior unsecured notes that matured in March 2017 but assumes Costco issues $3 billion to finance the special dividend and prefunds $1.1 billion of 1.125% notes maturing December 2017. FCF, excluding the special dividend, is expected to approximate $2 billion in fiscal 2017, due to the acceleration of $1.7 billion of vendor payments in fiscal 2016 which resulted in FCF being negative $100 million. FCF is expected to range between $700 million to $900 billion thereafter, reflecting Fitch's assumption of lower comp growth. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Costco include: --Revenue grows at a mid-single digit rate annually due to 2% to 3% comps growth, excluding fuel and currency, and expansion; --EBITDA grows at a mid- single digit rate rising to above $6 billion by fiscal 2019; --Gross margins and EBIT margin remain near current levels as the negative impact of rising fuel prices on gross margins and information technology spending on SG&A are offset by benefits of the new co-branded credit card and higher member fees; --FCF approximates $2 billion (excluding the $3.1 billion special dividend) in fiscal 2017 due to timing of vendor payments and at least $600 million thereafter.; --Total adjusted debt/EBITDAR of 1.8x in fiscal 2017, 1.5x in fiscal 2018, and then in the low to mid 1x range thereafter. RATING SENSITIVITIES Positive Rating Action: Continued strong operating momentum with comp growth (excluding the impact of fuel and currency changes) in the low- to mid-single digits and stable operating margins with a public commitment to maintain total adjusted debt/EBITDAR in the low-1x range could result in an upgrade in Costco's ratings. Negative Rating Action: Sustained weakness in operating trends, caused by meaningfully lower comps (excluding the impact of fuel and currency changes) and membership declines combined with shareholder-friendly actions that lead to increased debt levels would be viewed negatively. A sustained period of total adjusted debt/EBITDAR in the high-1x range could lead to a downgrade in Costco's ratings. LIQUIDITY Costco's liquidity is supported by the company's significant cash and short-term investments balance. At Feb. 12, 2017, cash totalled $4.7 billion and short-term investments totalled $1.2 billion. Approximately 30% of the company's cash and investments were held in foreign subsidiaries in fiscal 2016. Costco also had $406 million of availability under uncommitted credit facilities, $333 million of which was at international operations, at Feb. 12, 2017. Fitch currently rates Costco as follows: Costco Wholesale Corporation --Long-Term IDR at 'A+'; --Senior unsecured notes at 'A+'. The Rating Outlook is Stable. Contact: Primary Analyst Carla Norfleet Taylor, CFA Senior Director +1-312-368-3195 Secondary Analyst David Silverman, CFA Senior Director +1-212-908-0840 Committee Chairperson Monica Aggarwal, CFA Managing Director +1-212-908-0282 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: Additional information is available on ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. 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