Running head: COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET
Costco Wholesale entry into Brazilian Market
Students’ Names:
ALPHA DIALLO
BOUBACAR BAH
Institution: Brooklyn College
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 1
1.0 Introduction
Costco Wholesale Corporation is an American retail company founded in 1976 and
operates a number of warehouse clubs. The company’s major products are wine, chicken,
organic foods, and beef. Costco recorded $152.7 billion in revenues in 2019 and a net income of
$3.66 billion generated by more than 254,000 employees. The key drivers of success include
after-sale services, green energy use, and online presence. Currently, the company is present in
782 locations including North America, Iceland, South Korea, Japan, Australia, and Spain. The
company continues to expand abroad with the latest entry into Shanghai China in 2019. This
report performs financial analysis, risk analysis, and financing decisions with regard to the
company’s new entry into the Brazilian market.
Brazil has about 215 million people with 62% of the population under 29 years of age.
About 50% of the population has college education and majority work in services sector. The
average salary of a Brazilian is $7,100 per year with varying inequalities based on regions
([Link], 2019). Brazilians tend to save more than they spend and are sensitive to
product prices. They shop on discount chains and are increasingly utilizing the online customer
support services. Since they have access to information, Brazilian consumers have higher
preference for reputable and popular brands. Young consumers buy beauty products and
electronics most of the time but also spend a good portion of their household income on transport
and food and beverages.
1.1 Financial analysis of the investment decision
Costco has a unique business model of selling own brands and making little on the
products sold in-person or in warehouses. The company relies on repeat shoppers buying
memberships at about 90% renewal rate. Membership fees accounted for 17% of the gross profit
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 2
in 2017. Omni-channel experiences provide buyers with a wide of products in stores or online.
Using the warehouse approach helps the company to make huge net margins based on large
quantities of certain items purchased and quickly sold to customers. This trend has led to
dramatic rise in revenue growth is shown in the graph below.
Figure 1: Average sales per warehouse
For the management team to spend cash on operations, it must contend that future cash
flows have greater worth now than the current price of the stock. Potential cash flows from
operations are valued based on their present value using a discounted rate (Damodaran, 2012).
n
t C
NPV = ∑ (1+i)t
−Initial investment …………………………………………………. (i)
t =1
Where; C t – Future cash flows
i – Interest rate or the discounting rate
t = time period of the future cash flows
The discounting rate is formulated from the weighted-average cost of capital with the details
from the 2018 financial year.
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 3
Table 1: Weighted-average cost of capital
As shown above, the weighted-average cost of capital = 7.14%. This figure is used as the
discounting rate of the free cash flows. Meanwhile, the required rate of return is assumed to be
the cost of equity which is 7.425%. This rate is slightly higher than the cost of capital implying
that the company is still profitable. Using discounted cash flow (DCF) analysis the present value
of the expected future cash flows is $302 billion as shown in Table 2. This was obtained by
taking a five year projection of cash flows discounted to the present value.
Figure 2: Options to expand a project
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 4
Table 2: Valuation of Costco Wholesale Corp Using DCF Analysis ($millions)
Valuation of Costco Wholesale Corp Using DCF Analysis ($millions)
Costco Wholesale Actual Actual Actual Actual Projected Projected Projected Projected Projected
Projected Income 2016 2017 2018 2019 2020 2021 2022 2023 2024
Revenue (USD, millions) $118,719.0 $129,025.0 $141,576.0 $152,703.0 $158,811.1 163,575.5 171,754.2 180,341.9 189,359.0
Revenue growth (%) 2.00% 3.00% 3.00% 3.00% 4.00% 5.00% 5.00% 5.00% 5.00%
(113,692.0 (135,559.0 (149,199.5 (151,439.0
Less direct & indirect costs (20%) ) (123,524.0) ) (146,274.0) ) (146,844.8) ) (15,7036.7) (16,6961.5)
EBITDA 5,027.0 5,501.0 6,017.0 6,429.0 9,611.6 16,730.7 20,315.3 23,305.2 22,397.6
EBITDA margin (%) 4.2% 4.3% 7.6% 4.2% 6.1% 10.23% 11.83% 12.92% 11.83%
Depreciation (179.4) (190.6) (192.4) (192.4) (600.0) (675.0) (675.0) (725.0) (725.0)
EBIT 4,847.6 5,310.4 5,824.6 6,236.6 9,011.6 16,055.7 19,640.3 22,580.2 21,672.6
Costco Wholesale
DCF Valuation 2016 2017 2018 2019 2020 2021 2022 2023 2024
EBIT $4,847.6 $5,310.4 $5,824.6 $6,236.6 $9,011.6 16,055.7 19,640.3 22,580.2 21,672.6
Less recalculated taxes (30%) (743.0) (2,225.0) 720.0 (700.0) (2,703.5) (4,816.7) (5,892.1) (6,774.1) (6,501.8)
Add back depreciation 179.4 190.6 192.4 192.4 600.0 675.0 675.0 725.0 725
Operating Cash Flow $4,284.0 $3,276.0 $6,737.0 $5,729.0 $6,908.1 11,914.0 14,423.2 16,531.2 15,895.8
Less Capital expenditure ($2,649.0) ($2,502.0) ($2,969.0) ($2,998.0) ($2,998.0) ($2,998.0) ($2,998.0) ($2,998.0) ($2,998.0)
Free Cash Flows $1,635.0 $774.0 $3,768.0 $2,731.0 $3,910.1 $8,916.0 $11,425.2 $13,533.2 $12,897.8
Terminal value $370,004.0
PV of cash flows (7.15%) - - - - 3,649.18 7,765.79 9,287.25 10,266.72 271,098.14
Cumulative PV ($millions) 302,067.09
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 5
The expected present value of cash flows if Costco enters the Brazilian market is $302
billion. This will make the investment decision worth if these cash flows are greater than the cost
of expansion into the new market. Moreover, the firm has to find out its competitive advantages
over the existing competitors in the market and whether these advantages are sustainable. Costco
Wholesale may need to redefine the market, neutralize competitors including Wal-Mart and
change ownership. To succeed in this market, it may need to diversify to new products and
develop the effective strategy against major players as Sendas, Carrefour, and Wal-Mart.
1.2 Foreign exchange risk analysis and mitigation
Costco Wholesale’s financial statements and most of its operational financial transactions
are denominated in US dollars. Entry into the Brazilian market means that the company will
begin to make transactions in a foreign currency, Brazil real (BRL). Foreign exchange
transactions BRL/USD keep fluctuating due to the volatility in exchange rates as shown in the
graph below.
Source: [Link]
Figure 3: BRL/USD exchange rates over the past five years: $US/BRL= 0.4
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 6
From the chart above, the Brazilian real has been depreciating relative to the US dollar
since mid-2017 to present. Brazil is grappling with deeper economic issues and company returns
are vulnerable to high inflation and volatility in currencies. The rising US dollar against the
Brazilian real means that US goods or raw materials will be expensive for Brazilian buyers but
Brazilian goods will be cheaper to American buyers. As the Brazilian currency depreciates, its
goods become cheaper abroad especially in the United States. In addition, the volatility of the
US/BRL exchange rate will affect Costco Wholesale assets and liabilities denominated in
Brazilian real. Operating profit is susceptible to operating exposures from year to year in
globally competitive industries including retail.
The long-run behavior in exchange rates in the nominal dollar – real exchange rates affect
the price of traded goods (Saunders & Cornett, 2012). This is because the nominal US-to-BRL
exchange rate = US-Brazil inflation rates. If the Brazilian inflation rate is 3% higher than the US
rate in 2019, the dollar will strengthen in about 4% against the Brazilian real. In the short-term,
exchange rates become volatile and makes it less profitable to obtain materials and labor from
different countries. This means that nominal exchange rates do not offset the differences in
inflation rates for the two currencies. Assume the Brazilian real strengthens against the US dollar
by 2% and the inflation rate in Brazil is 3.67%. If Costco imports beef or chicken to its stores in
Brazil that is served by Brazilian producers, the real currency would rise in price by 5.67%.
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 7
Source: [Link]
Figure 4: Brazilian inflation rate
As explained above, transactions in Brazilian real will expose the company to
translational and transaction risks. Costco will use the foreign exchange-exchange contracts to
cushion against fluctuations in future expenditures in the foreign currency. For example is the
spot rate of US dollars to the Brazilian real is 3.24 in 31 st December 2019, $2.5 million of
Costco’s accounts receivables will be worth BRL8.1 million. Assume the one month forward
rate is 3.05 real. At the end of January 2020, the company would have; 8.1million/3.05 = $2.65
million in accounts receivables. The company would have made a gain of $150,000 in one
month. The contract will help to economically hedge exposures to inventory expenditures made
by international customers or subsidiaries in non-dollar currency. Even so, the company does not
engage in forward foreign-exchange contracts for speculative purposes.
Costco Wholesale estimates that any 10% increase in the strength of foreign currency has
a capacity to reduce the fair value of contracts by $80 (Costco Wholesale, 2018). Moreover,
assets and liabilities recorded in Brazilian real will be translated to the US dollar on the balance
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 8
sheet date. The translation adjustments will be captured in the section ‘accumulated other
comprehensive loss’.
1.3 Possible financing alternatives
Table 2 above provided the revenue estimates over the next five years including revenues
from the Brazilian investment. After market sizing and comparing with the present markets, it is
time to seek financing options for the expansion project. Cash flow projection and returns on
investment are important to be evaluated as this would influence the amount of financing needed.
Cash flows from operational activities form a significant source of financing for the expansion
project. The company’s net cash from operations increased from $4.28 billion in 2015 to $6.3
billion in 2019. Options for financing can be limited by the uncertainty of success. Excluding
capital expenditures, the company free cash flow performance is as shown below.
Costco Wholesale - Free cash flows
$4,000.00
$3,500.00
$3,000.00
$2,500.00
$millions
$2,000.00
$1,500.00
$1,000.00
$500.00
$0.00
2016 2017 2018 2019
Figure 5: Costco Wholesale – Free cash flows
As shown above, Costco Wholesale has about $2.73 billion in free cash flows in 2019.
This implies that the company has existing operations that generate positive cash flows.
Although it will decrease potential dividends that can be paid to investors, it is the best possible
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 9
financing option. Waiting for excess cash in future may not happen as competitors stream into
the market to seize up any market opportunities available.
Secondly, bank loan is another alternative to finance the expansion. The company will be
looking forward to the relatively low risk premiums charged as interest. Lenders are interested in
the credit rating and interest coverage of the company. In 2019, the company repays less interest
expense ($89 million) for a long-term loan of $6.487 billion. The interest coverage increased
from 28.94 in 2018 to 32.77 in 2019 implying that the company can cover the interest expense
many times using operating income. The company improved on its liquidity level over the recent
past with increase in current ratio from 0.99 in 2017 to 1.01 in 2019. In terms of capital structure,
the company reduced its debt from 0.61 in 2017 to 0.34 in 2019. The company is financed more
from equity than debt. Moody’s rating agency upgraded Costco to the Aa3, a stable outlook
which gives it a clean bill of health to secure a bank debt.
Thirdly, joint ventures are common in Brazil and are one of the viable options for foreign
firms when entering the market. The common ventures are corporate and contractual joint
ventures. Costco can enter into joint ventures with Dia, Mini Mercado Extra, Cassino or any
other retail or convenience store of interest. It is the best way to expand the business into a cross
border market. Nevertheless, the company will face drawbacks of unfamiliar business practices,
culture and local rules.
Fourth, Costco can invest on green field or brownfield investment by building and
branding new facilities on the ground or leasing an existing facility. The country has been
receiving numerous foreign direct investments in the recent past. Costco can control business
operations and sale of products by bypassing trade restrictions. However, it is extremely risky
and is associated with high market entry costs and fixed costs. As it stands, Costco has a pool of
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 10
free cash flows or retained earnings that can be used to finance a new international investment. It
can also supplement these cash with a bank loan since the company is not in much debt at the
moment.
1.4 Tax optimization views
Tax optimization is about the minimization of income taxes to maximize the outcomes
from such taxes. Most of the time, it seeks to minimize the tax base for investments and
financing activities. Brazil has one of the complex tax systems in the world with three levels of
taxes: federal, state, and municipal. Although these tax systems have numerous exceptions, they
can reach up to 68 percent of the total income of the company. If one fails to comply, it results in
heavy penalties which could even be more than the taxes. Some of the federal taxes are corporate
income taxes, value-added taxes, withholding income taxes, and turnover tax. Each Brazilian
state has own systems with unique periods and forms to fill in the taxes. To succeed in tax
compliance, Costco may need to hire a specialized tax accounting firm to prepare the list of
taxes.
The taxation regime of Costco’s operating income has been decreasing in the recent
years. In 2016, the tax rate was 34.35% and that figure has dropped drastically to 22.27% in
2019. The company will continue using the asset and liability method, which will take into
consideration the Brazilian tax bases, tax credits, and loss carry-forwards (Costco, 2018). Future
tax consequences will be accounted for as deferred tax assets and measured using enacted tax
rates. Change in tax rates will be recognized in income and will account for the effects of
deferred taxes and liabilities. In order to reduce deferred tax assets, the company will continue to
establish a valuation allowance. It will rely on expert judgment to sustain certain tax positions
and timing deductible and taxable items. These positions will be recorded in the consolidated
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 11
financial statements after confirming that uncertain tax positions in the new market. Costco will
reassess changes and probabilities associated with uncertain tax positions from time to time.
1.5 Conclusion and recommendations
The present value of the firm’s expected future cash flows if it chooses to pursue the
project is $302 billion. The international expansion project is worth the cost of investment and
will generate substantial income streams for the company. The required rate of return (7.4%) is
higher than the cost of capital (7.15%) which makes the project acceptable. Since the company is
moving into a new market, it is susceptible to fluctuations in foreign exchange rates. It will enter
into forward foreign exchange contracts to mitigate foreign currency exposure. Given the size of
free cash flows and retained earnings, Costco Wholesale can add this amount to a bank credit to
raise the required amount of capital. Retained earnings and bank loan are advisable because they
do not dilute the company’s shareholdings. It is recommended that Costco Wholesale take
advantage of the opportunities in the Brazilian market and should go ahead to create a club
warehouse in the region through green field investments. Moreover, the company can buy
political risk insurance against the possibility of losing money from political events in Brazil.
Political events have changed in the recent past in the country and there is need to protect
purchase contracts and physical assets.
COSTCO WHOLESALE ENTRY INTO BRAZILIAN MARKET 12
References
Costco Wholesale. (2018). Annual report. Retrieved from
[Link]
pdf
Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of
any asset. John Wiley and Sons.
[Link]. (2019). Brazil: Reaching the consumer. Retrieved from
[Link]
Saunders, A. & Cornett, M. M. (2012). Financial markets and institutions. McGraw-Hill
Publishers.