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Overview

The acquisition target company’s risk exposure often adds to that of the acquisition company,

creating new risk exposure for the combined entity. Determining what that risk may be is part

of determining whether an acquisition should be undertaken.

Company Profile

 Ticker Symbol- COST

 Mission Statement- To continually provide our members with quality goods and services

at the lowest possible prices.

 HQ Location- 999 Lake Drive, Issaquah, WA 98027

 Date of Incorporation- May 12, 1987

 Public Auditor- KPMG LLP

 Name of CEO- Mr. W. Craig Jelinek

 Name of CFO- Mr. Richard A. Galanti

 Stock Classification- Common

 Exchange- NASDAQ

 Dividends- Last dividends issued effective 11/2/16 for $0.45

Industry Profile

Costco is part of the Consumer Goods market sector of the economy. This sector is

comprised of companies that are engaged in the production of consumer goods as well as any

retail operations and related services. Costco is involved in production through its private label

of products called Kirkland Signature, and obviously operates a lot of retail space for consumers.

It also provides warranties and consumer benefits through its membership program.

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Costco is more specifically in the discount and variety store industry. As a wholesale

retailer, Costco promotes its low prices. It has a maximum limit of a 15% markup on all

products, and will refuse to deal with producers that don’t have low enough wholesale prices.

Costco also sells a huge variety of products, from car parts, to contacts, to caskets. The huge

warehouse stores have sections devoted to groceries, electronics, books, home supplies and

more.

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1. Costco published a relatively weak 3rd quarter financial report on May 25, 2016.

Analysts, however, recognized cost impacts of the company’s recent change in

membership credit card Company, and encouraged buying of the stock, which caused the

price to rise after a weak April sales report.

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2. 2015 Stock Market Crash- Following a burst of a Chinese real-estate bubble, global stock

markets fell dramatically, as signaled by the DOW Jones 581 point fall in Early August.

This nearly instantly wiped out most gains made in 2015. Like most companies, Costco

recovered quickly in the month following, as it wasn’t based on anything specifically

wrong with the company.

3. On June 6, 2016 HR software provider ADP published their monthly employment report,

which included a growth of 287,000 jobs in the US nonfarm job market. This beat

expectations and caused the stock market to surge as a whole in the following days.

Costco’s Stock rose approximately 6% in the days following that report.

Market Capitalization

Market capitalization describes the total value of a firm’s outstanding shares. This is

calculated by multiplying the closing stock price of the company by the amount of shares

outstanding. It is a better signal of the value of a company than its stock price. It is not, however,

comprehensive. It doesn’t take into account other factors of a company’s value such as its debt.

2 Year Industry Market Capitalization


300
Market Capitalization (in billions)

250 267.71
200
211.55
150

100
99.9 88.295
50 67.07
60.62 43.22 43.46 28.05 31.1
0
2014 2016 2014 2016 2014 2016 2014 2016 2014 2016
Costco Walmart Target Kroger Average

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As shown, Costco has the second largest market share in the industry, yet trails significantly

behind the largest company, Wal-Mart. Walmart’s market share, however, is the only one falling

whereas all others are rising. As a whole, the industry is declining in total market capitalization.

Costco’s market share raised the most of any firm, possibly due to its current expansion strategy

as well as its commitment to low prices.

Financial Statement Research

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Metric 2015 % Change 2016

Sales (Revenue) 116,199,000 2.2% 118,719,000

Cost of Sales 101,065,000 1.8% 102,901,000

Gross Profit 15,134,000 4.5% 15,818,000

Net Income 2,377,000 -1.1% 2,350,000

Inventory 8,908,000 0.7% 8,969,000

Cash 4,801,000 -29.6% 3,379,000

Total Current Assets 16,779,000 -9.3% 15,218,000

Total Current

Liabilities 16,539,000 -5.8% 15,575,000

Total Debt 5,861,000 -6.0% 5,509,000

Total Equity 10,617,000 13.8% 12,079,000

*All Numbers in thousands

Financial Statement Research

Gross Profit: Costco’s increase in gross profit shows strong performance in its new and existing

stores. Sales are up at a higher rate than cost of sales, which goes against market expectations

from 2015. Analysts predicted a decline in gross profit due to Costco’s inability to raise

markups. Stiff competition in the warehouse sector makes it difficult to raise prices when

competitors are able to maintain low prices. I think that it’s possible that Costco’s expansion into

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new markets entirely is what allowed its gross profit to rise. Another contributing factor could be

Costco’s raised membership prices.

Net Income: Whereas Costco’s expansion into new markets had a positive impact on its gross

profit, I think that it’s likely the cause of its current decline in Net Income. The high costs of

expanding into new markets (construction, marketing, etc.) bring down the bottom line. I would

like to know if net income will rise in the future as revenues from these new stores come in and

the initial costs are paid off.

Total Current Assets: Costco’s decline in Total Current Assets may be tied to its decline in Total

Current Liabilities and Total Debt, as it pays off many of the obligations it acquired during rapid

expansion.

Financial Statement Analysis

Ratios COSTCO AVG

Name Formula 2015 2016 2015 2016

Current Assets/Current

Current Ratio Liabilities 1.046 0.977 1.566 1.597

Debt to Equity Total Liabilities/Total Equity 2.150 1.746 1.774 1.730

Return on Equity Net Income/Owners Equity 0.224 0.195 0.169 0.200

Inventory

Turnover Sales/Inventory 13.044 13.237 11.425 11.501

Profit Margin Net Income/Net Sales 2.05% 1.98% 2.41% 2.86%

Return on Capital Net Income/(Total Assets-

Employed Current Liabilities) 0.141 0.134 0.078 0.092

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Current Ratio
1.800
1.600
1.400
1.200
1.000
0.800
0.600
0.400
0.200
0.000
2015 2016

COSTCO AVG

Return On Equity Ratio


0.250

0.200

0.150

0.100

0.050

0.000
2015 2016

COSTCO AVG

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Financial Statement Analysis

Current Ratio: Costco’s low current ratio is somewhat alarming at first glance, but is acceptable

to analysts, considering that the retail industry generally keeps low current ratios due to financed

inventory. I don’t understand, however, why Costco’s is even lower than other companies in the

industry. I’d be curious to see how a consistently low ratio would affect Costco’s ability to

finance using debt in the future.

Debt to Equity: Costco’s decreased debt-to-equity ratio has lowered from 2015 to 2016, likely

due to its slowed expansion in that period. Costco opened 23 new stores in 2015, but only 11 in

2016. This likely cut down on the amount of debt financing required and therefore lowered its

D/E ratio. Costco recognizes the possible risk of last year’s high D/E ratio in the 2015 annual

report, stating that “We may be unsuccessful implementing our growth strategy, including

expanding our business, both in existing markets and in new markets, which could have an

adverse impact on our business, financial condition and results of operations.” The profitability

of this expansion is not yet known.

Inventory Turnover: Costco’s abnormally high inventory turnover rate is helpful for several

reasons. It reduces the risk of the need to liquidate inventory at a lower price, and allows for

more competitive pricing. By increasing turnover, a greater value of goods can be sold with

consistent fixed costs. One question I’d like to look into is how Costco manages such a high

turnover, but I have a feeling it’s related to its status as a wholesale retailer.

Sales model

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Costco focuses on selling products at low prices, often at very high volume. These goods are

usually bulk-packaged and marketed primarily to large families and businesses. Furthermore,

Costco does not carry multiple brands or varieties where the item is essentially the same except

when it has a house brand to sell, generally by the Kirkland Signature label. This results in a high

volume of sales from a vendor, allowing further reductions in price, and reducing marketing

costs. If Costco management feels the wholesale price of a product is too high, they will refuse to

stock the product.

Lighting costs are reduced on sunny days, as most Costco locations have several skylights.

During the day, electronic light meters measure how much light is coming in the skylights and

turn off an appropriate percentage of the interior lights. During an average sunny day, it is very

normal for the center section of the warehouse not to have interior lights in use.

Most products are delivered to the warehouse on shipping pallets and these pallets are used to

display products for sale on the warehouse floor. This contrasts with retail stores that break down

pallets and stock individual products on shelves. Costco limits its price markup on items to 14%.

Business Model Canvas for Costco

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Key Partner Key Activities Value Propositions Customer Customer Segments

 Save consumer Relationship  Targeting busy

 Wholesale  Control of money in long  Guarantee, female professionals

Channels Production and term product  Values quality over

 Shipping manufacturing  Easy to store quality and price

Companies  Manage websites, packaging different

 Internet Search online order schemes

Engines  Branding

 Lawyers  Marketing

&Promotion

Key Resources Channel Cost Structure Revenue stream

 Web  Direct to  Material,  Direct to

infrastructure; consumer manufacturing, consumer

retail outlets  Established retail packaging, revenue

 Patent and outlets distribution,  Wholesale to

brand  Direct marketing marketing, retail revenue

copyrights  Social media operations  Subscription

 Marketing and revenues

operation

development

partners

 Capital

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Strategy

Costco’s generic strategy is cost leadership. This strategy entails maintaining the lowest prices

possible. Retail giants like Wal-Mart also use the cost leadership strategy. Costco’s strategy also

combines the membership warehouse club business model to differentiate it from other retail

firms.

The company’s business model is a core factor that enables Costco to follow its mission. In fact,

this business model aligns with the company’s mission. The generic strategy of cost leadership

also agrees with and is needed to sustain Costco’s business model. A firm’s vision statement

guides the overall direction of organizational development. In Costco Wholesale’s case, the

vision statement emphasizes customer experience and satisfaction. On the other hand, a firm’s

mission statement determines the strategies and tactics needed to achieve the vision. Costco

Wholesale’s mission statement highlights the importance of creating value for customers,

especially through pricing.

Mission: Costco’s mission is “to continually provide members with quality goods and services at

the lowest possible prices.” This mission is directly linked to its business model and strategy.

The firm’s mission emphasizes quality and cost leadership, which are factors consumers usually

look for in the retail market.

Vision: The vision of Costco is to give the costumer the best value that they can and Costco is

going to be the company that’s on a first-name basis with everyone.

Business objective: The main business objective of Costco is not to try to be too much and

know on what level they are competing. Its main objective is to stay focused on its core business

and know their costumer well.

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Interpretive Analysis

1. Liquidity refers to how easily an asset or group of assets can be converted to cash or a

cash equivalent, but in accounting, liquidity more specifically refers to a company’s

ability to meet short-term financial obligations. This can quickly be assessed using the

current ratio. From 2015 to 2016, Costco’s current ratio fell from 1.046 to 0.977. This

means that Costco may have issues paying off liabilities due in the next 12 months. Both

of these figures are dismal compared to the industry average current ratio, which runs at

around 1.5. In the short term, such a low current ratio can lead to missed payments on

short-term obligations and lost efficiency. In the long term, a low ratio can lead to issues

in finding creditors. Consistently low current ratios signal that a loan may not be paid

back on time.

2. Profit margin is a measure of a company’s net income compared to its net sales. For

every dollar of revenue, the profit margin refers to the amount kept as earnings. Costco

saw a slight decrease in profit margin from 2.05% to 1.98%. This is against the industry

average trend, which rose from 2.41% to 2.86%. Profit margin figures don’t signal future

performance as much as they describe prior conditions. They can signal that a company is

struggling to keep costs low, that it is overspending on inventory or other expenses, or is

going through a sales slump. A low profit margin can also signal that a firm is under

pricing goods in order to gain market share. Companies in Costco’s industry generally

maintain low profit-margins, as they are marketed as discount retailers. Costco’s current

expansion plan, as well as its recent and costly switch from AMEX to Visa for its

membership cards, is reasons why its profit margins may be lower than competitors in

these recent years.

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3. The debt-to-equity ratio is essentially a ratio describing the risk that a company takes on

in its financing. It compares the amount of financing acquired through debt to the amount

acquired through its equity. Costco lowered its ratio from 2.15 to 1.74, signaling that it is

relying less on debt for financing now. Its current figure is in line with the industry

average, 1.73. A high debt-to-equity ratio can result in great gains for owners, but can

also result in high losses, dependent on earnings. Costco’s previous ratio likely is related

to its expansion plan, where many new stores were financed. Currently, its more standard

ratio signals that it’s likely financing normally within its industry, taking on an average

amount of risk. It will not likely experience excessive growth or losses due to this lower

ratio.

4. Inventory increases liquidity in certain measures, but it’s really dependent on inventory

turnover. Inventory only increases liquidity if it can be sold quickly without changing its

price. High inventory turnover means that a company is able to sell its inventory quickly

and is therefore more liquid. Costco experienced a slight increase in inventory turnover

from 13.04 to 13.27, with both figures greater compared to the industry change from

11.42 to 11.50.

Strategy Map

Profitability

Financial
Increase Revenue
Manage development

Expenses ROI

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Strengthen customer Improve customer
interaction value

Customer

Improve market Improve product Improve concept


assessment life cycle mgmt. development
customer
interaction
Internal Process

Improve innovation Enhance


Innovation culture partnership

Financial Perspective: Costco accomplished 14.1% sales growth and a 17.4% increase in

operational financial gain. This can be because of the 10.4% increase in membership fees that

flowed on to operational financial gain. This ability to extend sales together with undefeated

valued containment has allowed for a 12.2% increase in earning.

Customer Perspective: Costco has set the vision to give the customer the best value that they

can. Entrepreneurial ability to continuously reinvent itself has given it a powerful world-wide

competitive advantage. Through its unyielding insistence on the highest quality to yield the best

value for its members, Costco has indeed earned the trust of its members. That my products

were sold in Costco thus ensured customers and other potential partners that the products were of

the highest standard. This same trusted reputation has also allowed Costco to expand.

Business Process Improvement: Costco had recently redesigned the store layout, so much so

that I simply gave up on a few of the items I was trying to find. They assess their market

properly, manage product life cycle and improve concept development. There are few other steps

that Costco has taken are:

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 Keeping their Immigrant Perspective

 Employing a Circular Vision

 Unleashing their Passion

 Living Your Entrepreneurial Spirit

 Working with a Generous Purpose

 Embracing a Cultural Promise

Innovation: The challenge of globalization place special requirements on organization

development. Intellectual asset development and their value creation capabilities need to be

considered. It is a safe bet that Costco’s good fortune will continue as it keeps innovating – like

an entrepreneur. The result is a perpetual harvest that continues to benefit the company, its

vendors, and its members. Costco clearly sets the standard for not only living its entrepreneurial

spirit, but also through its passionate pursuit to reinvent an industry. And it has created new

opportunities for others every step of the way. Costco has brought improvement in innovation

culture and enhance partnership.

Costco versus Competitors

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Business Process Improvement of Costco

Costco Wholesale Corporation implemented a high volume Captovation Capture scanning and

barcode indexing process for accounts payable, legal and employee documents.

Costco operates an international chain of more than 386 membership warehouses that carry

brand name merchandise at substantially lower prices targeted for small to medium size

businesses. Enterprise Content Management software industry. Costco continues to utilize Oracle

Imaging and Process Management software for content storage and retrieval. Captovation

Capture is used for image scanning and automated barcode indexing process. Initially, 50 Costco

users scanned approximately 25,000 documents per day, which equaled to 550,000 images per

month and 6,600,000 per year.

The Challenge

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In order for Costco to provide high quality products at lower prices it had to be able to

communicate quickly and effectively with thousands of vendors. The company could no longer

afford slow response times when accessing accounts payable documents such as purchase orders,

debit memos or invoices. There was no direct access to these transaction documents. The image

quality from microfilming was unsatisfactory and storage space was becoming limited. Costco

also processes and stores a large volume of legal documents including agreements and claims

which need to be stored and accessed easily. They began searching for a technology that could

handle the growing volume of paper, microfilm and microfiche.

Costco believes the Image Source solution is a strategic and competitive advantage in their

market space. While these technologies are new to some organizations Costco simply sees the

solution as an everyday necessity.

One of the main steps in the operations process with potential for improvement at Costco is

Costco Supply Management Business Process Options to create ROI in store merchandising. The

store merchandising system is one of the beginning steps of the operations process at Costco.

The Costco store merchandising system helps Costco determine what products to offer to

members, the price range of these products, and the audience for the products carried. Currently

Costco offers a wide range of products that are deemed essential to middle class families.

Costco is a success story of multiple partners, teams, and champions. And they’ve achieved that

success because they’ve been able to build support across constituencies inside and outside their

organization. Costco has grown so much over 25 years that many of the systems haven’t kept

pace.

Costco de-coded some of the key terminology issues:

• “Green screens” for the business were synonymous with business inflexibility.

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• work lost in stacks of paper and email, actually speaks to non-standard manual processes

• “Business” felt that BPMS meant no more green screens – in other words, return of

business flexibility

• “IT” felt that BPMS meant continuous process management and improvement, in other

words, tracking down all these ungoverned processes and improving them

There was also great BPM consulting advice conveyed in this presentation. Tie your efforts back

to company culture and mission. In Costco’s case, how can BPM fail to be tied to?

• continually provide our members with quality goods and services at the lowest possible

prices

• take care of our customers (members), take care of our employees, respect our suppliers

Business process improvement done by Costco are:

i. Plans for boosting online sales

Costco.com hopes to launch mobile apps for Apple and Android this month, grow internationally

in the coming year and improve its ranking in online searches.

ii. Benefits given to customers and employees

Costco cares more about its customers and employees than its shareholders; it pays workers an

average of $17 an hour and covers 90% of health-insurance costs for both full-timers and part-

timers. Yet revenues have grown by 70% in the past five years, and its stock has doubled.

iii. Leadership role of Costco

To continually provide our members with quality goods and services at the lowest possible

prices. In order to achieve the mission it will conduct its business with the following Code of

Ethics in mind:

 Obey the law

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 Take care of our members

 Take care of our employees

 Respect our vendors

 Reward our shareholders

There are a few big lean leadership lessons we can gain from Costco, they are:

 Put the focus on the customer

 Respect people and invest in them

 Value and respect partner firms

 Raise quality and lower costs

 Good processes bring good results

Business Process Improvement Methodology

The true definition of quality control is the stabilization and maintenance of a process to produce

consistent output. The key to Costco's ability to maintain their low prices and quality is because

of good wages and benefits. According to CEO Jim Sinegal, this is why Costco has extremely

low rates of turnover and theft by employees. And Costco’s customers, who are more affluent

than other warehouse store shoppers, stay loyal because they like that low prices do not come at

the workers’ expense. Also by selling a limited number of items, keep costs down, rely on high

volume, have customers buy memberships and aim for upscale shoppers, especially small-

business owners.

Costco has in place a quality assurance program. Its objective is to ensure that all products are

placed under the same stringent Costco quality guidelines. Each produce item has a Costco-

supplier confidential specification sheet that lists specific acceptability factors. Inspections

(testing) for fresh produce start at the very beginning while being grown and end at warehouse

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checkout as customers make the final purchase. If concerns arise, production ceases. Costco is

known for its high quality control process especially in produce, jewelry and meats.

Costco wants to provide great products to its customers while also keeping their prices down. In

order to do this, Costco decided to improve its transportation methods by adopting new

technology to better not only their shipping time but costs as well. Costco has provided different

membership schemes such as below:

Costco’s sustainable business model is embedded in how they have embraced the 6

characteristics of the Immigrant Perspective on Business Leadership which are:-

1. Keeping their Immigrant Perspective: They stay true to their cultural perspective by

continuously seeing and seizing opportunities that others don’t see and are fearless to take action

even when the market disagrees.

2. Employing a Circular Vision: Costco anticipated crisis and change in the retail industry as

Wal-Mart’s low price strategy forced consolidation amongst the many retail outlets. As such,

Costco’s circular vision helps them reinvent a new retail distribution channel that focused on

delivering value to its members through continuous innovation.

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3. Unleashing their Passion: Costco pioneered the warehouse industry. Its passionate pursuit

to create a community-minded and collaboration-driven approach focused on innovation delivers

a new kind of value model.

4. Living Your Entrepreneurial Spirit: Costco’s leadership is all about the entrepreneurial

spirit. They have worked the warehouse floors themselves and understand the specific needs of

their members to keep the buying experience fresh, dynamic and new. Every visit to Costco is

an entrepreneurial experience and their treasure hunt merchandising approach proves this to be

true.

5. Working with a Generous Purpose: Costco is all about servicing the needs of others just as

much as their own. They are meticulous about listening, learning, and implementing the ideas of

their members and vendors voices. They share ideas to their partners to deliver momentous

outcomes.

6. Embracing a Cultural Promise: From the time one walk into the warehouse location, he

feels the promise that Costco is delivering to its culture. He always senses that it is delivering

value in every aisle and with a promise that is consistent, honest and true.

Innovations of Costco

Costco is the largest membership warehouse club. Costco’s process of innovation has been

continuously beneficial to the corporation because it has enhanced their selling power. The new

innovative growth segment of Costco is Costco Gas, Costco Car Wash, Costco.com (online

business), Costco Travel and Costco Home. They offer a wide variety of products that attract

consumers of different purchasing needs. They carry an assortment of products and home

essentials such as produce, food services, home electronics and jewelry. Costco also offers

pharmacy services, gas stations and Costco travel. Their target markets are not only business

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owners as the first wholesale warehouse Price Club did, but Costco opened up the markets to the

general public.

Both Sinegal and Brotman used strategic entrepreneurial ship of selling products at a low price,

but at a high capacity. Costco is also innovative by not selling products from various brands that

are fundamentally the same, but they sell more of their store brand Kirkland Signature label. This

enables Costco to sell more goods from one label which initially reduces the price of the

products and marketing costs. They also save on bags for packing material, lighting by using

skylights and refusing to stock products from companies that sell to them at high wholesale

prices.

Another innovative strategy that Costco acquired was being a wholesale corporation that only

members and their guests can use at a yearly fee of $55.00. Costco’s entrepreneurial approaches

are to seek innovation from suppliers and complete productivity and value.

Costco has managed to earn a net income of $1.462 billion dollars throughout this year. Part of

Costco’s ability to earn and provide trustworthy services to the general public is due to the

founders of the corporation. Costco has the potential to earn a high net income in a fluctuated

economy because they have the means and resources in order to do so. Costco’s vision,

entrepreneurial perspectives and cultural promise has benefited Costco in numerous ways that

has allowed them to continue their success. Costco Wholesale’s entrepreneurial ability to

continuously reinvent itself has given it a powerful world-wide competitive advantage.

With offerings as diverse as merchant accounts, banking, and financial planning to Web

development and group health plans, there is often little need today for members to venture

anywhere else. Today, Costco holds the position of fourth-largest retailer in the United States

overall, after Wal-Mart, The Home Depot, and Kroger. Costco is firmly entrenched as the

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number one warehouse club chain in terms of sales volume even though it has approximately

two hundred fewer stores than its next closest competitor, Sam’s Club.

It is a safe bet that Costco’s good fortune will continue as it keeps innovating – like an

entrepreneur. The result is a perpetual harvest that continues to benefit the company, its vendors,

and its members. Costco clearly sets the standard for not only living its entrepreneurial spirit, but

also through its passionate pursuit to reinvent an industry. And it has created new opportunities

for others every step of the way.

Integration Issues

Leadership selection

Costco will implement its employee its own specific design in terms of hiring and managing its

employment. Current Costco CEO Craig Jelinek is a very fair and generous individual who

believes in paying individuals a livable wage. He has been an advocate for raising the federal

minimum wage to $10.10 an hour. Currently Costco’s current starting pay is at $11.50 per hour.

The average wage for Costco employees is a substantial $21 per hour and this does not include

overtime which many employees tend to work on a routine basis. Due to this policy of Costco

most likely the strategy for the first year would be to not change Sprouts Farmers Market current

employee wages unless they are receiving below $11.50. During the year after the acquisition an

evaluation of wages and impact analysis will be conducted. Also, the current plan for

employees would be that all employees would remain. There will not be an immediate firing of

Sprouts Farmers Market employees. The employees currently employed by Sprouts would be

incorporated into the Costco employment plan and will receive all benefits and compensation as

other Costco employees.

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Currently, about 88% of Costco’s employees receive company-sponsored health insurance.

According to Costco’s benefits structure, equivalent level Sprouts Farmers Market employees

will be offered the same health care benefits. The Mr. Jelinek told Bloomberg in an interview “I

just think people need to make a living wage with health benefits. It also puts more money back

into the economy and creates a healthier country. It’s really that simple” (Short, K. 19 Nov

2013). A trend that has been implemented over the last many years has been working on

Thanksgiving. Costco has traditionally been closed on Thanksgiving. Costco and Sprouts will

be closed on Thanksgiving. The employees will be able to spend it with their family. Costco

and Sprouts will also be closed on other major American holidays like New Year's Day, Easter,

Memorial Day, Independence Day, Labor Day, Thanksgiving and Christmas.

Costco will implement and embrace diversity as it always has within the company. Sprouts

Farmers Market will follow the Costco’s model on this topic for Human Rights and Equal

Opportunity. Another hiring model used by Costco that will be implemented at Sprouts Farmers

Market is internal hiring. Seventy percent of Costco warehouse managers started at a register or

on the store floor. This is a great prospect for current employees of Sprouts as they now have a

great opportunity for growth within the company. Costco has always promoted this aspect in its

business because who better to manage a location then someone who is a veteran and knows the

business better than any new individual. From a business perspective, this is essential because

any new individual who is not familiar with the industry may not so easily grasp the job and may

take time and possibly hinder growth. One of the beliefs of Costco is that if employees are

treated well they will treat Costco well. The current employee turnover is less than 6%. In

several articles, there seems to be some employee dissatisfaction about upward movement.

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While Costco want to keep highly qualified and talented employees within Costco, the merger

could allow a flow of these employees between the two companies.

Corporate culture

The corporate culture of Costco is a major success factor for the business, especially since there

is very high employee morale, along with customer satisfaction and overall performance. The

following factors are the main characteristics of Costco’s organizational culture:

1. Common goal of excellence

2. Positive attitude

3. High energy and fast pace

4. Service orientation

5. Teamwork

Costco Wholesale’s organizational culture focuses on excellence in performance. The company

believes that “good enough” is not enough. This characteristic of the organizational culture

allows Costco to push its employees further to achieve high quality service to satisfy customers.

This focus on excellence creates a sense of direction among workers in terms of their personal

and career development. It allows employees to strive to achieve higher knowing that their hard

work will pay off in the long run and their determination will be rewarded and acknowledged.

The positive attitude portrayed allows for courteousness and friendliness for all consumers of

Costco Wholesale. The company believes that these behaviors are important in attracting more

customers to its warehouses/stores. This is essential to their business as everyone loves to shop at

a location where they feel comfortable and respected as well as a location where they are helped

in purchasing anything their heart desires. The various departments filled with knowledgeable

personnel help consumers in determining and satisfying their needs and wants.

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The next factor is the high energy and fast pace of Costco employees. Efficiency is also included

in Costco Wholesale Corporation’s organizational culture. Through high energy and a fast pace,

employees are motivated to maintain optimal productivity. This characteristic of Costco’s

organizational culture also contributes to the energetic buzz that helps satisfy customers based on

speed and efficiency of service. Because, in any store consumers want to get what they need and

leave as soon as they have found what they were looking for. This leads to our next factor of

Costco’s service orientation. Service orientation is a common feature in the organizational

culture of retail firms like Costco. The emphasis on service helps align workers to the business

goal of providing effective retail service. Costco also uses this service-oriented characteristic to

encourage employees to interact with customers in a productive and profitable way, such as by

promoting certain products to customers on the warehouse floor. Or by providing samples of

grocery items to consumers free of charge to boost product awareness.

Another factor is the teamwork aspect of Costco which helps facilitate work teams. This

characteristic of the company’s organizational culture maximizes performance by utilizing the

synergy of teams. Through teamwork, employees achieve flexibility that enables Costco to

address variations in customer preferences. These work teams also enable the company to

facilitate camaraderie among its employees. Such a method will form strong bonds between

employees and will similarly affect their customer service. Being able to rely on your fellow

employees is key between departments because it allows for the satisfaction of customers and

excellent customer service as consumers are helped and guided in all aspects of their shopping

experience (Meyer, 2017).

Networks and information flow

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When all else fails, follow this rule... “Pick the Right Team, will give you a fighting chance, a

margin of safety even if you make a mistake on the other rules. The M&A team requires legal

leadership but also requires teamwork – finance, tax, sales, R&D, manufacturing, marketing,

HR, and IT. Virtually every department will, sometime during the process, need to help with

diligence or integration planning” (Levinson, 2012). In any business, no one is immune to risk

factors. Costco faces many risks factors that can have adverse actions on their business. For

Costco and Sprouts membership loyalty and growth are essential to a business model. Failure to

maintain a company’s membership loyalty or brand recognition could adversely affect

operations.

With the economic prospects looking up, Costco may be in a great position to acquire Sprouts

making it a strategic acquisition, however digging a little deeper, Costco has to look at the

acquisition more than a financial transaction; there must be thought and planning to make

everything mesh together. It’s key to have a steady flow, you want to ensure that people can see

and understand the steps clearly, forecasting the performance and results. Furthermore, to have

the ability to envision and solve challenges that will be faced with integration is a must. It’s

imperative Costco create a smooth transition to Sprouts. Throughout the acquisition process

there will be many conversations with stakeholders. It is important to set a realistic pace and

goals focusing to make sure the projected benefits, synergies and teamwork can be realized.

Communication plan

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In creating a plan, Costco needs to analyze both the competitive position beside the future

objectives. We need to know what is feasible. Costco has to have a strong platform for how they

do business during the acquisition. They need to know how to integrate the companies

understanding the organizational and operational challenges. Their business model needs to state

where they’re going and what is most valuable. The Executive Team needs to evaluate targets in

revenue and layout cost models for the future combined companies. A strong plan carries

accountability. It is important that they maintain uninterrupted operation with the high volume

of transactions they process. For example, some key thoughts would be as followed;

 Does Costco have to have a plan on how to increase market shares?

 Can Costco define the marketing plan pre-acquisition and post-acquisition?

 Will they set up or expand a product line, eliminate or change processes, or distributions?

Regardless, Costco needs to have a plan aligning the acquisitions and building a bridge removing

any gaps between companies.

The best way to tackle acquiring Sprouts is to give a thorough financial check, shifting the focus

to liquidity which shows that the capital structure is not strain. Costco will need to do their due

diligence on the best way to perform and future prospective targeting. They need to define key

success factors and threshold position forecasting what you must achieve to have a successful

merge. They should not overlook the customers, understanding the positions they hold in both

companies and looking to see how to sustain them once the acquisition goes through.

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Being in an acquisition requires strong leadership. It is critical to place a steering committee

beside other for the business model. These leaders should engage in both side of the acquisition

giving the expectations and support throughout the merge. Processing two cultures Costco and

Sprouts must validate the business model, remembering the values, critical spots and not to sweat

the small stuff and taking the time to watch each milestone, embracing creative plans, and having

a successful execution.

Transition of non-management staff

The transition of non-management staff will be difficult initially but Sprouts employees will

accept the Costco benefits package with open arms. With the ability to have growth through hard

work and dedication as well as health care benefits every employee should be satisfied with the

acquisition. Since Costco will most likely keep the business separate and slowly incorporate the

acquisition into its own stores the employees of Sprouts will have ample time to adjust. Being

part of a larger company will allow even non-essential personnel to strive to achieve new

lengths. This motivation will hopefully drive sales and allow for further growth of Costco and

Sprouts as time progresses. The incentive of being able to move up the corporate ladder will

promote employees in non-essential positions to take up more responsibilities in aspirations of

growth and prosperity.

Facilities

The facilities managed by Costco already carry organic and fresh grown products. The products

and uniqueness of the facilities does not come from the items but from how they are made. The

overall structure and building of a Costco facility is comprised of many recycled materials.

Costco in its construction adheres to the standards of the leadership in Energy and Environmental

Design, as they are internationally accepted as the benchmark of green building design and

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construction. The way these standards are employed varies from the part of the facility being

considered. The main structure utilizes up to 80 percent of recycled steel. The roofing and

exterior also consists of a portion of recycled materials as per LEED standards. Costco goes as

far as utilizing recycled asphalt in their new parking lots to aim for a high usage of recycled

materials to manage new landscaping requirements that arise in the business. The water is also

managed using bio-swales which preserves the groundwater and also helps to prevent runoff in

certain areas.

Costco began the management of water usage initially in Mexico, from their it has moved on to

manage facilities within the southern United States. These facilities have saved up to 30 million

gallons of water due to the management of water. With software analytics, the process has been

made even more efficient as now they are able to detect mechanical failures along with any water

waste as a result of operations. The water management system helps to cut costs as well as

saving water in large amounts throughout all of Costco’s facilities. This leads to the usage of

non-chemical water treatment systems that help in cooling towers and is great because it prevents

chemicals to be deposited into the sewer systems. Every single Mexico warehouse has their own

wastewater treatment systems. By coordinating with local and national incentive programs, these

and other energy-saving systems help us lower the cost of operating our facilities (Costco

Sustainability, 2017).

Franchise Services

Franchising as we know it today is a recent phenomenon. In the private sector, franchising was

used by privately owned businesses with methods of expansion. Costco, as a successful business

owner does not have any ties to franchising and has no future intentions of pursuing this avenue.

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International operations

Costco has been very successful in the retail industry. Due to their successful ventures, it has

brought on many competitors from large chains to high – end retail stores. To be competitive,

Costco must focus on delivering the highest quality of products, customer experience, bargain

prices, and convenience to the member. In the US, an ongoing focus has been on larger

competitors which would be very similar in the international market, which could hinder growth

and sales results in the market.

Just as Costco has success in the American market, Costco also wants this success mirrored in its

overseas market. Costco in 2016 operated 214 warehouses in eight countries outside of the U.S.

Costco plans on expanding the international operations, the annual reports go on to say future

operations could be negatively affected by political conditions, economic conditions, regulatory

constraints or other matters in the countries or regions in which they operate (Sinegal, 2016).

Costco formula works well with consumers. The unorthodox strategy works not just on the U.S

side but all outs the U.S. Its states that Costco international stores in ten countries have proven

successful quoted “Apparently to know Costco is to love Costco, no matter where in the world

Costco is. And the international consumers who are quickly becoming part of the Costco Craze

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probably don't care which candidates of which political party do (or don't) shop there. They just

want quality merchandise, good prices, and a low-tech touchy-feely experience” (Farfan, August

2017).

Sprouts Farmers Market, Inc. Risk Analysis (Target Company)

Strategic Risk

The analysis of Sprouts so far has not identified any moderate or significant financial issues.

Sprouts are a popular small chain that is recognized for organic products. There is a strong

trend in customer desire for healthy and organic food at a good price. As long as this trend has a

large following, Sprouts sales will be strong based on the business model.

Sprouts have a slightly larger debt ratio than Costco but it is at a manageable level. It has also

been successfully managed by Sprouts over the years. The culture has also been identified as

similar to Costco with respect to treating employees, charitable giving and possessing a loyal

customer base.

As Costco evaluates the strategic risks there are relatively low risks at this time based on the

analysis. When evaluating a company for acquisition there are a few reasons to execute the

merger. According to The Risk Perspective, there are four reasons for companies to merge.

 Acquiring a competitor to gain market share

 Acquiring a smaller company whose business is similar to yours in order to strengthen

your industry standing

 Acquiring a complimentary business or a business from your supply chain

 Acquiring a business in a totally different space that will allow your organization to move

in a different direction in the future (Salter, J., 2015).

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Sprouts would be identified in the second category of being a smaller company whose business

is similar. This strategy is often used to strengthen the parent’s position or compliments

customer trends in the industry. A sprout is known for his philanthropic activities and organic

products at a 20-30% discounted price when compared to competitors. The lower prices

capitalize on the current popular trends of purchasing organic products. Customers increase their

volume purchase because of the lower prices. This helps sprouts which reduce waste costs.

“Perishables generate significant amounts of waste in the traditional grocery store model, with an

estimated $15 billion being discarded annually in the United States, so Sprouts has focused on

unlocking the operating margin potential embedded here” (Downie, R., 2016).

The supply leverage Costco has with its suppliers could help improve Sprouts net revenue.

Costco offers organic products and can incorporate these deliveries to include Sprouts stores.

Utilizing economies of scale, the potential lower unit costs and the larger volume purchases of

organic products at Sprouts could allow for a healthy margin.

Because there is no proprietary technology advantage about Sprouts or new product lines to

assist Costco in sales, a risk to Costco is the organic trend ends soon. Sprouts primary advantage

to Costco is the popularity of Sprouts in the organic grocery shopping. If Costco can maintain

Sprouts image and the customers continue to welcome the Sprouts atmosphere the merger should

be successful in the short, medium and potentially long term.

As with any merger discussion, the acquisition should be kept confidential. When the market

identifies a public company might be acquired, the demand usually increases the stock price.

The increased stock price can inflate the value of the company past a favorable market

capitalization. This could make it difficult to acquire Sprouts at a competitive price.

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Reliance on Franchises

Sprouts Farmers Market does not offer franchising opportunities. All of our stores are operated

from the corporate headquarters in Phoenix, Arizona.

Reliance on Growth

Sprouts are a profitable company. It is not relying on expansion to be successful. However, to

realize significant revenue growth in the grocery industry, one has to expand location to gain

those significant volume increases. Sprouts is modernizing its stores and expanding locations to

generate higher revenue.

The year 2016 was a busy time for Sprouts. They made improvements to several of their stores.

The result was a growth in sales 15% over 2015 to $4 billion. Sprouts have seen significant

growth in its private label brands. It has matured to 10% of sales. It also makes up 2,100 items.

Sprouts increased the size and offerings of 76 delis its stores. They have a plan to expand 50

more in 2017. Sprouts will also be expanding their digital engagement to customers via email, a

mobile app and social media.

Sprouts have plans to continue growth in 2017 by expanding into two new states, Florida and

North Carolina. They have targeted to open 32 new stores in 2017. Sprouts have publicly

announced a vision to open 30 stores each year. Sprouts are working with Amazon Prime Now

to offer delivery to new markets. They expect their private label will continue to grow and the

new media avenue will help expand those lines (Pogorelc, D., 2017).

Sprouts do realize that the new stores may not realize the same sales or revenue volume our

current stores experience. In the competitive marketplace and opening a new store in a new

region, could cause a negative impact on the financials in the short term. Sprouts have been

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successful in gaining customers once the area becomes familiar with the business model and

Spouts’ products.

Credit Risk

Sprouts have an agreement governing its credit facility that requires it to maintain a specified

total net leverage ratio and minimum interest coverage ratio at the end of each quarter” (Sprouts

Farmers Market, Jan 2017). The allowable aggregate that can be borrowed is $450 million.

Sprouts must also “maintain a maximum total net leverage ratio not to exceed 3.00 to 1.00 and a

minimum interest coverage ratio not to be less than 1.75 to 1.00. The covenants are tested on the

last day of each quarter” (Sprouts Farmers Market, 2017). Sprouts total debt as of 1 January

2017 was $255 million. Sprouts are well below their debt allowance.

Liquidity Risk

According to the Retail Owners Institute, the average grocery store current ratio is 1.6. Sprouts

current ratio at the end of 2016 was 1.1. This is below the industry average. However,

analyzing the financial and knowing the company recently executed a $250 million stock

purchase buy back, some through debt financing, the 1.1 current ratio is not that concerning at

this time.

Capital Requirements

Sprouts forecasts their operation will sufficiently meet their anticipated cash needs for the next

12 months. Combining this forecast with their debt flexibility and room to take on more debt the

company appears to be financially healthy. Sprouts collects majority of cash from sales to its

customers in the same day. In the case of credit and debit cards payment is collect within days

of the transaction. Cash flows from operating activities increased $14.5 million to $254.4

million in 2016 from $239.9 million. The average of Cost of Capital in the grocery industry for

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2016 was 4.9%. Sprouts Weighted Average Cost of Capital is 5.23% in 2016 (Damodaran, A.,

2017).

Interest Rate Risk

Sprouts exposure to interest rates is mainly based on their outstanding debt under their $450

million Credit Facility. This outstanding debt is currently $255 million, and the interest rate is

based on LIBOR plus 1.25%. Based on the current amount of $255 million, each hundred basis-

point rise in LIBOR would result in an increase of $2.55 million in annual interest expense.

With interest rates at historically low rates this is a risk that is likely to occur in the future.

Sprouts Credit Facility has covenants regarding mergers. Because Sprouts overall debt of $255

million is not a significant amount, if Costco decided to acquire Sprouts, it would have a

negligible effect to Costco. Costco would most likely pay off the debt in cash or absorb it into

their own debt.

A change in interest rates would also affect the amount of the capital and lease obligations on the

company’s balance sheet. Any increase in the borrowing rate would decrease the NPV of the

minimum lease payments.

Risk Exposure to Foreign Exchange Currency Rate Changes

Sprouts do not currently have any exposure to foreign currency rate changes, as all of their sales

and purchases occur in the United States.

Market Risk from Portfolio Price Movements

Sprouts do not currently own any assets that would be affected by the markets other than their

long-term leases which were discussed under the interest rate risk section.

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Transaction Risk

Because Sprouts has no exposure to exchange rates they have no transaction risk. They do have

risk associated with the price of commodities, and do not currently hedge that risk with the use of

derivatives.

Compliance Risk

As with all companies in the grocery business, Sprouts is subject to many local, state and federal

laws they must comply with. These laws are regulated by the following agencies:

 FDA/USDA

o Food safety

o Labeling

o Promotion

o Dietary supplements

 FTC

o Advertising

 Department of Labor

o Equal employment

o Minimum wages

 Accounting

o SOX

o Dodd-Frank

o Nasdaq listing requirements

Failure of Sprouts, or their suppliers to comply with all regulations regarding the above could

cause adverse effects to their business and their financial condition.

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Reputation

Any claims of non-compliance, as well as being found guilty of non-compliance with any of the

above regulations would cause not only cause hardship to the financial well-being of the

company, but would also cause significant damage to the company’s reputation. Sprouts have

built a great reputation with not only their customers, but their suppliers and employees as well.

Any claims of non-compliance with any food safety regulations would be especially hard to

recover from for Sprouts because of their reputation of a company being dedicated to healthy

living, and could be extremely hard to overcome in the competitive organic grocery sector.

Costco Wholesale Corporation Risk Analysis (Acquisition)

Strategic Risk

Difficulty in adhering the strategic vision: Proper alignment of business vision is required for a

successful business acquisition (Rothaermel, 2011). Costco and Sprouts both are engaged in the

retail grocery industry, and the goals and business strategies of these companies show high levels

of convergence. Costco can ensure proper integration of the vision of both companies by actively

working with the management of Sprouts.

Cultural Difference: The cultural differences between the two organizations may create a

problem in the collaboration of operations (Rothaermel, 2011). High levels of cultural

divergence can create strategic risks in the merger and acquisition process. Usually, as the both

firms are from the same industry, the internal cultural difference is considered to be low. The

cultural difference issue can be mitigated by Costco with due diligence, and providing support to

the employees of the Sprouts to adopt to the internal culture of Costco.

Difficulty in the integration of marketing strategies, distribution channel, and brand name:

Problems may arise during the integration of marketing strategies, distribution channel, and

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brand name of the combined companies after acquisition and merger. Since Costco and Sprouts

both have the same business nature, the integration of marketing strategies, and distribution

channels will be an easier process. Costco can consider opening the products under the joint

name of Costco- Sprouts to create a quality image and high acceptance from consumers.

Poor or inadequate communication: Poor and inadequate communication between the

management of the two companies can result in non-achievement of objectives for the merger

and acquisition (Allen, 2013). Costco can mitigate this risk by approaching with a friendly

takeover bid, convincing the management of the benefits of the merger to both companies, and

maintaining adequate communications with the management of Sprouts.

Credit Risk

There exists low debt in the capital structure of Costco. The current debt ratio of Costco is 0.64.

The usage of low debt in the capital structure implies low leverage of the company, and a high

credit rating. Additionally, the earnings of the company will be less volatile (due to less

mandatory of the requirement of debt burden) (Vishwanath, 2007). The company has adequate

capacity to meet up its periodic interest burden. The current time-interest-earned ratio of the

Costco is 28.21 (Morningstar, 2017). The acquisition to Costco will increase overall leverage as

well as credit risk of Costco slightly. The current debt ratio of the Sprouts Farmer is 0.53. Given

consideration of the financing of the acquisition with debt and without debt, the post-acquisition

debt ratio of the combined company will be 0.67 and 0.63. Currently, Costco has an AA- credit

rating (Morningstar, 2017). The company has $6 million in bonds outstanding on the market.

Thus, arranging of the bond issue or bank loan will not be a problem for Costco. Overall credit

risk of Spouts is said to be low. Currently, Sprouts is one of the fastest growing retailers in the

USA (Sprouts Farmer, 2017), and Costco has already established a strong position in the market.

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After the acquisition, the sales and income of the combined firm is expected to increase. Thus,

Costco will have no problem in meeting its incremental periodic interest burden if the acquisition

is financed with debt issuance.

Liquidity Risk

The current ratio and quick ratio of Costco are 0.98 and 0.38, respectively (Morningstar, 2017).

The current ratio and quick ratio of Sprouts are 1.02 and 0.15, respectively. Given consideration

of the 100% ownership of Sprouts, after acquisition the current ratio and quick ratio of the

combined company will be 0.89 and 0.31, respectively. After the acquisition, the current ratio

and quick ratio of the combined company will still be strong. Given the post-acquisition current

and quick ratios of the combined company, the liquidity risk of the acquisition of Sprouts would

remain low.

At the end of August 2016, total cash balance (including cash and cash equivalent, and

marketable securities) of Costco was $4,729 million. Current total assets size and the market

capitalization of Sprouts Farmer are $1,440 million (Morningstar, 2017), and $2,560 million

(Yahoo Finance, 2017). In 2016, the additional investment in the non-current assets of the

Costco to support the growth was $1,804 million. Given consideration of continuation of the

same pattern of capital expenditure in this year, Costco will have enough cash to acquire the

Sprouts Farmer in any format, asset purchase or stock purchase. After the acquisition, Costco

will not have to face a severe liquidity problem. Thus, the liquidity risk of the acquisition of

Sprouts is low.

Interest Rate Risk

Costco can consider issuing debt in the market to finance the acquisition of the Sprouts Farmer.

Interest rate risk may arise in that case. The interest rate in the U.S. is on an upward trend (See

41
Figure 1), thus, debt payment choice, as well as consideration increasing debt by $1,440 million

to finance the purchase of Sprouts Farmer, is subject to high-interest rate risk. The current prime

rate is 4.25%. Based on the opinion of market experts, this rate is expected to increase in the

upcoming period (Fed Prime Rate, 2017). According to Trading Economics, by the end of last

quarter of 2017, the interest rate in the U.S. is expected to be 1.25%, up from current level of

1.05% (Trading Economics, 2017). The high-interest cost in debt financing will lower the net

benefit from the acquisition (Vishwanath, 2007).

Figure 1: Federal Fund Rate of USA (Past and Future Trend) (Trading Economics, 2017)

Except for the interest rate risk, the risk factors for the acquisition of Sprouts are low. High-

interest rate risk can be avoided with the choosing of acquisition mode of cash payment or stock

issuance. Thus, the overall risk in the acquisition of Sprouts Farmer is low.

Foreign Exchange Risk

At the end of fiscal year 2016, Costco operated 715 membership warehouses, with 501 (70%) of

these warehouses being located within the United States or Puerto Rico. The remaining 214

(30%) warehouses were operated internationally, primarily in Canada (91, or 12.7%). The

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internationally operating segments generated 27% and 39% of net sales and operating income,

respectively, during FY2016. Over recent years, the new warehouse opening data reflect that the

gap between the U.S and International locations has been shrinking. Since the beginning of

FY2013, 107 warehouses have been opened, net of closings and relocations, and of these, 58%

(62) were located within the US, and 42% (45) were located internationally (Costco Annual

Report, 2016).

Costco operations are primarily conducted in the local currency of the respective countries in

which the warehouses are located. While the majority of locations and net sales are located

within the U.S., foreign exchange risk still applies to a signification portion of Costco operations,

particularly to that of the Canadian Dollar (CAD) vs. the U.S. Dollar (USD). The adverse impact

of exchange rates on net sales was predominantly due to CAD ($1.65 billion), with an overall

impact of $2.69 billion.

(Costco Annual Reports, 2017)

Over recent years, the USD has been gaining strength relative to the local currencies that

denominate significant international operations of Costco, which accounts for the significant

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year-over-year increase in the adverse impact of foreign currency exchange reflected in the chart

above.

(Historical Exchange Rates, 2017)

Market Risk

Economic and market conditions may cause Costco’s investments in financial instruments to lose

value or increased the cost of energy related commodities, such as natural gas, oil, and any others

uses in electricity production. Many Costco locations include car fueling stations and severe

increases in the market price of oil may have a direct impact on gasoline sales. Additionally, all

of these commodities are significant costs in operations of Costco warehouses as well as integral

distribution network.

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Compliance Risk

Costco is subject to many laws and regulations, and non-compliance could adversely affect the

success of operations. Since the company operations are international, Costco must contend with

a wide scope of regulations that will vary by country and any significant changes to the laws,

regulations, or political climate in individual countries may reduce the effectiveness of

operations. Examples of these may include:

- Product Handling and Safety

Food products and labeling

Pharmacy

- Labor

Minimum Wages

Working conditions and safety

- Accounting and Financial Reporting

Changes in standards under US GAAP or IFRS

Changes to significant assumptions or estimates

Underreporting of income tax liabilities

Audit results

- Current and future legal proceedings or litigation

Reputation

A recent Harris Poll ranked several of the top companies by their reputation, in which Costco

ranked 13th by the general public, and 6th by “opinion elites” (defined as more informed and

engaged segment of the general public). Membership renewal rates reinforce this high ranking,

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as 90% of member renews membership in Costco’s primary markets, the U.S. and Canada, and

88% renew worldwide (Costco Annual Reports, 2016).

If Costco cannot maintain the high reputation that it has garnered thus far, it runs the risk of

losing a competitive edge in the industry. Other factors that could adversely affect the reputation

could include issues with suppliers that may leave Costco short on stock levels for essential

items that customers expect to find, or a high level of product recalls that are disproportionately

associated with Costco. Continued issues of this nature could cause Costco to be seen as less

reliable to consumers and affect their purchasing decisions or the companies they purchase goods

from. Additionally, Costco has benefited from higher satisfaction of their workforce due to

better compensation levels (Ton, 2012). A reduction in the overall employee compensation or

cuts to staff may adversely affect the reputation among customers and their financial condition.

Costco Wholesale Corporation’s main competitors in the highly competitive retail market of

large discount stores are Wal-Mart Stores and Target Corporation. These companies are also

sometimes classified as consumer defensive stocks. While Wal-Mart and Target pour money into

marketing, Costco has a no-frills approach and doesn't advertise. The company also sells a

limited number of items. Despite Costco's large store volume, it has been known to sell a fraction

of the number of toothpaste brands as Wal-Mart, according to The New York Times. Selling

fewer items increases sales volume and helps drive discounts. Costco's focus on driving sales

also helps explain why it offers better pay and benefits than competitors. Many retailers drive

profits by paying workers less, but Costco wants to retain good employees who will motivate

customers to come back.

Wal-Mart Stores, Inc. operates retail stores around the world through three primary segments:

Wal-Mart U.S., Wal-Mart International and Sam’s Club. Sam’s Club most closely resembles

46
Costco’s sales format; however, Costco is still considered to be in direct competition with both

Wal-Mart and its subsidiary. Wal-Mart stores offer a wide variety of goods including deli and

bakery items; meat; produce; frozen foods; dry groceries; health and beauty aids; photo

processing; pharmaceuticals; apparel; hunting products; automotive goods and consumer

electronics. The company also provides some financial services and product including money

orders and prepaid cards, check cashing and bill payment. Wal-Mart Stores, Inc. operates retail

stores around the world through three primary segments: Wal-Mart U.S., Wal-Mart International

and Sam’s Club. Sam’s Club most closely resembles Costco’s sales format; however Costco is

still considered to be in direct competition with both Wal-Mart and its subsidiary.

The Target Corporation is a general merchandise discount retailer operating in the U.S. This

chain offers household essentials; pharmaceuticals; personal care items; cleaning and paper

products; apparel; accessories; sporting goods; electronics; and food items, along with furniture

and other products. Target also offers Red card debit and credit cards that provide consumers

with a 5% discount on purchases. Though slightly lower than Wal-Mart’s, Target’s yield, at

2.9%, is substantially higher than both Costco’s and the industry and overall market average. The

five-year expected PEG ratio for Target is the lowest of all three companies at 1.58, and is lower

than the industry’s average of 1.6. This is significant because it indicates Target’s stock price is

not outpacing the company’s actual projected growth rate. Target has the lowest inventory

turnover ratio of the three, at six, indicating it only turns its inventory half as often as Costco and

slightly less often than Wal-Mart. The relatively lower ratio may indicate that, on average,

Target carries a somewhat more dated inventory than Wal-Mart or Costco. Costco's focus on

driving sales also helps explain why it offers better pay and benefits than competitors. Many

47
retailers drive profits by paying workers less, but Costco wants to retain good employees who

will motivate customers to come back.

Conclusion

Generally speaking, Costco and Sprouts operate in similar manners when it comes to overall

corporate and capital structure. The alignment should allow for a much more manageable

acquisition process than if the companies varied drastically. Given the similarities of various

risks and risk management strategies between the two companies, the combined entity should see

relatively little change in these areas.

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References

Allen, T. (2013, September 06). The 4 Greatest Risk Factors for Leaders. Retrieved from:

https://www.vistage.com/research-center/leadership/mergers-and-acquisitions-the-4-

greatest-risk-factors-for-leaders/

Costco Annual Reports (2013-2016). Retrieved from: http://phx.corporate-

ir.net/phoenix.zhtml?c=83830&p=irol-reportsannual

Costco Sustainability. (2017, September 24). Retrieved from:

https://www.costco.com/sustainability-buildings.html

Damodaran, A. (2017, January 1) Cost of Capital by Sector. New York University. Retrieved

from: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wacc.htm

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