Fitch Ratings has downgraded Costco Wholesale Corporation's (Costco)
Issuer Default Rating (IDR) to 'A+' from 'AA-'. Fitch has also assigned
an expected rating of 'A+' to Costco's planned issuance of $2 billion or
more of three, five and seven-year notes based on market demand. Costco
had $1.6 billion of debt outstanding at Sept. 2, 2012. The Rating
Outlook is Stable. A full list of rating actions is provided at the end
of this release.
The rating action follows Costco's announcement that it plans to issue new senior unsecured debt securities to substantially fund a special dividend of $7 per share, or around $3 billion. This announcement reflects management's view that this is an opportunistic time to take advantage of low borrowing costs in order to pay a larger dividend in advance of higher dividend tax rates beginning in 2013. Together with its normal dividend, dividends will total $3.5 billion in the current fiscal year (ending August 2013).
Assuming Costco were to issue up to $3.5 billion of new debt securities, adjusted leverage would increase from 0.8x at fiscal year-end (August) to 1.7x on a pro forma basis, and leverage would remain in the mid-1x range over the next three years. Fitch expects leverage could return to the low 1x range longer term, as it believes management will not issue additional debt for the foreseeable future, and that management will utilize free cash flow (FCF) to repay future debt maturities, the nearest of which will fall in 2016.
The debt issuance notwithstanding, Costco enjoys a strong competitive position, solid operating performance, and ample FCF and liquidity. Costco's strong competitive position is supported by its focused merchandising strategy, with only 3,300 - 3,800 fast-turning products per warehouse and limited pricing mark-ups, resulting in a loyal customer base and highly productive warehouses that generate, on average, around $150 million in revenues annually.
High frequency categories account for a significant percentage of sales, with 56% of sales from food and sundries and 18% from ancillary businesses, which include traffic-drivers such as gas stations and pharmacies.
These factors have enabled Costco to generate solid operating results, with comparable store sales (excluding fuel and foreign exchange) growing 6% in fiscal 2012 (ending Sept. 2, 2012) and in fiscal 2011. In addition, membership renewal rates in the U.S. and Canada have remained high at around 90%.
At the same time, Costco's margins have been steady, with a 3% EBIT margin in fiscal 2012 and 2011. FCF after dividends was $1.1 billion in fiscal 2012, and should track around $700 million - $1 billion over the next three years as capital expenditures move to a range of $1.8 billion - $2 billion, from $1.5 billion in fiscal 2012, to support a faster pace of new store growth.
Looking ahead, Fitch expects comparable store sales (excluding fuel and foreign exchange) will continue to grow in the low-to-mid-single-digit range, and that operating margins will remain within their historical range, resulting in mid-single digit growth in EBITDA.
Costco repurchased $632 million of its shares in fiscal 2012, and Fitch expects ongoing share repurchases will be financed with FCF and existing cash, and will not cause leverage to increase. Costco had cash and short-term investments of $4.9 billion as of Sept. 2, 2012.
WHAT COULD TRIGGER A RATING ACTION?
Positive: Continued strong operating momentum combined with a sustained reduction in lease-adjusted leverage to the low-1x area could lead to a positive rating action.
Negative: Additional shareholder-friendly actions that push adjusted leverage to the high-1x range for an extended period could lead to a negative rating action.
Fitch has downgraded the following ratings:
Costco Wholesale Corporation
--IDR to 'A+' from 'AA-';
--Senior unsecured notes to 'A+' from 'AA-';
--Convertible subordinated notes to 'A' from 'A+'.
The Rating Outlook is Stable.
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