May 9, 2017 / 6:29 PM / 7 months ago

Fitch Rates Costco's $3.8B Planned Issuance 'A+'; Outlook Stable

(The following statement was released by the rating agency) CHICAGO, May 09 (Fitch) Fitch Ratings has assigned an 'A+' rating to Costco Wholesale Corporation's (Costco) issuance of $1 billion four-year senior unsecured notes due 2021, $800 million 5-year senior unsecured notes due 2022, $1 billion 7-year notes due 2024, and $1 billion 10-year notes due 2027. Proceeds will be used to finance Costco's $7 per share (around $3.1 billion) special dividend. The notes, which are being issued under Costco's First Supplemental Indenture dated March 20, 2002 which supplements the original indenture dated Oct. 26, 2001, rank pari passu with Costco's existing debt, and contain a Change of Control Triggering Event provision. 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 forma for the $3.8 billion debt issuance and subsequent repayment of $1.1 billion of 1.125% notes maturing Dec. 15, 2017, total adjusted debt/EBITDAR is 1.7x. 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 (August), 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, which consists of households with higher incomes than the U.S. average, and the enhanced rewards and savings that generally follow fee increases, and therefore we do not expect the pending increase to have a negative impact on 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, 5% in the 31-week period ended April 2, 2017, and 3% in the 35-week period ended April 30, 2017, 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-digits to the mid-teens over the past several years but is not making a significant contribution to comps because e-commerce represents only about 4% of Costco's net sales. Fitch projects comps (excluding fuel and foreign exchange) will pace near current levels in fiscals 2017 and 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 in order 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% 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 it to operate profitably with low but relatively stable gross margins in the 12%-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 in order 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-1x 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 and refinancing of the $1.1 billion of 1.125% notes maturing December 2017. FCF is expected to be negative in fiscal 2017, due to the $3.1 billion special dividend. FCF is then projected to range between $700 million-$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 by mid-single-digits annually due to 2%-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 is negative in 2017 due to the $3.1 billion special dividend and $700 million-$900 million thereafter; --Total adjusted debt/EBITDAR of 1.8x in fiscal 2017, 1.5x in fiscal 2018, and 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. FULL LIST OF RATING ACTIONS Fitch currently rates Costco as follows: Costco Wholesale Corporation --Long-Term Issuer Default Rating 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 Fitch Ratings, Inc. 70 W Madison St Chicago, IL 60602 Secondary Analyst David Silverman, CFA Senior Director +1 212 908-0840 Committee Chairperson Monica Aggarwal, CFA +1 212 908 0282 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: Date of Relevant Rating Committee: April 6, 2017 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements: --Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and one-time charges. --Fitch views operating leases as debt-like obligations, so capitalizes gross rent expense using a multiple of 8x for its total adjusted debt/EBITDAR calculation. 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