Monday, October 23, 2006

Costco's CEO Refuses 2006 Bonus--Not Exactly Financial 'Hari-Kari.'

On October 17, the Compensation Committee of Costco Wholesale Corp. (COST-$51.69), the nation's largest wholesale club operator, approved final bonus awards for executive officers for fiscal year 2006. The Committee did not release (previously approved) performance bonus awards to President and Chief Executive Officer James Sinegal or Chief Financial Officer Richard Galanti of $200,000 and $82,000, respectively.

According to last Thursday's regulatory
8-K filing with the SEC, Sinegal and Galanti suggested that they not receive their bonuses this year due to to prior irregularities in the Company’s stock options granting process that occurred on their watch.

Following the recent publicity regarding the granting of stock options, Costco initiated an internal review of its historical stock option grant practices to determine whether the stated grant date of options (made during the years 1996 through 2005) were supported by the Company’s books.

As the 10Q Detective has repeatedly disclosed in prior postings, it is rare that corporate leaders unclothe themselves to be held accountable. They would either deny wrongdoing—seeing himself or herself above the law—rex non potest peccare (“the King can do no wrong”); or hide behind the veil of immunity just because they were the leaders—immunity rationae materiae.

We laud the gestures of accountability displayed by both Sinegal and Galanti to refuse their cash bonuses. Sadly, however, the 10Q Detective suspects that both executives might have been motivated more by their regard to self-interest than by unselfish minding for corporate governance.

Although the inside review identified no evidence of fraud, falsification of records, or intentional deviation from generally accepted accounting principles, the audit did find, however, that in several instances, it was impossible to determine “with precision” the appropriate measurement date for specific grants. For these grants it was feasible only to identify a range of dates that included the appropriate measurement dates, where some dates in the range were after the recorded grant date.

In April 1997, both Sinegal and Galanti received “one grant subject to imprecision that may have benefited (Sinegal) by up to $200,000” (and Galanti. by an undisclosed amount).

Louise Augusta, Queen of Prussia, met the conquering Napoleon (July 1807) in person at Tilsit in Russia to sign a peace treaty, she toasted to him: "To the health and kindness of Napoleon the Great. He has taken our states, and soon will return them to us." Napoleon bowed and replied, "Do not drink it all, Madame."

Although the Company has not disclosed the total compensation for fiscal year 2006 earned by each of the above-named executive officers, it is safe to suggest that their absence of performance bonuses (for the option “imprecisions”) will not be a cause of financial hardship:

· In FY ’03 – ’05, the Company granted Sinegal and Galanti 450,000 and 225,000 stock appreciation rights (SARs), respectively;
· During FY ’05, Sinegal and Galanti exercised stock options worth a realized value of $3.74 million and $2.72 million, respectively;
· At Fiscal Year-End 2005, the value of in-the-money (exercisable) Options/SARs held by Sinegal and Galanti were $20.77 million and $5.98 million, respectively.

Certain Relationships and Transactions

· James D. Sinegal’s son and brother-in-law were employed by the Company during fiscal year 2005 at annual salaries (including cash bonuses) of $266,209 and $216,541, and received grants of 37,500 and 18,750 options, respectively.
· In addition, a company controlled by one of Mr. Sinegal’s other sons (who is not employed by the Company) sold merchandise to the Company for resale in FY ‘05, for which the Company paid $1,351,826.

Suffice to say, in light of all these facts, Sinegal and Galanti were no corporate martyrs committing

One might readily argue, however, that compared to their respective peers at BJ’s Wholesale Club (BJ-$28.60), the nation’s third-largest warehouse membership club, that CEO Sinegal and CFO Galanti are either under-paid in terms of performance (or BJ’s top executives are overpaid)?

Costco’s and BJ’s operating margins and ROEs (trailing twelve-month basis) were 2.71%, 2.36% and 12.18%, 12.40%, respectively.

In FY ’05, the Chief Executive Officer of BJ’s, Michael T. Wedge, and the CFO, Frank D. Forward, earned cash compensation of $1.63 million and $742,000, respectively. In comparison, Costco CEO Sinegal and CFO Galanti earned cash compensation of $450,000 and $536,800, respectively, in the last fiscal year.

Valuation Analysis

This no-frills, self-service BOX-Retailing business model enables the Company to operate profitably on smaller margins than discount retailers like Target Corp. (TGT) and Wal-Mart Stores.

On October 12, 2006, Costco reported that
4Q:06 Earnings Edged Up two cents (share-net of 75 cents) on an 8 percent rise in same-store sales comparables and net-income growth of 0.25 percent to $355.6 million.

In our opinion, the 9.4% gain in the price of the Common Stock already discounts an improving earnings growth picture (given the nearly 43 percent drop in the price of retail gasoline—in the same time period—to about $2.00 per gallon).

For fiscal year 2007, consensus estimates call for Costco to earn $2.58 on estimated sales of $65.4 billion. The Common Stock is fetching 17.6 times forward September ’08 share-net estimates of $2.94.

The Common Stock is selling at about an 8 percent discount to its intrinsic value of $56.00 per share (derived from a blend of average P/E multiples and discounted cash flow analysis—which includes a weighted average cost of capital of about 7.6 percent and a forward earnings growth rate of 11.3 percent).

Risks to this value proposition include rising energy prices, delays in store expansions, and decreasing pricing power (due to increased competition).

Editor David J Phillips does not own any of the stocks mentioned in this article. You can see his portfolio holdings in the sidebar. The 10Q Detective has a full disclosure policy.

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