好市多 (COST) 2002 Q3 法說會逐字稿

Good morning, my name is Beth and I will be your conference facilitator. At this time I would like to welcome everyone to the Costco third quarter fiscal 2002 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remark, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number 1 on your telephone key pad. If you would like to withdraw your question, press the pound key. Thank you. Mr. Richard Galanti. You may begin your conference

Thank you, Beth and good morning to everyone. As usually, I would like to review with you several items related to the third quarter results this morning. To begin with our third quarter operating results, week ending may 12, came in at 28 cents a share earnings, up 5 cents or 22% over last year, a penny a share better and at the high end of our prior guidance of 26 to 28 cents. I know we brought our guidance down a penny from the 28 to the 27 cents on our March 5 conference call for the second quarter. Frankly that was the appropriate guidance at that time as earnings growth was better in the latter part of the third quarter than it had been in the first part, so we showed acceleration there. Comp sales for the quarter, 6% and I'll go into some detail in a moment.

the usual topics of interest I'll review with you, include recent openings, coming expansion plans, ancillary business results, new initiatives, Costco on line results, second at this membership results, and of course the balance sheet for the third quarter. Lastly, I'll walk you through all of you through current guidance for Q-4, fiscal 2002, which frankly remains the same as the prior guidance of 48 to 50 cents range previously given to you and I will give you a preliminary look at fiscal 2003.

Over all, progressing this fiscal year with the guidance given to you at the beginning of the year with earning per share growth flat in the first quarter year over over year. Up 28% in the third quarter. Let me start by stating the discussions we are having will include forward looking statements within the meaning of the private securities litigation reform act of 1991, and that these statements involving risks and uncertainties that may cause actual events, and or performance to differ from those indicated by such statements. The risks and uncertainty include not litted to those outlined in today's press releases as well as other risk identified in the company's statements and reports filed with the SEC. With that stayed, we'll get started.

Sales again for the quarter were up 11.6%, 8.4 billion from 7.6 billion a year ago, with same store same or comps of 6% up. Up 6% for the 12 week third quarter. Overall, good sales showing compared to retail overall and in line with many of the other strong value discounters. For the quarter, comp sales results weren't affected that much by weaker foreign currencies, only about one-third negative effect hit to that. Some of the foreign currencies which had be weak are showing strength to the dollar. Average transaction in Q-3, up 2% year over year, average frequency was essentially up 3% in each of the months of February, March, and April, and the first part of May, so again, a combination of a frequency increase of 3% and a transaction, average transaction size increase of 2%, reasons for the 6% comp for the quarter. Terms of sales comparison by geographic regions, northwest was 5% compared to 5 and 8% respectively for the first and second quarter, California was 7, at the high end of the 6 in Q1 and the 7 in Q-2, so it remained at 7 in Q-3, northeast was 8 compared to a 7.5 in que 1 and 10 in Q-2. South east picked up, 9, compared to a 7 and 6 in the prior two quarters. Midwest remained strong at 17 compared to an 11 and an 18 in Q1 and 2, so for the year - for the U.S. overall, Q1 was a 6, Q-2, 8, Q-3 was a 7

In Canada in U.S. dollars, we actually showed our first positive number, up 1 in U.S. dollars and up 3 in local currency. That was our first U.S. dollar positive comp in Canada in over a year. Other than international was up 5 in third quarter and on a local currency basis up 7

for the total therefore, for Q-3 of a 6 compared to a 5 in Q1 and a 7 in Q-2. Mexico, which of course we do not incorporate in our numbers, Mexico comps on the dollar basis were up 13% and on a peso basis up 9% in line with what it had done for most of the year so far

In terms of merchandise categories, food and sundries, we have four - five major categories. Food and sundries was up 5% in the quarter, compares to 6% up in Q.1 and 5% up in Q-2, so fairly consistent. Hard lines was up 6% in the third quarter compared to a 3 and 11 in the first and second quarterters. The 6 by the way in Q-3 was helped by hardware and lawn and garden and toys. With a little less, I think majors - I'm sorry, it was a 7. But with majors being about 5 for the quarter. That being electronics. Soft lines was also - was up 6% in the quarter compared to a minus 3 in Q1 and a plus 6 in Q-2, so eastbound again at the high end its perspective range. Again, soft lines up 6 was helped by a apparel, domestics and jewelry, which were the stronger departments in that category.

Fresh foods remained strong at 10 compared to 8 and 10 in the first two quarters of this fiscal year. That continues strong and actually has for over a couple of years

Ancillary businesses were up 9%, without gas, it was actually up 14%, so the base business is besides gas were up stronger, with gas of course gallonage is up industry strong, but the average price per gallon is down about 20, 25% year over year, so again, total company was 6% for the year.

Continuing down the numbers, to membership fees, we reported in Q-3 membership fees of $179.9 million or 2.13%. That's up 16% in dollars and up eight basis points from the last year or $24.5 million increase year over year. So strong showing in membership fees. By the way, on a cash basis, we reported on a deferred accounting basis, on a cash basis, the dollars were up almost similar amount, up $23.7 million.

These continue to be very good membership numbers and actually slightly better than average budget on a cash basis.

Remember in terms of reported book membership fee income, still benefiting on a small amount from the September, October of $20,005 fee increase, again with deferred accounting, it takes about two years for that to flush all the way through since the fee increase occurred months 1 through 12, it's actually month 24, which would be this August/september when we'll see the tailend of that benefitting book earnings. That incremental benefit has slowed, we'll be completely out of of the figures after August. Cash basis, continued to be helped by the first year membership sign ups that we did in markets a year ago. As well as the fact that we are also benefiting from members converting to our $100 per year executive membership from the normal $45 per year membership.

This is growing at a level greater than actual original budget this year, in part because of some of the activities we've done to push it and market it to our members.

At third quarter end, close store members in terms of total members, gold star members totalled 14.1 million, up from the beginning of the year at 12.7 million and up about 100,000 from Q-2 end. Primary business was 4.4 million, pretty much in line with where it's been. Recognizing some of those people have converted to the executive member, which is typically - which is put into the gold star. Business add ons, 3.6 million. Total membership is 22.1 million, up 100,000 from Q-2 end, and up 8.3% on an annualized basis. In fact, in Q-3, our paid sign ups, excluding all the free beast were do. So including free spouse cards, we have just under 40 million card holders out there. At third quarter end, in terms of paid executive memberships, which are part of these numbers, we ended up with 1.475 million paid executive members, an increase of 168,000 in the fourth quarter or about 14,000 a week new paid executive members.

That a compares to 13,000 a week increase in Q-2 and 11,000 a week in Q1.

In Q-3, executive membership sales in the U.S. where they're offered, so this is a percent of U.S. sales, were total 23% of total sales versus 15% of such sales in last year's Q-3, so you can see that program continues to grow.

Keep in mind, in the first year when executive member converts, we see a big bump in the average sales, something in light of the mid teens and then we see it stay at that level, not at that level of growth, but at the higher level, getting back to regular growth there after.

Membership renewal rates, as I expected and discussed with you on the March conference call for Q-2, our rates did trend back up to our all time high of 86%. Again, as we've anniversaried through the $5 increase, we went from an 86% all time high renewal rate down to 85, as we would have expected and now that we've anniversaried that for more than a year is 86. 86 is split between business members and gold star members, at 83%. Recall that our - oh, and this is despite the fact that Costco's annual membership fee is 5 to $15 higher than our main competitors. We think it's a combination of what we do in the warehouse, the constant innovation and new products an services that we offer, an we feel that frankly that our membership fee is still a very good value out there, and I think that's evidenced by the renewal rates.

One operational efficiency that should slight live help renewal rates and actually speed up collection of membership dollars is the recent completion really a major rewrite of our whole membership system. For the last nine or ten years, we've effectively continued to a band aid approach to changes in our membership system. About a year ago, we embarked on a major rewrite, which took close to 50,000 labor hours, if you will, to complete. It has a lot of benefits, most notably, the ability that a member can renew at the register rather than having to go over to the membership desk, more importantly, it will - once the membership card is scanned at the register, the cashier will be notified when the renewal date is and can remind the member that even if their membership renewal is one or two weeks from now or just occurred, stay would you like to pay right now and save the means of having to write a check later, and what we find is it enhances the membership renewal rate slightly and certainly speeds up by a few weeks if not more of when the income comes in and can start being recorded.

We think that's a big positive. There's many other advantages to the new rewrite, which include the introduction of the new Costco cash card, how we process gift cards as well as ultimately, you know, phone card sales. I'll talk about that in a moment.

In terms of American Express, it continues to grow in the third quarter. We added 143,000 American express co-branded cards to be 1.7 million accounts, close to 2.7 million card holders, and American express now represents just over 20% sales penetration up from 18% a year ago.

Going down to the gross margin line. In third quarter, we of course had a very strong gross margin. In fact, stronger than originally predicted. 36 basis points up at 10.12% versus 9.76% a year earlier.

Like in the past, if you want to jot down a few numbers. Wee tie this up to help better explain membership, and gross margin percentages as we will do in a minute with SG and A. Look at the components of it. We break down the 36 basis point improvement into five categories, core business, the core warehouse, the 2% executive member award which is an offset to sales, effectively reduces gross margin as we build that business. The benefit or detriment related to ancillary businesses, the fourth category is international and the fifth category is LIFO, for then a total for sixth line. Just in terms of a trend, I'll ask to you jot down three columns. Q-1, Q-2, and Q-3. And if you go across on the core line, in Q1, year over year, core gross margin was down 16 basis points in Q1, up 10 in Q-2 and up 30 in Q-3. I'll give some more flavor to the 30 in a moment.

the 2% reward was minus 14 basis points in each of the three quarters. That compares to minus 19 percent last year.

I'll ancillary, which was plus 16 in Q1, was flat in Q-2 and up 17 in Q-3. A lot of that has to do with gas. In Q-2 as an example, that zero had minus 9 related to gas whereas in Q-3, the 17 had plus 7 related to gas. Other things that were strong in gas - in ancillary in Q-3 were the very strong operating results in the pharmacy.

International was plus 6 basis points in Q1 and plus 3 in each of Q-2 and 3 and begin, these are the components. When you add these - LIFO was 0, 0, 0. In each of the three quarters this year and each of the three quart trs last fiscal year the lie photograph charge was $2.5 million. So on the basis point year over year, it was no change. Keeping in mind that's an estimate at this point. I'll talk about that in a moment as well. Total reported gross margin year over year in Q1, which had been down 7 basis points, in Q-2, down 1 basis point was up a healthy 36 basis points in Q-3. In terms of the core improvement, the food and sundries and soft lines were stronger year over year. Hard lines was about flat year over year and fresh foods was particularly strong. we've shown very strong increases in our - in the efficiencies which is ultimately reflected in our gross margin as sales continue to be strong there.

the next gross margin component, the 2% executive member reward, it's pretty straightforward and again I've tried to share with you some of the components of that. If you would jot down a little table with four columns, Q1, 2, 3, and 4, and three line items, fiscal 2000, 2001, and 2002, this matrix would start in Q-3 of 2001 with a minus 1, Q tour would be minus 12, the four quarters of 2001 going across would be minus 17, minus 21, minus 23 and minus 17. In 2002, Q1 through 3 would be minus 14, minus 14 and minus 14. What you see here is we initiated the 2% reward program at the tailend of Q-3 of fiscal 2000 and the effect of increasing sales penetration being afforded the 2% member reward is a reduction reflection in the reduction of sales by 2% on those sales and therefore the same costs of sales, you have a hit to gross margin. On a cumulative basis, if you added these quarterly columns downward each quarter, you can see that in Q1, for the two years that we've done it, it represents 31 basis points, cumulative, Q-2, 35, Q-3, 38, and of course Q-4 for the first two partial quarters there, two quarters of the first 2 years, 29. We would expect to see the level of sales penetration continue to increase, but at a slower rate. Frankly, it's been at a higher rate than we had planned this year, which we think is good and we'll talk about that in a minute.

We think that the strength in the program by the way is again, increase in our warehouse - in warehouse signup efforts as well as we believe the word-of-mouth.

I would guess that in Q-4, it will probably be about 12 basis points detriment, which would give us again some number in the low 40's, about 40 basis points cumulative year to date. Next year, while still a detriment to gross margin, a very small detriment.

I believe that in last year east conference call, I stated that we would expect the detriment to gross margin from executive membership to ratchet down a bit faster than it appears. We think that's great. More members are selecting the executive membership it means and frankly with less of them being the initial adverse selectees, if you will, so we think the program works. We know it works based on incremental sales and profitability from the sales, incremental membership fee income. Here's is where you see the offset.

with regard to ancillary businesses which were up 17 basis points, again, better pharmacy and optical and food core profits with pharmacy being particularly strong. And in a positive reversal from last year's third quart, our gasoline business, which was quite frankly abysmal last year was a little less abysmal this year and a little profitable in Q-3. That added 7 basis points year over year. Whereas it was about minus 9 basis points last year.

International 3 basis points better, no big surprises there. And again, I mentioned LIFO. Now I would say that current reserves so far, we think that exceeds the year to date level on inflation. In fact, on a net basis we have seen a slight amount of deef flags, although again we won't know until the end of the year. To the extent that continued and there's no reason to expect it won't, that would help Q-4 in Q-4's margin, reversal of some of the LIFO charges, but that would be an of 0 set - that would be an offset to what most likely will be a very tough year over year gasoline comparison. Again, going back to the volume tilt of gasoline P and L where was last year east Q-3 was abysmal, last year's Q-4 was very, very good. In fact, I went back to my notes when I reviewed Q-4 last year, and the gross margin related just to gasoline profits in Q-4 last year were up 24, 25 basis points. So again, while we are on a profitable trend in the last several weeks for gas, we're not at the same level as last year, so I think those two might offset those. Gross margin outlook in Q-4 and fiscal - Q-4, again, our budget to start with is in the high single, low double digits.

the fact that last year's again core was down 21 basis points will help. The fact again that gasoline was up quite a bit will be a hard one to compare, so that could be an offset.

I would also expect in fiscal 2003 and I'll go through some more of this at the end of the call, we would expect in fiscal 2003 to get at least 10 basis points of margin improvement, again while remaining the most competitive operator out there. There's no - margins are not our problem as we've shown. The cha eng continues to be to drive our expenses down.

Before going into SG and A, let me briefly go over some of our ancillary businesses. As you know, - you don't know yet, we have 295 pharmacies, having opened one in the third quarter, and about 23 year to date. Food service, we added four in the quarter to essentially be at all locations. One hour photo labs, we added 4 to be at 382, up 43 from fiscal year end. Optical, we also added four to be up 24 since fiscal year end. We added one copy center to be at 12. Which was actually the same number year end and we add one hearing aid center to be at 105 which is up 24 and gas stations we add one in the third quarter to be at 160. That would represent - that represents our 21st since the first of the year when we had 139. We've opened just in the last few weeks since the fourth quarter began two more, including one in Rancho Cucomango [phonetic] yesterday which was a relocation of a units and we plan six to eight more to be at fiscal year end to be right around 16 - I'm sorry, 170 by fiscal year end. These businesses are doing fine overall. They're highly profitable, with the exception of the gas business of course, its profitability is up and down, which pays many more dividents in terms of the loyalty factor and driving additional businesses in the warehouse and over any 12 month period, we've always seen a modest amount of profit in the gas. These drive our overall business, have better than average company comps and again they're yet another reason to be a member of Costco, which we think helps our renewal rate.

In total for Q-3, ancillary businesses comps again I mentioned were up 9% and without gas were up 14%. So many of the, if you will, mature ancillary businesses like pharmacy, optical, food court, have continued to show good comps and good growth.

Before moving on to SG and A, I will like to mention one change at the gasoline pumps, which it says it will become effective June 1, although there's kind of a one month grace period where even though we say we won't accept certain cards, the individual out there will have the ability to override that. Effective again in June, Costco will no longer accept Visa, MasterCard and discover at the gas pumps. As I'm sure you he know, we do not accept those cards in store. Initially we chose to accept them out there because we don't accept cash and checks out there since typically there is not an employee out there doing that. We will have continued of course to continue to accept American express as well as our private label card offered by household, and debit cards as well.

with traditional credit cards of course the merchant fees already high by our standards and recognize we have some if a national particular standards out there giving given our low gross margin to start with, are even higher in a transaction where there's not an employee present to be able to check your card, so we've run relatively high merchant fees out at the gas station, in what has proven to be a low margin business, with of course debit cards, their lower fees than credit cards overall and with American express, while I cannot discuss pricing, this is a partnership, it goes well beyond simple credit card acceptance at the gas pumps. We have tested it, and we do believe that it that will help our profitability. All things being equal, we estimate that this card could help gasoline P and L by 10 million to $20 million, while allowing the same credit card and debit card alternatives as we have in the warehouse.

Also, the timing coincides with a roll out of the Costco cash card, which essentially is a stored value card. We haven't been the pioneer in this. I've gotten the store value card at some other retail merchants when I've returned merchandise item or two, but it has many opportunities and benefits for us. This is being rolled out now as we have - just this week as we've completed the major membership rewrite, which included a lot of rewrite in the point of sale system allowing us to do this. The Costco cash card has many opportunities, not only for people to buy goes but to give out as gifts, for parents to give to kids, going off to college, it will replace gift certificates in the warehouse, which we had, if you recall, stacked up on pallets, which was actual value on the gift certificate and in a corrugated plastic container. Now it will simply be a card on a peg board rack with no value on it. The net value can be added in any increments up to $1,000 at the register by initializing the card through the scanning and card swipe system.

We also think it has merit out at the refund desk, although will still give members the opportunity to take cash or to take the credit against their credit card or debit card.

That again is being rolled out as we speak.

Moving on to SG and A, it came in year over year as a% of says higher than planned. Due mostly to the new locations we've opened in the last 12 months, 29 new locations. In Q-3 SG and A higher or worse by 23 basis points coming in at 9.56% of sales and this years through Q-3, versus 9.33% of sales in last year. Again, this will be the last chart I ask you to write down, but again, if you look at the first three quarters, and there's again five line items, the core warehouse, central, which is our administration offices, ancillary businesses, international, and other. In the first quarter, the core in terms of the basis points of detriment are benefit to SG and A overall and again a negative number means SG and A was worse or higher. Core business was minus 21 in Q1, minus 20 in Q-2 and minus 19 in Q-3. Central was plus 5, plus 7, and plus 4, so plus 4 in Q-3. Again, that would be lower by 4. Or better by 4. Ancillary, minus 7, minus 4 and minus 7 fnlt international, minus 3, plus 2, plus 2 and other, 0, 0, and minus 3. For a total year over year SG and A being higher by 25 basis points if Q1, 15 in Q-2 and 23 in Q-3. Now in terms of the core warehouse SG and A year over year, are higher by 19 basis points. Analyzing components of this, nearly all of it again relates to the many new market warehouses we opened. If you take out the - if you separate our company in to one year or older warehouses an one year or newer warehouses, basically, that's 18 of the 19 basis points, similar explanation that we had in the second quarter. The other thing that you know, I've been asked a lot of questions'last you few months, and particularly I think since Wal-Mart had talked a little bit about, particularly at Sam's some of the health care and related costs, I did look at that and in the quarter that represented year over year about four basis points. We think that's manageable. I might have add that even though it's up year over year 4 basis points on a decent comp, that's not withstanding the fact that our virtually all of our ratios of claims and incidences per labor hour continue to improve based on safety programs in place.

We'll continue to monitor that and share that with you. But year over year, that was 4 basis points

the only other thing that I'll note is in terms of other being minus 3, that relates to again a year over year delta in terms of what we call site location costs. These are not closing costs which go on the closing cost line, but whenever we spend money in initial stages of identifying a site, whether it's legal, any development work, ultimately that site does not go forward, we write those off, and again, with the ramp up in expansion, we had about $2.5 million year over year higher than that. I generally won't speak about that number, but again, just trying to show you where that was, that was three basis points.

Next on the income state is it preopening expense. Preopening improved by 6.7 million or it was lower by 6.7 million year over year. 12.8 million last year and 6.1 million this year. Nothing unusual about that. While it's lower than budgeted because of some of the pushing out or delaying of some of the locations, just as things have happened here, in last year's third quarter, we had nine openings, no relocations actually, and this year we only had four openings, again with no relocation, so again, a slightly more than doubling of openings a year ago versus now and a year ago preopening was slightly important double as well.

In terms of revision for impaired assets and closing costs, this year it total 4.5 million pretax, last year it was zero. I believe in last year's conference call I shared with you that the zero was actually reflected 2 million of actual closing costs, 3 million of Canada restructuring charges and 5 million of real estate gains for a sum total of zero. But again, that is again our numbers overall this year include a year over year $4.5 million reduction related to higher closing costs net. So all tolled, operating income in the third quarter 41.7 million up, up last year 23.8 percent. Not a lot of change reflected below the operating income line. Net income expense was - I'm sorry, total interest expense was slightly lower year over year by about $400,000, essentially flat, and interest income and other was actual better by - was actually slighter lower by a couple hundred thousand dollars. So the net of those two means that we had an improvement in net interest expense year over year in the third quarter by $200,000, whereas operating income was up 41.7 million, pretax income up 41.9 million, also 23.9% year over year on a pretax basis.

We're pleased with the showing giving our ramped up expansion program in the last 23 months and including nearly 75% of the openings over the last 20 months were in new markets.

One other point I wanted to make on SG and A I wanted to make while it is a little higher than we had expected, you know, we probably are our own toughest critic of SG and A. We are concerned about expenses, we run a very tight ship out there, although we do things to drive our business and to enhance customer service. In reviewing these numbers over the last couple of Mondays with Jim and others at the budget meetings, we have continued to place a big emphasis on customer service as we feel that we focus on that more than anybody as we drive our business.

That being said, I do believe and I'll share with you when we go through some direction for next year, we do believe that we'll be able to show a small improvements in SG and A over the next year.

Now for a quick run down of our balance sheet. As of may 12, cash and equivalents, 841 million. Keep in mind, well over half of that is not - are the equivalents like debit card and credit card receivables receipted to the weekend sales since we closed our fiscal periods on a Sunday night, you have some Friday and all of Saturday and Sundays related receivables related to that. Inventories of 3.025 billion. Other current assets of 520 million, total current assets of 4 billion 386, net P.P.E. of 6.339, other assets of 423, total asset of 11 billion 148 million. On the right-hand side of the balance sheet, short term net I have, Accounts payable, 2.841 billion. Other current liabilities, 1.433 billion, total current liabilities 4.329 billion, total long term debt, 1 billion, 167 million, deferred and other, 125 million for a total liabilities of 5 billion, 621. Minority interests of 119, stockholders equity of 5 billion 408 million, for a total of 11.148. As well, during the quarter by the way, we did $300 million public debt deal, and a couple of you had asked why did we do that, it didn't seem like we had all the cash. As I mentioned to you, bulk of that cash is really cash equivalents as it relates to various receivables on the credit and debit card side. We actually - we had about 180 million of short term borrowings under a commercial paper program. What we did effectively taking advantage of good rate out there, we borrowed 300 million, we - a 5 year fixed rate money, we swapped it into overnight, and the effect of that as the effect of essentially lowering our previously LIBOR based pry sighing to LIBOR minus 27 basis points.

In terms of the balance sheet, let me point out a couple things. The cap ex ratio continues low an strong at 18%, that is never a concern of any of yours, the financial strength of the company. On terms of managing our inventories and payables, again, we take every term and discount and pay as quickly as possible to earn those terms of discount, because of our high inventory turnover, we show good accounts receivable ratios. Our third quarter ratio of account payable to inventories was 94%. Down from a year ago, 98%. Keep in mind, this is not just merchandise inventories, it also includes payables related to construction in progress with contractors. If you just look at merchandise papers - of course a year ago we had a lot more going on than we do now, although we have a lot more going on now, we had a lot more going on a year ago. If you take out those types of payables shs merchandise payables as a percent of inventories is up 2% at 80% versus 78% a year ago. This is seseasonally low period of time in the third quarter.

Average inventories per warehouse, tweaked up slightly year over year, coming in at 8.2 million per warehouse or up about 330,000 year over year. Most of that increase is in three categories, tobacco, as we build up for pending price increases, which occurred already, toys, which is principally a reflection of all the electronic game stuff with X box and play station, and pharmacy, an again, pharmacy has been - our pharmacy sales growth has been particularly strong both on the R.X. side as well as the over the counter side.

In terms of LIFO, I note nothing new to say there. In terms of cap ex, our original budget for this year, 1.3 billion, down from about 1.45 billion a year ago. You know, again our original budget was 35 planned openings and 7 relocations, it looks like the 35 will be 29 and the 7 will be 6. Most of that relates to simply timing where things have been pushed into the early part of next year. But we do - with that, we'll see a slight reduction in cap ex. I would guess our cap ex this year would be about 100, maybe even more than 100 million lower than our original budget. Our original budget on a net free cash flow basis was to be down 200, 250 million, so that would I am employ you're net free cash flow would be down about 100 million negative.

Next topic, Costco on line, it has been profitable for the last several months. Recall last year east sales of 73 or 76 million, I think it was 73. First quarter sales increased this year was up 35%, second quarter sales increased up 109%, some of that was helped by - a couple of coupons in the Costco wallet program which is the equivalent of our passport coupon program'summer. Third quarter sales increase without any wallet items up 73%. And we would expect fiscal 2002 sales to be in excess of 130 million and most importantly to be profitable on a fully allocated and spendsed bay expensed basis.

Expansion, year to date through may 25, we opened 24 new units and relocated three, between now and September - the end of the fiscal year in early September, we'll open five new units and three relocations. So again for the total year, 29 new locations, six relocations, and total of 35 openings.

In terms of the eight that we have planned between this past weekend and the end of the fiscal year, again, we just yesterday relocated Rancho Cucomungo, California, we'll open on June 6 in Laguna [Phonetic] we'll relocate our original Honolulu site in Hawaii to [inaudible] on June 12, we'll open our second Pittsburgh area site, Pennsylvania, on July 9. We'll open a site Fredriksburg, Virginia, on July 10. We'll open our tenth Texas site on July 11, San Antonio. Sometime later in July, we'll open Port Chester, New York, and on August 8, we plan our last relocation of a year in Bakersfield, California. So with 29 net new openings this year on the basis of 345, that would total 8.4% unit growth, and about 9.5% square footage growth, recognizing these units are a little bigger than the company average, coming in around 148,000 and we do relocation activities and other remodel activities, which expand a little bit on a year end base.

In terms of 2003, through the end of the calendar year this year, on September 5, we'll open our third Japan location in Tommasaki [phonetic], a sub burr of Tokyo, that's on September 5. In September, we'll also open in St. Louis, Missouri, may field heights, Ohio, Tracey, California, Indianapolis, Indiana, as well as a relocation in Boca Raton, Florida, and about ten more unit that I haven't announced, since they haven't actually started construction by calendar year end, so a total of about 16 new units between September 1 and Christmas.

Finally, before I turn it back to Beth for questions and answers, let me briefly go through some things for Q-4 and some very preliminary direction for 2003, recognizing we have yet to start - we have just started the formal budgeting process, but as bob and I and others sat down to walk through the numbers, to try to come up with some expected assumptions there. In terms of the fourth quart, again, our guidance remains from the 41 cents last year to be in the 48 to 50 sent range this year. I know some of you are going to call me and say you brought us down from 28 to 27 and came in at 28. I promise you that the 48 to 50 is a good range and hope we would get to the top there, but we could be in the middle or lower end and we'll be just fine. That 48 to 50 sent range by the way is a 17 to 22% increase year over year and that would imply a 10 to 13% increase for the year which again has been a transition year when we're comparing to when we were flat, down 4% earnings in fiscal 2001 overall and flat in the first quarter of this year, fiscal 2002. In terms of where we get, you know, assuming we get to that range, you would - I would expect to see some still year over year increase in SG and A, but a better showing than we did in Q-3.

Gross margins showing some strength, not as much as we saw in Q-4 recognizing the thing I mentioned about gasoline.

and membership still up, you know, 3 to 5 basis point. Again, the rate of increase still increasing, but not the same effect given the $5 increase.

In terms of in a very preliminary outlook for 2003, our bay assumption is going to be about 30 new locations and maybe a couple more, but if we just did the 30, that would be 8% unit growth and 9% square footage growth. More importantly, the mix of those units as we mentioned, I think I mentioned on the third quarter, will be rather than again about 75% of the unit that we've opened in the last year and three quarters, being in new market, this would be more of about a 40/60 mix new market to existing market the that is again a conscious effort on our part and bodies well for our bottom line. Decent gross margins and good membership fee income. SG and A, the assumptions there are - include the benefit of or the less detriment of a mix shift in terms of where we open our locations.

the anniversarying of these older locations in these new market which I think continue to show help. Continued leverage of central expenses to a small amount. I mentioned the improved merchant fees at the gas station are expected, and offset a little bit by slightly higher health costs as I indicated in Q-3, you saw that about four basis point higher.

with that, with the assumption of comp in the 5 to 6% range, we would expect to see, you know, sales growth in the 11 plus range, and we would expect that based on that, and again, you can do your own analysis, and this is purely, you know, back to the envelope expectations now, I would expect gross margin improvement to be in the 10 plus basis point range to have SG and A improvement in the 0 to 10 range, to have membership fees at least flat, maybe a little better as a percent of sales, but again that would be good given the fact that we don't raise our fees every year. In fact, I was asked recently what's - with what's going on with our competition and membership fees, where we haven't seen, not only haven't we seen the types of increases that we've shown there, but we've actually seen many promotional activities related to membership fees, I can assure you that as it relates to promotional activity, we have limited it to doing the free check mailer and new markets and we have every confidence that at some point we will do that, although I don't expect to see that in the next few months.

the other - we'll get a little basis point improvement also from preopening and closing costs as a percent of sale.

So all tolled, we could see - we haven't an exact goal yet, but we think it's pretty easy to do the back of the envelope to see how 11, twem,% sales growth and at least 10, if not 15 plus basis points of total improvement on the various lines, if not even a little more, we could get at least 15, frankly if not a little bit more, we could get in excess of 15 percent growth, but we'll share more with you as we go along. This is back of the envelope outlook at this point. With that I'll turn it over to Beth for Q. and A. D

I would like to remind everyone, to ask a question, press star then the number 1 on your telephone key pad. We'll pause for a moment to compile the Q and As roster.

Your first question comes from Daniel Ferry [phonetic] of Merrill Lynch.

Good morning, Richard. Congratulations on a great quarter. A question about your - the expansion program. You fell short of the number you originally indicated at the beginning of the year. Was any of that deliberately cut being back, slowing down to help the margins or was there just delays? Since you did delay some units, it would appear you should be pushing more units in the first half of next year, but your rate next year is actually less than in the first half than for the year as a whole?

None of it was deliberate. I can think of one or two units that we've postponed indefinitely and I won't tell you where, but in markets where we've opened, where we've fallen a little short of expectations and we've sad let's not add insult to injury, let's get the ones working first, and that's I think one, maybe two. Aside from that, the answer, it's more of just a timing delay, recognizing when we put or original budget together, on the 35 units, there's always, you know, 10 or 12 in the last, you know, inevitably, there's 10 or 12 in the last couple of months, because we, you know, we're working on them, we believe with a very high probability that it will occur, but when push comes to shove and we're going through the permitting process and Port Chester is a good example in New York, that was in our original budget to open in the first half of the fiscal year, and it's now going to finally open in July. Now it's still in the same fiscal year, but we've run into a lot of probably an extra million dollars of site costs. This will be capitalized as part of the construction project, related to Blassing of rock on the site where we found more rock than dirt frankly, and it's taking a little longer. So those things happen.

Now, I guess, you know, usually I start off the year by saying we're going to do about 35 to 38 and we end up doing 32. This year we started by saying we will do 35, we're going to do 29. My guess is, when I say we're going to do about 30 next year, it assumes we will have a budget that probably has about 35, with five or six of those frankly being the ones that are carry over from this year, but inevitably, same thing will happen next July and August, a few will fall out. So I don't see a big delta year over year. Maybe there's one or two net reduction, not for any reason other than that's what's on the list right now. I think the bigger change is a conscious effort to have our real estate people really starting about six or nine months ago to start focusing on tougher sites. In other words, the no brainer sites and the L.A.s, and the bay areas and Seattles and the Portland and long islands and the Virginias, where we are very successful and we should find more locations and even though we've been looking for a long time, we need to double up those efforts

Again, a related question, you once said you were looking for a 10% growth rate in units over let's say the next five years. You've done eight this year and you forecasted eight for the next year, so should we lower our forecast to 8% unit growth rather than 10

I would say it's fair to lower it to a 9. I don't see - I basically see, you know, as you know, with all this growth, with little less, you know, little tougher economy over the last year, we had minus 4% earnings last year, we'll be up this year, but again, that it's that transition year. I'm pretty much convinced if we follow through like we think we can next year and we've got the momentum that carries in, not just in 2003 but in 2004 with some of the things we have going oranges I could see that bumping up a little more, so I would say 9 is a good number.

and the 9 would give you 10 square footage

Yes.

Thanks.

Your next question comes from Charles Lee most of Deutsche Banc

Good morning. Congratulations on a solid quarter and on great press in the "New York Times" yesterday. I guess my question, I've got a couple hodgepodge questions. Can we touch on the special order kiosk, how that's growing in the last year, you did about 3.1 in sales, how is that doing, how many do you have?

Okay. We have - especially kiosk program is essentially in the U.S., although we plan to roll it out over the next six or eight months in Canada. When we first started it, our original guess and goal, and it was probably more guess than goal, was that in a typical $100 million warehouse, could we add incrementally, above and beyond that what square footage did, could we add a million dollars to the each building and in in the first year we did about 70 percent of that, added about roughly 130 million. Of I don't have the exact numbers, the current estimate is to do close to 300 million order in special order kiosk. And the important thing there is that, you know, it's a test to figure out what sells and what doesn't. We're trying new things, we're learning - we've had some surprising winners and surprising losers. Things we thought were going to do well, things that we thought weren't do well, we thought try it and it did well. We will continue to do that. You should consider it very much part of the warehouse now and we're going to continue to do it.

On the margin improvement in the ancillaries is some of that being driven by a shift to generic in pharmacy?

Well, we definitely have strong margins in pharmacy. Some of that is a shift to generics, recognizing we've set our own - we set caps in our business. Companywide, we have a markup limit, if you will, of 14% on branded goods and 15% on private label. Clearly, though, the pharmacy gross margins are closetory the high ends than other departments in the company. And, frankly, even though I said the high ends, we probably percentagewise are saving customers more money in the pharmacy than anywhere else.

My last question, which is private label, have you seen shifts into private label sales away from branded and is that one of the explanations for improvement in gross margin?

That's an ongoing reason over the last few years for some small improvements in gross margin. I don't think that's the bulk of - you know, that's a small piece of Q-3, if that. You know, private label sales for us are in the 13 to 14% range, so it's ratchetted up a another point in the last year. I - I must say, I think there is probably an added benefit of private label. There have been instances where even when word was out that we were looking at a private label alternative, lo and be hold, we found extra money from the vendor, and so it is - and that doesn't necessarily stop us from doing the private label, but no some instances, that branded good has to compete with the private label. I'll give you an example, just in terms of our savings, we just in the last few months began introducing a flavored sports drink called Kirkland signature sports drink or whatever, something pretty basic name, it's a 29% savings to our price that we sell the branded sport aide drinks at, and it has taken market share and with that we can see, you know, greater pricing power on the branded goods, and I'm not - I didn't mean to pick that one out. On virtually every item, whether it was spies a few years ago or chicken or you name it, we have the ability - or you know, cranberry juice, we have the ability to not only improve as we improve our margins saving the customer money on private label, but I am professor our buying power an keeping some of the savings on the branded goods as well.

Thanks a lot.

Your next question comes from Amy cost love [Phonetic] of Sanford Bernstein

I have a couple of questions on the gas business. The first one is Richard, can you just go over what the basis point swing in sales is required to move earnings a penny? Second, what are you embedding in your Q-4 guidance with respect to gas. Timely, will there be any positive impact from changing the card acceptance rules at the pump or is it just way too early and we won't see that until 2003?

Let me do the last one first. I think there will be a little bit this quarter, but it will be more in the first quarter, you'll start to see that 10 to 12 million I talked about on an annual baicy. As it relates to the gas business, let me try to quickly do this on my calculator. You know, gas is a 1.3 billion for us, so call it 100 million for us, rough numbers, we can have a P and L link in a month of as much as $3 million. Recognizing you never have a 3 million-dollar swing in the same direction every month. Most times, it's a lot less than 3 municipal. But you know, you could make 1 million in one week and lose a half a million the next week or vice versa, so - but on $100 million in sales, could you have a three quarters of a penny swing, which would be $6 million on an extreme basis? 6 million on 100 million is 6%. So - I'm talking about as a percent of gas sales, not as a percent of total sales and we have seen that. We've seen our gross margin on gasoline range from 13 to 14% frankly. Whereas we might have need, you know, 5 or 6 cents a gallon to break even. 5 or 6 September a gallon would be 4%.

Okay. And what are you embedding in Q-4 guidance with respect to gas?

In our Q-4 guidance I'm embedding a small level of profitability compared to a very high level of profitability a year ago. The leather off the ball last year.

Okay. Great. Thanks.

So it is a decline year other year. Go ahead.

Your next question comes from Sherry Eberts [phonetic]of J. P. Morgan

Good morning. Richard, I just wanted to talk to you a little more about the 2003 guidance that you gave. You mentioned that the SG and A would be down slightly for the year. I think that was sort of similar to the guidance you gave for 2002. I was hoping you could talk a little more about the timing of this and exactly when those new store losses should start to anniversary more favorably

Well, it's - even with all the knowledge that we have, which is more knowledge on our business than you have, it's still a little bit of a guessing game. What I can say is is that, you know, the you know, in 2001, we had 80% new market openings. In 2002, while they improved year over year, the aggregate lo was greater because they were open for a whole year, not a of half a year, so in 2003, we're finally now on a full year to full year comparison, they'll be helped. In 2002, the year that we're currently in, we've opened up again a large number of new openings, but it wasn't 80% new markets, it was 65%, so that delta should still hurt us next year because again it will be a full year comparison versus a partial year comparison on those, but not hurt us as much as the 2001 hurt us and 2002. In 2003, we again are going to improve that analysis a little bit by opening up about the same number of units, but again a focus on units that are profitable. I can tell you and I don't have the exact numbers in front of me, but if I had to look at, you know, the last five years of new market units versus existing market units, what do they do in the first 12 months, recognizing those first 12 months generally will overlap the fiscal year? Because they don't all open on day one of the year. That on a pretax P and L at the warehouse level, we could make as much as 2 million in a unit but let's say make 1 million to 1.5 million in an existing market and we could lose the same in a new market unit, so if we switched, you know, eight to ten units from new market to existing market in a given year, let's say eight, that's eight over the next 12 months, recognizing these are partial years though, but in the next 12 months, you might have eight units that instead of losing call it 1.5 million say 2 million each even, so you're safe that 16 million and then you have 8 units making a million each or a little more than a million each, so you have about 20, $25 million swing there. Again, that's how I can best explain it off the top of my head.

Okay. And then secondly just on the gross margin improvement for 2003, is most of that just the executive membership improvement or what else is factoring into that?

The executive member will still be a negative year over year, but a whereas in 2001 year over year it was like 15 or 18 basis points, in 2002, it's about 14 trending down hopefully in the quarter a little bit next quarter, you know, let's say it's 5 to 7 next year, so it's less - we'll have less to pick up there. I would assume, since that - for the year this year it hasn't been a great gas year, I don't think it could be any worse next year, but I've been proven wrong before, but let's assume we get a little bit there, I sthil think you're going to find the bulk of our improvement on the core business and you know, it's funnily, when I'm asked over the years why can't you guys get a little more margin, then we get a little more, everybody says, are going to hurt your competitive situation? I can assure you we will do nothing to hurt our competitive situation. If anything, our toughest competitor is Jim 16 that goal [Phonetic] even with the kind of improvements we've shown, recognizing there are a little extra benefits in Q-3 relating to gas year over year and things like that but the fact of the matter is, I have no worry and personally I have no worry that we can't achieve and remain very competitive with the buying power that we have, with the global sourcing that we're doing, with a lot things we're doing.

Okay. Good. My last question, I was wondering if you could talk about renewal trends in last year's new markets and just any comment on the broader offering that you did for the new memberships, if you viewed that as a success and is that part of the operating plan going forward? I am

I'm sorry. I missed that part of that it was breaking up on me.

In terms of the renewal trends in last year's new markets and then, if I remember correctly, you extended new membership to a broader geography, and I was wondering how you felt that went and if you would use that going forward.

I think in terms of a broader geography beings I think in some of the new market we went out geographically, 20 miles instead of 10 to get to a trade area. I don't think there's been a big change there, partly just depends on how big that trade area and how far people have to travel in. What we've seen historically is about a 30% renewal rate on the first year free beast, and it's interesting, sometimes, if I use as a bench market the average number of free beast we do in a new warehouse let's say over the 10 weeks prior to opening and 8 to 10 weeks post opening, I would sale the average is probably 60,000 free beast, so a year later, 30% times 60,000 is 18 or 20,000. It's interesting, when we signed up 100,000 free beast, as we have, we find the renewal rate slower and with we sign up 45 or 50,000, we find the renewal rate slight live higher, some range of paid sign ups a year hence, while there's a range, it's a smaller range than that 50 to 100,000 free beast. It's really not been a lot of change in that that we've seen over the last couple of years.

the free membership, when we go into somebody else's market, the free check mailer does work and we'll continue to do that. I think the other pro mowingal thing that we - promotional thing we do as you know, relates to the summer passport program that was just sent out. If any of you didn't get it, feel free to call or e-mail me and we'll get you 1 and the winter wallet which is essentially the same thing although over a shorter number of weeks. Between the two, I think we cover about 18 or 20 weeks, 12 in the summer and eight in the winter, and that's been pa very successful program for us. It's a way to take the monies at that vendors are willing to give us to reflect directly in 100% in the price of their goods and to drive their business and our business at the same time. And increase frequency, so I think you will see - continue to see us do those things as well.

Okay. Great. Thanks very much.

Your next question comes from may yen [PHONETIC] Salomon Brothers

I have two questions on foreign exchange. The first one is in terms Q-4, what sort of aassumptions do you have in terms of the Canadian dollar and I would expect you would see some sort of benefit if the currency remains where it is, and if you talk about the impact to comps and also profitability.

Well, you know, frankly, on Canada, even though it has historically trended down, ten years ago the Canadian dollar was 85 or 86 cents, it troughed about at 62 cents a year ago and it's now in the mid 60's, sick 6 I at this 4 lish, 63, 60 four-ish, so it's come up a little from its low, we frankly assume whatever it was last month it's going to be this month and change it accordingly. Let's assume it improves a little bit. Canada, we probably had a bigger poor economy than we have had in the U.S. frankly and we've seen - so we've seen relatively slow growth up there. It has picked up a little bit. Our budgets assume a continued slight pickup income ps up there from its current low, you know, 3 or 4 percent. But not a lot.

Okay. So the fourth quarter guidance that you have already assumed some sort of benefit

Our fourth quarter guidance assumes very little benefit, if any, from that.

kay. Thank you.

Your next question comes from Todd slater of Losard[Phonetic]

Thank you. Richard, you talked about the expectation of lower gas profitability in the fourth quarter I guess versus last year's comparison. What does this translate to in terms of your expectation on year over year change in gas prices, what are you have assuming? I

Todd, frankly, your guess is as good as mine on that. You know, we - for whatever reason, last summer was, you know, as bad as Q-3 was last year, Q-4 was better than it was bad, the prior quarter. While we're starting off profitable, we don't expect to be at a million plus a week in gas profitability. As of today, our current assumption - bob actually has preliminary numbers from Paul lay thumb, is that gas prices will come up a little bit but not a lot, 5, 10 cents is what I'm reading, whereas right now they're down 20, 25% from last year.

The pricing obviously has impact on your view of gas profitability, right?

You know, it's interesting, a year ago, the trends that we had seen, recognizing, we're now experts'gas business because we've been doing it for four or fooifs years, what we're experts in is selling a lot of gas. Early on what we saw trendwise is because we turned our inventory so fast in gas, literally every day, compared to the guy down the street turning it every five or six days, when prices were rising rapidly, like 3 or 4 cents a gallon per day for a week or two in a row, that the guy down the street was pricing off of cheaper gas than they had bought five or six days ago. In doing so, when prices were rising, we saved the customer less and in many instances lost money. Conversely, when prices were falling, because of our very fast turn, we saved the customer more and made more money. So it was either both bad things or both good things. Pair par that was logical based on what we saw.

In the last year, that logic hasn't occurred and part of that is that if anything, we've probably seen a little less competition out there in gas pricing. I don't know if it's the pressure and the publicity that the refiners, you know, the argument that the refiners are making all the money in the refinery and not making money at the retail branded gas pumps. What ultimately our view and certainly Jim's view as impatient people like me and bob and I have continued to say to him, we have to do something because we're losing money this month, his feeling was and he seems to have been proven right so far is is that, your know, operators like Costco can weather that storm and we'll be around. I think what you're finding out there is that there is a little less competition both from the majorrings and the independents, which has helped us even when prices have risen or fallen. But not helped us as extreme as they had before or hurt as as extreme as they had before.

Okay. And does your fourth quarter guidance include a likely positive 1 cent a share or so LIFO adjustment that you talked about?

My gut tells me yes, but we'll see that if not a slightly bigger negative, even with profitable gas not near as profitable as last year. We could be profitable and 1 to 2 cents profitable next year in Q-4, but I also have confidence in our margins overall that we should be okay, but all that - all the things we just talked about are baked into that 48 to 50 cents range.

Okay. Do you care to comment at all about sort of the current comp trends given that that a lot of retailers seemed to be a little below plan this month

We're 5 to 6 I would expect for the month. So no change.

Thanks a lot.

Your next question comes from Debra WeinSmith [phonetic] of Salomon Smith Barney

Good morning, Richard, a few quick questions. You focused on the question of cost reduck. Are we seeing any improvement in preopening cost per club especially as you're opening new clubs in existing markets?

You will see - every year we - I know Jim's talked about with operators how can we reduce preopening by 100,000 a warehouse. The reality is when we go into new markets, it's more expensive, so to the extent the mix changes, I would expect that our budget would be a little less next year per warehouse, recognizing fully a third of the preopening is not just new warehouses but relocations and when we do a major remodel activity.

Okay. And then on the pharmacy area, you talk about that as being particularly strong with a lot of competitors adding pharmacy counters, what would you kind of indicate as driving that business in the Costco clubs

Two things. One thing, but then I'll break it into two things. It's pricing. If you look at the - as I understand, just on first of all the RX, the prescription side of the business, in the typical chain pharmacy in the country, fully 90% of their prescriptions are under negotiated plans with company programs. At Costco, it's 50/50. What that means is is that anybody that has to pay their own medicines has to come to Costco because of the savings. On the pricing - pricing savings is more extreme on the over the counter. I remember a year or so ago when there was yet another wave of political news about the government was going to focus on driving down the cost of prescriptions and I was getting calls from people saying, you know, on Medicare or Medicaid, isn't that going to hurt our business because everybody will be on the same price on certain things and that was a goat yes and I asked Charlie burr net, our senior V.P. of pharmacy operations, and his first out of the box comment was over the counter drives our business. Whatever we save the customer on the pharmacy, we save them multi-fold on the over the counter. We're so incredibly low. You can tell you a very anecdotal personal experience.

I was in a - I won't mention which one, but a chain pharmacy in town a couple months ago and just needed - are run out of an antihistamine or allergy pill and bought collar trim ton, a 24 back for $5.99, let's say, $6.99, $4.99, whatever it was, I was in Costco subsequently and bought a 600 count of the signature generic, two, 300 count bottles, for the same price, within a dollar. Now that's extreme, but it tells you, I can assure you that if you saw a 600 count generic at a chain store, you would find it at two or three times that $4.99 price.

So on the - on the private label stuff, we're able to save substantially more because that's where frankly traditional retailers make a lot of money.

Okay. The last question is you mentioned that the clubs you're opening are large at 148,000 square feet. What is the extra square footage going to?

It's really going to everything. It's going to an expanded fresh foods, wider aisles frankly, the ancillary businesses, expanded tire center the I would say all of the above. And general merchandising. The freezers and refrigerators are a little bigger, few extra doors.

Thanks so much.

Your next question comes from David Chick [phonetic] of sun trust Waubanson [phonetic].

Hi. How are you. Only one remaining question for me. In the core groups margin, 30 basis points that you mentioned, was there anything outside a mix shift that you can talk about? You mentioned mix shift when you were going through that, but anything sort of inside each category? Thanks

The glaring big thing was rather than mix shift, there's a little mix shift because fresh foods is comeping at this greater number than the rest of the core warehouse, so there's a little mix shift, but more important is the strength in fresh food margins. I think there probably were a couple examples, David through the quarter. I gave you have the example a couple years ago on muffins, $4.99 a dozen muffins was a great price point that we allowed ourself to go from a 12 to 6 margin on a fully allocated muffins, simply by maintaining a price for eight years. We have relooked at a couple things similarly in fresh foods where we are so below the market and we've hurt ourselves because we've been so strict, but those are small examples. The bigger thing is is that you know, there is great leverage in - if you could run your produce department at a higher volume, and we are because of global sourcing frankly of produce, even a small change in higher volume translate well to the bottom line in grows margin, fully allocated gross margin, because you have less spoilage, less labor in picking through the spoilage. It's even more extreme in backry, where, frankly, I think as good as our bakeries are, some of the items got stale and we saw great pickup in the last few months in bakery. Go connected out some of the Danish, they're bigger and better, they have more sprinkle stuff on top, everything is bigger and better. On the 12 pack of Danish, we actually raised the price point but kept or lowered the price per pound or price per ounce because the stuff is 30% larger, so it's a better value, better item, all the stuff we talked about.

Thanks.

Your next question comes from Robert Tumy [Phonetic] of R.B.C. Dan Rausher [Phonetic]

Good morning. A couple questions. Richard, on comps, you talked about geographic performance of comps. You've seen some strength recently, it looks like in New England and the Midwest. How much of that is do you think new stores or how much of that is market share? Can you comment on that?

Well, on a comp basis, of course, it's not new stores. Other than the fact that I think new stores - I'll give you an example, Chicago. When we first opened in Chicago, we have five or six in Chicago, when we opened the first couple in Chicago, frankly, they start off a little slower than we planned. Once we got the third and fourth units and we became a bettory known name in that market and more importantly, when we opened I think it was Lincoln park, which we kind of considered the flagship location for us in that market, a great awe fluent area, we saw all of them pick up faster, so there is something to that critical mass, even though we don't have the types of efficiencies that a traditional retailer would have because we don't advertisement we don't have those kind of efficiencies.

What was the other part of the question?

Well, market share relative to, you know, -

Clearly it's market share. I think in the case of the Midwest, it's probably more the fact that they're immature units growing and in the northeast it's market share.

Against your traditional competitor up there?

Against everybody. It helps, you know, while we probably didn't get as much benefit as target and wall mortgage did with Kmart's problems, it can't hurt. I think you know, frankly, when you see, if any of you caught that date line or 20/20 special a couple - a week ago on the supermarket industry and the dating of meat products, meat and poultry products, we think that as bad as that hour-segment was on the retail supermarket meat industry, it helps you, and it's one of our signature areas, and fortunately, we think we do a good job there and I think that all those things help us. And it helps us when we get Levis direct and it helps us when we buy tight list golf balls. Our relationship with the likes of well known, high quality names like Levi, versus having selling a limited amount of Levi when we were diverting is a tremendous boost to our business and is driving market share.

the other question I have is long-term store expansion plans. Your talking about your 2003 projections a little while ago. At one point you thought you could basically double your store base. I forget what actually year that was off, it was 19 or 2000, but are you still on track with that?

You know, we just went through that process literally on the back of an envelope. We took a big - a blackboard and went through every market with the map of the U.S. and went through with the operators, and right now I think we have 289 or 290 locations in the U.S., and the feeling is is that if we continue to figure out what we do and evolve and continue to grow and continue to infiltrate, which is important, we think that Jim just the other day said the 28, 290 can be 600. Now let's assume it's 500, for more reasonableness, I think that - we are optimistic about that. We believe we can continue the same market share.

What's probably given us a positive feeling domesticically is that in new markets, we're doing fine. Saleswise, recognizing you lose money in the most of them for the first couple, two, three years, but more surprising and more gratifying I guess short term is is that we think that we can penetrate and saturate our existing markets to a higher level than we ever thought possible. We opened up two units in the western Washington a year and a half ago, Pieolo [phonetic]and Burlington, Burlington being about 50 or 60 miles north of Seattle and Pieolo [phonetic]being 10 to 15 miles south and east of the airport in Seattle, and here are two markets where - and they were 10 to 15 miles away from the nearest Costco in each direction. In both instances, he they averaged in their first 12 months, $100 million, with about 25 million being cannibalized sales, so in a market where we have strong gross margins, because we dominate the market, and we did $75 million with lower preopening because we don't do the free check mailer, so I think that that - those examples are reason as extreme if not more extreme in L.A., so those are the assumptions that are built into that as well as the assumptions that we'll keep getting vendors to sell to us before and keep figuring out what's the next special order kiosk item or what's the next ancillary business.

Part of that is the faith we have in ourself that we'll continue to evolve.

Internationally, I still look at that as over the next five years a step our toe in the water type of concept. We will continue to grow the U.K. as fast as we can. In early May, we opened our 12th, 13th, and 14th locations. I think we have one more before the calendar year end. But because of restrictions and planning and zoning over there, we probably won't get more than four or five openings a year, even though we would probably like to do five or eight a year. Asia, is still an unknown. In the case of Korea and Taiwan, where we have five and three units respectively, neither market will ever be more than 12 or 15 units each. Japan is the big question mark.

Original plan was in the first five years to open five or six units. We're now in the beginning of our probably about the beginning of our third year, we're getting ready to open our third unit. We'll lose money for the first five years. We will see if we can make it work. We're encouraged by the fact that our second units, its one in toak Tokyo, started off and is doing quite a bit better than our first unit, but we haven't proven anything this. My assumptions from going to 290 in the U.S. to 580 or whatever, I think it's probably - I'll call it assertive, not aggressive. But, what it's not 580, it's 500, I think that would still be healthy.

Overseas, my guess is you're talking for the next few years, four to eight units a year total. Hopefully growing to 10 or 15 units a year in years 6 through 10.

Okay. Great. And just - I think you answered - last question was new products. I think you kind of answered that. Do you still feel confident about your ability to in know elevate merchandisingwise?

Absolutely. You know, I remember when the 8 track became a cassette, I never thought they would have anything beyond a cassette, how can they ever improve technology? I think that is anecdotal to our business. Every buyer has a list that they are measured on every year of getting vendors that won't sell us, whether it's Godiva chocolate or Estee Lauder perfumes, whatever it may be, and recognizing we won't be successful in some of these, but some of the years we thought five years ago we wouldn't be successful n we are and every buyer is thought to in know elevate the, to drive the business, to go to trade shows, so I don't think that that mentality with change.

Great. Thanks very much.

Your next question comes from Adrien Shapiro of Goldman Sachs.

Thanks. I'm just wondering perhaps with continued gross margin expansion opportunity and the start of potential SG and A leverage, what do you think we should be thinking reasonably in the long term EBIT margin target for Costco

Let me do it instead of EBIT - or I'll do pit, pretax earnings. You know, if you look back ot our annual report, I think there was one year where we peaked at a time 3.3% pretax margin, a couple years we were at 3.2. Last year we were 2.9. This year, we'll be around 3. You know, in reading between the lines here, we feel and Jim has stated, both privately at budget meetings and publicly, that we deserve to make more money and we have created a great franchise, we save customers a lot of money and shareholders are one of our stakeholders, but we're going to do it on his time schedule, which we all understand as well and not to hurt our competitive advantage.

That being said, he has said that he sees no reason that over the next five years we can't see a number, you know, in the closer to a mid 3 number. Whether it's 3.4, 3.5, or 3.6, I can't say. We have to first figure out how to get from 3.0 to 3 - or 3.1 plus, we can do that. But I would say that our own internal, you know, it doesn't do - we can all do the back of the envelope to say, on, you know, 11 or 12 percent sales growth or 10 to 12 percent sales growth, how many basis points do you need to get, you know, about 16.5% earnings growth, which would translate into 15% E.P.S. growth. Doing that base case, you need about 9 or 10 basis points a year over the next five years,. I think we can easily get that based on our own budgeting, but it's - again, one of our problems is we're always focused on basis points and I think we should be, but there can be a volatility that one quarter versus the next. You've got a couple of basis points change. I think overall we're going to be good

great. Thank you for.

Next question comes from Danielle binder of Buckingham research.

It's Dan binder. A couple questions. You commented a new product store activity, international, just can you give us a little more detail year to date where you are on new stores and also with fewer stores opening up for the total year, what would you be looking at for preopening and should that allow us to get to the higher end of guidance? It seems that would be the case.

You know, our guidance reflects all our knowledge right now. So I - and again, I - I know that a couple of you are saying guidance, they've got us down to 27 so they can come in at 28. I've got to tell you, earnings during the quarter, 2, 3, accelerated and on March 5, when we had our conference call, we were three weeks into the quarter and frankly I was hopeful to get to 27 and felt more comfortable about 26, but we - you know, we performed.

I think that if I - as I look at Q-4, all the things we're doing are embedded in the - maybe preopening is a couple million less than I thought on March 5, but there's also, I hadn't focused as much on the strength of gas profits. You know, there's 10 things that each go, five in each direct, so I don't think there's any change in our expectations right now

On the new store productivity year to date

The new store productivity. I'm sorry. We're probably more than a half - say probably somewhere in the 4 plus million dollar range, maybe 5 or 6 million worse than our original budgets for the year. On the stores that we've opened, recognizing that that will translate probably into being closer to even given that we've opened a few less units.

4 to 6 million on a total basis

Pretax P and L worse than our original budget on the 29 units. And again, many of these are new market units that are, you know, we try to be reasonable but reasonably aggressive on our assumptions and doing a little bet.

Okay 689 the comp plan for Q-4 continues to be 5 to 7.

Comp 4 is still in the 5 to 6 range.

Great, thanks.

your next question comes from Barbara Miller of federated Kaufman

Thanks. Two questions. One on your kind of philosophical on the expense structure. If you look at your expenses over the last few years, on a variety of reasons on a square footage basis went off now they're starting to level off. Over the next couple of years, do you see any major changes in the business that would ratchet up the expenses from that standpoint or is it fair to say that you're at a point that's more level because of the mix of some of the more labor intensive businesses? And I have another question as well

I think on that one, with the exception of health and insurance costs, which are going up, but again, I think that's a less - that detriment is smaller one like when we introduced A.M.X., there's nothing conscious object our part, the conscious thing or our part is the gas thing that should help us, kind of an offset to insurance. No, I would hope and expect to see it go the other way. Again, we are our own - our toughest critic when it comes to spends control. At the same time, I was talking with Jim yesterday, I said, you know, 1 of the questions that we ask our self and we get, on per basis comp, why didn't we see - I can go through all the explanations. Buff he reminds me, he said this morning, let not forget that, you know, he's the one that's at the same time he's pushing warehouses to control labor, he's the one that when he visits eight warehouses a week around the world, is yelling at them to say I want more labor up front, customer service is important because that's how you drive market share, so I think we do a good job of controlling things. There's no bottom of the scale increases that kills you for a year or two. They're no more big thing like an A.M.X. program, so yes you're right with the small exception of health care.

the other question is on inventories, you explained some of the changes. Should we expect to see turns level with last year going forward into the fourth quart of next year?

I would - I mean, my guess is assuming the 5 to 6% comp continuing, I would guess that's probably level in Q-4 and improves a little next year, in part because of the mix change in new warehouses and the fact that 30 warehouses on a bigger basis, half a point lower.

Okay. Great. Thank you.

Your next question comes from sally Wallich [Phonetic] of lag mason [phonetic].

Good afternoon. Just one question. Richard, could you talk a little bit about your experience when a regular member becomes an executive member, what happens to spending and so on.

When a regular member becomes an executive member, first they pay us 55 extra dollars, we can't lose sight of that. In the first year, assuming they've been a member for a number of years, in the very first year the comps improves into the mid teens - I'm sorry in the first year, it's actually a little higher than that, in the very high teens or very low 20's and then it levels back off at a normalized rate of growth but at a higher base. Now when you do that initially, you get hammered by your highest, you know, the guy that's coming in and already going to earn on his current purchases a $200 rebate, but even at that level, he's going - that can be unprofitable for a number of years, but slightly unprofitable. We've now in our view done the adverse selection and, you know, have already felt the pain of adverse selection, where it's the guys already making the full 200 to $500 rebate. We've now getting people in that are also going to earn call it a $55 rebate, but we have the money early. There's some slippage in the fact that not all rebate checks ever get cashed, although we try to get them cashed and they spend more. We see a positive net of it.

Great. Thanks a lot.

At this time there are no further questions.

Okay. Well thank you everyone.