好市多 (COST) 2003 Q2 法說會逐字稿

Good morning.

My name is Melissa.

I will be your conference facilitator today.

At this time, I would like to welcome everyone to the second quarter Costco Wholesale Corporation conference call.

All lines have been placed on mute to prevent any background noise.

After the speaker's remarks, there will be a question and answer period.

To ask a question during this time, press star, then the number 1 on your telephone keypad.

To withdraw your question, press the pound key.

Thank you.

Mr. Richard Galanti, you may begin your conference.

Thank you, Melissa, good morning to everyone.

This morning, as usual, I'd like to review with you several items.

To begin with, our second quarter operating results for the 12 weeks ended February 16.

As you read we recorded a 39 cents per share earnings number for Q2, which is mentioned in this morning's release included a 3 cent after-tax per share charge to increase our reserve for prior period workers compensation claims.

Excluding this charge, We came in at 42 cents a share EPS, up a penny or 3% over last year's second quarter and at the low end of our December guidance of 42 to 44 cents.

And comp sales came in for the quarter at 4% and 4% for the 24 weeks fiscal first half as well.

Both of these fours were actually just strong 3s.

We are also reporting this morning, our February monthly sales for the four weeks ended this past Sunday, March 2.

Sales for the four weeks of February were strong, coming in at 7% in the U.S., 3% for international, implying a 6% overall for the company.

Other usual topics of interest I'll review with you this morning, recent opening schedule, as you know, we've opened a total of 18 net new warehouses since the beginning of fiscal year, on September 3.

We opened 13 new units in the first quarter, four in the second and while we've opened three so far in Q2, two of those are relos, so, one net-new unit in the third quarter to date.

Of the 18 we've opened to date, 16 are in the U.S. with 10 of those 16 being in existing markets.

I will go over with you our upcoming expansion plans, address questions we've had on saturation, review with you ancillary business results, as well as, our recent new initiative Costco Home, Costco online results, talk about the executive membership program, give you balance sheet numbers for the second quarter end and, of course, I will spend a few minutes talking about the worker's compensation increase in reserves of $26 million.

And lastly, before I turn it back over to Melissa for Q&A, I will reiterate the guidance for Q3 and 4 that I gave you back in December.

Overall, excluding the worker's comp charge, Q2 included a much tougher than expected December and a better-than-expected January to mid-February.

As with every conference call, I will start by stating the discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and in these statements involve risks and uncertainties that may cause actual events, results and/or performance to differ from those indicated by the statements.

The risks and uncertainties include but are not limited to those outlined in today's press release, as well as, other risks identified from time to time in the company's public statements and the reports filed with the SEC.

So, with that said, let's get going here.

Sales for the quarter were up 8% to $9.9 billion from $9.2 billion a year ago.

Second quarter included 1 less day this year than last, due to the timing of Thanksgiving.

We benefited by that day in Q1.

With comps of 4% for the 12-week quarter, as you know, that calendar basis reports, you know, monthly calendar comps.

The five weeks of December was a 3.

January was a reported 5.

And, of course, today we're reporting February as a 6.

Keep in mind also that, this year's second quarter began with the last week of November.

That last week of November was the six-day week versus seven day based on the fact that that was the week Thanksgiving fell this year, not last year.

With that, we started out week one of this quarter with a negative 5% comp in that week due to it being a six-day week.

That impacted the numbers, as well.

For the quarter and the month, our comp sales results benefited two factors, both of which helped the sales line more than the bottom line.

These are the weak U.S. dollar, given the concerns over war and what have you.

That and the Q2 represented about 70 basis points of benefit to the reported comp.

As well, related I think to the same incidence, is the rising gas prices.

That was about 57 basis points.

So, the reported four for the quarter adjusted for those two items, would have been about 2.5 on a normalized basis.

For the quarter, our average transaction, again, relating to the 4% increase, our average transaction was up 2.5% year-over-year and our average frequency was up 1.25%.

In terms of sales comparisons by geographic region, I will give you, for comparison purposes, both the first quarter and what we're reporting today, the second quarter and the month of February.

The Northwest in Q1 was a 2% comp.

In Q2 was a 3.

In the month of February was a 7.

California in Q1, a 3.

Q2, a 3.

February, a 7, also.

Northeast, a 2, a 2 and a 3 in February.

Be mindful of the fact that the three in February included a minus 14 in the third week of February related to the severe weather events back in the Northeast.

Southeast, in the first two quarters, were both a 4 and a 4.

The month of February was a 9.

Midwest, a 12, an 11 and a 17.

All told it put the U.S. at about a 3.5 for the first quarter, 3.5 for the second quarter and reported 7 for February.

In Canada, in terms of U.S. dollars was about a 4 in each of Q1 and Q2, 4.5 in Q1, actually.

And a zero in February.

A lot of that has to do with the fact that there was a tobacco benefit in Q2 and earlier in January, but in February we had the offset of that, such that I think in January, Canada and -- and Canadian -- and U.S. dollars was a 12 compared to the zero.

So, balancing those out, it's about a 6 over the last two months.

Other international was a 7.5 in Q1.

A 7 in Q2 and a 12 in February.

A little better in February, but again, that's benefiting by the effect that the foreign countries generally are stronger relative to the U.S. dollar.

So, all told, you know, a -- rounding up to a 4 in Q1, rounding up to a 4 in Q2 and a solid 6 in February.

In terms of merchandise categories, again, giving you the same three data points on each category.

Q1, Q2 and February.

Food and sundries was pretty much consistent throughout.

A 3.5 in Q1, a 3 in Q2 and a 3 in February.

We saw some pickup in hardlines and softlines most recently, starting with a 2.5 in Q1, a 1 in Q2 and a 4 in February.

Softlines, 3, 1 and a 2 in February.

Continued strength in fresh foods, an 8 in Q1, an 11 in Q2 and a 13 in February.

And ancillary businesses, again, with a huge impact on gas, was a 5 in Q1, a 13 in Q2 and a 26 in February.

Given the -- you know, huge increases in gas.

Parenthetically, that 26 in February was an 8 without gas, that's still pretty strong.

Again, putting it together, a 4, 4 and a 6 for the total company.

In terms of -- I mentioned that for the quarter, we benefited -- our reported comp benefited from both FX and increasing gas prices.

That particularly with the growth of gas prices, those effects were, you know, most evident in the February month.

The 6% reported comp had -- included a benefit of a little over 100 basis points regarding, you know, the weaker dollar.

And of 173 basis points regarding -- relating to increased gas prices.

Now, I might also say to you, I mentioned to you the -- the tobacco switch in Canada, that cost us about 60 basis points in February, as well as, two snowstorms cost us, we estimate about 100 basis points.

You put it all together, we normalized about a 5.

In terms of a little specific color in February comps since we're also reporting that today, the 4% in hardlines showed tremendous strength in office, in the mid-20s comps.

Part of that was benefited by the wallet of savings program that we do.

We had strong items in there.

Offset by majors being down in the high single digits.

Another strong area was the beginnings of lawn and garden for us in the low double digits.

Softlines, 2%, had positives and negatives.

Media was particularly strong, up close to 10%.

Offset by comparable weakness in apparel.

I guess two surprising categories within softlines which were strong, jewelry was up in the low double digits and photo camera was up in the mid single digits.

Again, in terms of fresh foods, all four subdepartments, meat, deli, produce and bakery were all strong, three of the four being in the low double digits.

In terms of the 6% comp for February, the average transaction was up 4.5%, again dictated by gasoline helps that.

And average traffic, which, you know, continues to be encouraging, up 1.5%.

Lastly, with the regard to February comps and in terms of weekly trends, some of you asked about, the four weeks were a 5, a 10, a 2, and again, that 2 included a minus 14 in the Northeast.

And then a 7 in the last week.

And mind you, this reported 6 for the February month is on top of an 8% comp last year in February.

Continuing down the numbers to membership fees.

Membership fees reported -- came in at $193.8 million or a 1.95% in the second quarter.

And dollars, this is up 11% or up $19 million and in -- basis points it's up 5 basis points year-over-year.

So, we continue to put up good membership numbers, helped by strong renewal rates, new openings, although that's been modified relative to last year's larger opening schedule and continuing conversions of some of our $45 a year business into the $100 a year executive memberships.

Into terms of renewal rates, I'm happy to say they continue strong at our all-time high renewal rate percentage of 86%.

It's actually, you know, tweaked up a little bit to a stronger 86.

In a business in which both a fiscal year and Q1 have been a 91% renewal rate, Q2 was 92.

Gold Star remains at 84, 84 and 84.

So again, still rounding to an 86 at year-end, first quarter end and currently.

In terms of number of members at Q2 end, a little over 14.8 million Gold Star.

Business primary, about 4.5 million.

Add-ons, a little over 3.6.

Totaling a little over 23, including spouse cards, about 41 million members in our company.

At Q2 end, executive membership program, continues to grow, recognizing that the first people you're going to get into it over the last three years are going to be the highest volume customers and -- but we still see good growth in it.

We ended the quarter with a little over 1.9 million members during the quarter, an increase of over 120,000 members or over 10,000 members a week.

In Q2, executive member sales represented, in terms of the reward, represented a 23% of our sales were paid the reward versus 18% a year ago.

Now, mind you not all of those sales -- not all the purchases made by the members are reward eligible, tobacco, gasoline, in some markets I believe alcohol are not eligible.

And, of course, once a member maxes out with the $500 cap, any purchases above that aren't eligible.

Despite the fact that 23% of our sales paid that reward, these members represent a little over a third of our total sales.

So it is certainly an important part of our membership base and the highest renewal rates.

Regarding AMEX, it continues to be a very good partnership, just over 23% sales penetration on the AMEX card versus 20% a year earlier.

Now going down to the gross margin line, in Q2, 7 basis point gross margin increase, not as strong as a year-over-year increase that's recent fiscal quarters, but still positive and more importantly, still a positive gross margin improvement outlook for our company.

You know, we recognize that, you know, deals happen when they do and you don't really smooth them out, you take them when they occur.

We still feel very good about where we're going with merchant.

If you would jot down the following in terms of the components of margin.

In Q2, the core margin was down 6 basis points.

The 2% reward, again, increasing penetration of that is an offset to sales, which reduces margin, of course, when you divide cost of sales into sales, was down 9 basis points.

Ancillary was up 10 basis points.

International up 9.

LIFO up 3.

For a total of plus 7.

Now, in terms of the core margin being down 6, food and sundries margins were essentially flat.

Nonfoods were down slightly and fresh was up very nicely, but only at an 11% sales penetration for the company.

I know I will be asked by many of you, is the minus 6 basis points core gross margin or a result of increased competition?

Frankly, the answer is no.

We -- while, you know, you're always going to see different things, different competitors talking about what they're going to do, we see continued strength in our ability to remain the price leader and to not -- not to have that impact our gross margins.

We did get a little hurt by having a weak first four-week period of our fiscal year, that last week in November, the first three weeks of December, and, you know, while we came out of Christmas with very clean inventories and frankly our fiscal inventories that we take at mid-year came in about a basis point better than last year, which was one of our all-time best inventory shrinkage, physical inventories, you know, we did have markdowns a little higher than the prior year, given the weakness in sales.

That was probably, we estimate, about 4 or 5 basis points extra this year versus last.

The next gross margin component, 2% executive member reward, pretty straight forward.

As you increase the reward, that's a reduction in sales, cost of sales is therefore divided into a slightly lower sales number, causing a little detriment to margin.

Again, the positive -- the negative is on the reported margin.

The positive is on increased sales and increased membership fees and that's where we're seeing that.

The trend of detriment has started to slow, but will continue to be a small drag on margin, but a diminishing drag.

With regard to ancillary businesses, again that, was a 10 basis point improvement related to our margin.

A lot of that is increasing sales penetration, 17% top line sales growth in ancillary helped by a 32% increase in total gasoline sales, but nonetheless, good pharmacy, optical and food court profits, offset by fairly low gasoline margins, even though how much higher gasoline sales.

But even In gasoline, gas margins this year were slightly better than last year and increased again in sales penetration in all of these departments.

International, 9 basis points better, same as the first quarter, related to gross margin improvement on an absolute basis, as well as, higher sales penetration.

Regarding LIFO, light the first quarter, we picked up 3 basis points.

At this juncture we're still slightly deflationary and despite rising energy costs, we haven't seen a lot yet.

What we are seeing is increasing freight costs from Asia.

The average container coming over from Asia is nearly 50% higher in terms of freight costs.

Again, that will impact LIFO somewhat.

As well as, we're starting to see some talk by manufacturers of products that include resins.

That actually include petroleum products like plastic bags and plastic containers and what have you.

But there has been more talk than action yet given the weakness in the economy.

We will keep you posted.

My guess at this point is we will see some bringback at the end of the year, if not sooner.

Before going into SG&A, in terms of ancillary businesses, 321 of our locations have pharmacies.

Virtually all of our locations have foodservice and one-hour mini labs, over nearly 300 -- actually, 368 have optical.

We have 12 print and copy shops, we now have 119 hearing aid centers and we have five more gas stations to be at 181 gas stations as of Q2 end.

I will mention Costco Home, Costco Home is a new test concept we opened in December in Kirkland, north of Seattle.

Basically taking some of the success we've had on a one off basis in store, felt that we wanted to try it.

So far so good.

It is a test, we're well above plan, but keep in mind it's only been open 12 1/2 weeks.

My sense is we won't make any plans beyond this first test location for at least another six months.

Moving on to SG&A, and I will speak to the $26 million worker's comp reserve in a moment, excluding this charge, SG&A was higher year-over-year by 37 basis points.

On again what was a, you know, high 3% comp sales increase and given how tough the first four weeks of Q2 were, actually a shade better than we would have expected going into January.

Again, if you jot down the following SG&A components: In Q2, the core was worse or higher by 25 basis points, that compares by the way to -- worse or higher by 27 basis points in Q1.

Central was flat year-over-year in Q2, compared to 1 basis point higher in Q1.

Ancillary was a detriment of 3 basis points versus a detriment of 4 in Q1.

International, a detriment of 9 versus a detriment of 7 in Q1.

Again, that's mostly higher sales penetration of the new units that start off with low volumes.

So, subtotal would be 39 basis points higher in Q1 and 37 higher in Q2.

Of course, the worker's comp charge, which I will talk about in a minute, that was 26 basis points, so, on a reported basis, we showed SG&A was higher by 53.

In terms of the core warehouse SG&A number being detrimented or higher by 25 basis points, of that amount, 14 basis points related to first-year warehouses.

Another 15 related to employee healthcare benefits and worker's comp costs, this is not the $26 million charge, this is just ongoing, similar to what we saw in Q1.

And aggravated, of course, by the lower than planned comp sales results.

Despite SG&A being higher by 37 basis points, the expense trends in the quarter were encouraging.

I mentioned earlier that the first four weeks of our fiscal second quarter were dismal at best, with week one of Q2 coming in at minus 5%.

Then the next few weeks being in the low single digits.

In fact, our SG&A increase in that four-week first period, which was the all-important Christmas period, was up 62 basis points year-over-year and needless to say the next eight weeks were under the 37 basis point detriment we had for all of Q2.

Again the 62 is without any of that worker's comp charge.

So, again, the following eight weeks were showing at least a positive trend that we're hopeful will continue.

With regard to the $26 million pretax charged to increase our worker's comp reserves, this stated in the press release, reflects the rising cost reflected in our recent paid claims experience and a mid-fiscal year evaluation of all open worker's comp claims by both our independent third party administrator, as well as, an independent actuary.

Historically, we have done these reviews at each fiscal year end and like all prior recent years, including fiscal '02, they were deemed adequate and appropriate and no major surprises.

During the last six months, we saw an increase in paid claims.

We chose to have the actuaries and third party administrators look at everything else, particularly given what we see going on in California, where California represents 37% of our U.S. workforce but over 70% of our worker's comp costs are incurred there.

Put another way, the average worker's comp claim cost for an out of work worker's comp incident at Costco is on average, over the last couple of years, booked at a cost of about $26,000 in 36 of the 37 states where we do business.

That range is all over the board.

But that average of 26 compares to an average of around $70,000 in California and rising.

We believe the $26 million reserves increase, more than 90% of which is related to California, is appropriate and in line with our desire to name the proper level of reserves related to prior worker's comp occurrences.

By the way, If you recall, in the first quarter conference call, in terms of looking at worker's comp, we mentioned that, you know, our experience in terms of incidents improved.

In fiscal '02, our actual worker's comp incidents per 1,000 labor hours was down 4 or 5%, but the costs were up 15% in total.

So, implying average costs up 20.

Again, that's continued.

Even if we include that small portion of this $26 million charge related to Q2 and Q2, we would still report a 42 cent number on an adjusted basis for Q2, so, it didn't impact the numbers that we've reported for the quarter.

Lastly, with regard to the issues of rising worker's comp costs, we and several other large companies are taking a very proactive position to affect change and help fix a problem not only affecting us, but more than 1.2 million Costco business members in California.

We think the changes will occur.

It's a system we feel is -- that is -- has been abusive and allows for, you know, much higher costs than feasible in any other state.

In terms of -- going back to the income statement, preopening expense came in about 1.5 million lower than last year, 7.1 million versus 8.6.

As expected, lower preopening related to new warehouses, total majority of this $1.5 million lower amount that we called last year in Q2 we opened seven openings, this year we had five.

In terms of provision for impaired assets and closing costs, these costs totaled $4.5 million pretax Q2.

That's about 1.5 million higher than the Q2 closing last year.

Just a question of timing, the numbers continue to be pretty consistent in terms of what we incur during the course of the year.

Most of this, by the way, is not actually impairing assets that are ongoing businesses for us, but related to the relocations we do, where you take a facility that is on our books that might have a couple million dollars of lease hold improvements in it, and if you're giving that up, you have to write it down.

All told, operating income in Q2, excluding the worker's comp provision, was up very slightly, up about 1% over last year's Q2 coming in at 321 million, versus 329 a year earlier.

Below the operating income line, reported interest expense was higher year-over-year by $1.8 million.

This is not all cash interest expense, but related to the fact that we had reduced capitalized interest in the quarter, which is an offset to interest expense.

As anticipated, interest income and other was better or higher year-over-year by 1.1 million coming in at $9 million versus $7.9 million a year ago.

Overall, pretax income was up slightly by about $1 million to $322 million for the fiscal quarter.

In terms of balance sheet, as of February 16, cash and equivalents, $1,169,000,000.

Inventories, $3,218 billion.

Other California, 6 -- other California -- other current assets, $674 million.

Total current assets, $5,061 billion.

Net PT&E 6,807 billion.

Other assets, 474.

Total assets, $12,343 billion.

Short-term debt, $103 million.

Accounts payable, 2,870 billion.

Other current, 1,780 billion for a total current liabilities of 4,753 billion.

Long-term debt of 1,253 billion.

Preferred and other are 165.

Total liabilities, 6,173 billion.

Minority interests, 123.

Stockholders equity, 6,049 for a total right side balance sheet of 12,343 billion.

A couple of balance sheet items, debt to cap ratio is very strong, coming in at 18%.

Plenty of financial strength.

In terms of accounts payable as a percent of inventory, as reported last year in the second quarter was 103%.

But a year ago we had a lot more construction going on, so, there was a lot of construction in progress in accounts payable, if you will.

But that 103 last year was a reported 89 this year.

Without construction and looking at just merchandise AP to merchandise inventories, we actually improved a little from an 80% AP ratio last year in the quarter and 81% this year.

Average inventories per warehouse were down for the first time in quite a number of quarters.

Ever so slightly.

Came in at $8,231 million in the quarter versus $8,243 year ago.

So, again, we're very much in good control of our inventories, clean, coming out with good physical inventories.

And as it relates to inventories, of course, LIFO is slightly deflationary at this time.

In terms of capex, in '02, we spent $1,030 billion, 1.03 billion.

Our budget this year was $1.1 billion, but that was a plan of 32 new units and 7 relos.

The 30 to 32 will be more like 25 or 26 and the 7 relos looks like it will be 5.

Most of that is timing delays.

Some of that we made a choice of a couple of units not to do.

With a slight reduction in openings, our capex, rather than coming in at about a billion, we're more like 950 plus.

And, again, we would expect positive cash flow on a net free cash flow basis.

Quickly, Costco online, it's profitable and growing nicely.

Last year's sales of $142 million, this year in the first half year to date were up nearly 70%.

And see no end to those trends currently.

In terms of expansion, I think it said in the press release, we're going to open, you know, 6 to 8 new units this year, the remaining part of their year, and one more relo.

That puts us at 25 or 26 units for the year and 5 relos.

That excludes, of course, three units in Mexico that we're beginning this year to bring our Mexico operations from 21 to 24 units.

Assuming the mid point, the 25 on a basis of 345, that would be about 7.5% unit growth and about 8.5% square footage growth.

And finally, before turning it back over for Q&A to Melissa, just relaying our direction for Q3 and 4.

And our December conference call we indicated that compared to last year's 28 cent a share number in Q3, that our current guidance would be in the 30 to 32 range.

And similarly, last year, actual was 52, that our guidance back in December for Q4 would be 54 to 56.

Both of those ranges in terms of guidance remain in tact.

If anything, I feel better about the three months in advance than I did three months ago about how we were coming into that one.

That's our guidance, that guidance would be a $1.57 to a $1.61 a year or up 69%.

And that's where we are.

With that I will turn it back to Melissa and open it up for Q&A.

At this time, I'd like to remind everyone, in order to ask a question, please press star, then the number 1 on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster.

Your first question comes from Emme Kozloff.

Hi, Richard.

Can you talk about sales productivity trends at the new units, are they moving up the at the same rate of last quarter?

And where are they versus your plan?

And then a quick follow-up on gas, can you tell us whether a strong comp in the gas business helps leverage overall SG&A in the warehouse, or are the profit dollars too small to have an impact?

Thanks.

In terms of the productivity of new warehouses, it's way up because we're opening more existing units.

And frankly, those units are a lot more predictable.

I would say that we're better on target this year than last year relative to the fact that we are -- they're more predictable.

And they've been generally fine.

In terms of gasoline, you know it does leverage, you know, SG&A a little bit just because, you know, it's a lot more sales.

In terms of bottom line, you know, and we lost a little bit in Q2 on the gas business, the last couple of weeks have been profitable.

That countered to what we used to say, that in rising gas prices we lose money because we turn it so fast.

The business overall is a lot more competitive since we entered it five years ago.

When we were the only box store out there doing gas, we could save customers money and make good money.

Today, as you know, other discounters are offering gas as well.

And using it in a more traditional loss leader factor.

That's caused it to be more competitive.

That being said, you know, people want to make money and so I think that at least it appears that we've seen a little better trend bottom line in the gasoline business, but, you know, it still requires a strong stomach lining.

All right, thanks.

Your next question comes from Bob Drbul.

Good morning, Richard.

Hi.

Two questions.

Number one, on the SG&A, as you, you know, the workman's comp issue, as you look at the business going forward, will you continue to be more reliant on improving gross margins to offset the added costs?

The second question is on cannibalization, can you give us an idea of what you are seeing in terms of cannibalization on the comps this past quarter?

Okay.

Okay.

In terms of -- what was the first question?

The added pressure on SG&A with the workman's comp issue.

Well, you know, ultimately, if there are permanent increases in cost structure, I think Jim, a year ago, gave the example of rising merchant fees as it relates to the introduction of credit cards.

Still a lot lower than any other retailer.

Over seven years, we've seen about 24 basis point increase in SG&A related to the change of how we tender our transactions like merchant fees for debit and credit cards.

That needs to be covered by margin.

That's always going to be the last straw.

And so, as you -- for many of you who have known Jim as many years as I have, or nearly as many years, it's going to take a little longer here because we're going to work very hard to find other ways to do that without impacting ourselves.

We are mindful of that, though, we are working on aspects of the expenses to see how we can reduce them, but in terms of mitigating any costs, that wouldn't apply to our employees.

I would guess that some of that will have to be covered with margins, as well.

Are you seeing better buying, you know, to help on the margins side like you were previously?

There's no shortage of better buying.

Recognizing that the bad economy in some ways helps that.

Recognizing that our purchasing power on our $40 billion is greater than normal $40 billion because it's -- it's put on so few items relative to, you know, traditional retailers, and we also don't care -- you know, carry all three brands of an item.

So, we have, I think, you know, in some instances, you know, relative, better negotiating ability on that and, as well as, the impact on private label.

So, again, I -- as I've said for the last couple of years, margins are not our issue and we should be able to continue to remain the price leader and see modest improvement in margins.

How about on cannibalization, on the comps?

Versus a year ago, it's an incremental 15 or 20 basis points in Q2.

Okay.

Okay.

Thank you.

Full number for Q2 was...about 70 basis points last year we estimated it at about 55.

Got it.

Thank you, Richard.

Next you have a question from George Strachan.

Richard, it's George Strachan, it's me!

I'd like to come back to the first question about productivity of new units.

Can you address what's happening with the new maturing units, ie the ones opened in the last couple of fiscal years, it looks like they're maturing looks a little light, especially without the gas impact.

I'm wondering to what extent that might be hindering your ability to improve the SG&A ratio?

You know, I -- I don't have that level of detail in front of me, I mean, but antidotally, when -- as we've gone into new markets, clearly we start off in the first 52-week period higher than we would with the free membership alternative in new markets.

Year two would be a smaller comp than we would have historically gotten in those.

In the units -- in the existing markets, they're continuing to grow.

I look at, you know, even the most recent numbers and the Northwest, we're showing good comps in, you know in units, just quickly here, if I can look at my sheet.

Yeah, this is just last week's numbers, the two units we opened in the Puget Sound is, I've got one week of data in front of me, but we're up 7% and -- where's the other one?

Where's Burlington on this sheet?

Up 7% and up 8%.

That is, you know, that's a single data point, but, again, I will look at that and I'd be happy to call you on that.

You know, one other thing, what, if any likelihood is there that you would take your membership fees up this year a little bit ahead of schedule.

Frankly, it looks like the best lever you have to pull here to improve profitability?

Honestly, we have not talked about it yet.

Not that it ever takes us long to talk about something and then do something.

History shows we've done it four times in the last 12 years.

Most recently, the September [INAUDIBLE] was three years -- you know, after the previous increase.

Three years would imply September '03, four years is September '04.

I can't say if and when it will be.

My guess is yes and the when is I'm not sure because we have not discussed it yet.

Thank you, Richard.

Your next question comes from Deborah Weinswig.

Good morning, Richard.

A few questions.

One, in terms of -- can you update us on the performance of the winter wallet?

And I know you guys extended the time that it ran through, also, the number of coupons, is there a change in philosophy going forward?

And a quick question on SG&A, it sounds like things were improving toward the end of the quarter, was there anything specific there?

And how do we think about leverage in the back half of fiscal '03 or moving into fiscal '04?

In terms of the latter question, I mean the big answer is comps.

We had stronger comps in January and early February than we did in late November and December.

And, you know, I would assume that the -- the mix change from new market units to more -- to a majority of them, you know, only 2/3 of them being existing market units, that helps a little, offset by healthcare.

In terms of the wallet, we did extend it five weeks this year, this is the third of those five weeks.

It has been a positive impact on sales the last -- I'm sorry, it just started in March!

So, this is the extra week.

So, we actually -- but it has impacted our sales positively.

I -- you know, in terms of the trend, you know, we went from six or seven weeks to -- thank you, Bob is helping me here, we went from 7 to 12 weeks with the wallet.

We've remained at 12 weeks with the passport program in the summer.

You know, never say never, we'll go beyond the 12 weeks to something greater.

Right now our plan is the 12 and the 12, which is up from 7 and 12 in previous couple of years.

Also, one question in terms of new warehouse construction, I think you guys had looked to kind of reengineer that process and take about 400 or $500,000 out of cost per club.

Have you been able to do that?

And what's your view going forward there?

We are, but recognize that's been in the last six or eight months.

So, most of what was on the board six or eight months ago is just now being built.

So, that's really going forward over the next couple of years.

And part of that, by the way, includes that we have found that, you know, our norm had been to build 148,000 warehouses.

We identified some markets that can still do 130, $150 million, but we don't need 148.

We can do 138, or 142, or 144.

Some markets, particularly smaller markets, smaller cities, like the Boises and the Bends, there are some markets to reduce the cost there, as well.

Great, thanks so much.

Your next question comes from Jay Maria.

Hi, just had a question about your capital structure needs going forward and, you know, whether you had given any thought to the convertible bond outstanding and your opportunity to redeem it this year?

We haven't made any decisions on that.

We're, you know, at the current stock price, which is about 27.5, a little better than that now, that's still slightly -- the convert is slightly in the money.

And the question there is if you were to call it for redemption, the question is we don't know what happened because over the next certain number of business days, you take the average price and to the extent the stock was in the money it would convert rather than be redeemed.

If I knew with certainty I could redeem it, we might consider that right now.

Other than that, we're going to just see how it goes.

Is it something that you -- you know, is it a situation where you would have to be sure that it was a -- that it would convert for you to, you know, offer the redemption?

I'd rather it redeem than convert.

So, again, I hope I don't have that decision to make because that would imply the stock is $4 or $5 more lower.

We would feel at that level, you would feel comfortable claiming for redemption and having it be redeemed.

We have plenty of cash, or net free cash flow positives right now.

We prefer it to be redeemed so that the money could be converted at this point.

Understood.

Thank you.

Your next question comes from Theresa Donahue.

Hi, guys.

I'm still a little bit confused on the workman's comp charge in terms of why we should not assume that's a higher cost going forward.

Or was there some positive offset in your blessing the guidance for the remainder of the year?

No, I think it's going to be a little higher going forward.

Keep in mind, you know, when -- when there's -- if an employee injures themself on the job, we set up a claim reserve, an open claim.

As they go to the doctor and get physical therapy, you know, a claim could be anything from getting half a dozen stitches to a box cutter cut on the arm, to having your leg crushed in a forklift accident and having years of, you know, surgery and rehab.

And, I mean it's all over the board.

If you look at what we have on our balance sheet at the given time, as of period 6 end, there's close to $150 million of reserves for prior claims over the last -- stretching back -- some stretches back 12 or 13 years ago.

I mean there's few of that, most of them stretch back, 80 or 90% of it stretches back over the last seven or eight years.

Every quarter, frankly, in every year, every quarter internally and every year externally and in the mid-year now, we look at what's happening over the last several months of actual paid claims and how does that impact the open claims that have outstanding?

So, what is happened is, we took another look.

There was one other trigger that caused us to want to do this.

California, in our view, given all the financial fiscal claims many states are having, but certainly California is having in a big way, as a self-insured entity, in other words, we self-insure our worker's comp claims, about every three years, the state of California insurance pool comes in and audits companies.

They had been in in December/January and based on the laws in California, the worker's comp laws in California, which are very favorable towards extending benefits, way beyond other states of -- a simple example would be chiropractor services performed for a back injury.

Most states limit the number of chiropractor services on rehabilitation to something in the 12 to 18 visits or the lesser of 12 to 18 visits or 30 days.

In California, it's virtually unlimited.

And it's become an industry.

So, that, you know, what is -- again, we file the same MO over the years, having outsiders look at it, being sure we're comfortable and at the end of the fiscal year, we were.

Given the fact that we've seen rising healthcare costs and given what's going on in California with the pressure that they have, we felt we had to relook at it and what we feel we're doing is taking a reasonable approach to that.

We've upped our expense accruals for the second half, I would estimate in each of the two quarters, about 2 -- yeah, about 2 -- about $2 million in Q3 and $2.5 million in Q4, recognizing Q4 is a 16-week quarter.

It's about a quarter of a penny a share a fiscal quarter.

That was up with the December guidance, Richard?

Or as of now?

I would say that would be in Q2 and as of now.

Okay.

So, the reserve -- the increase in reserve covers -- covers claims that are -- that have -- incidents that have already happened but where nothing's been paid out yet?

Incidents that happened where some has been paid out, but it could be an ongoing open claim.

Somebody, again, has an injury that might require, you know, medical attention and rehabilitative attention for years to come.

Okay.

These are examples.

You know, a lot of worker's comp claims, they go to the doctor, get six stitches and come back to work the next day with a bandage on their arm.

It ranges from the least to the worst.

Now, you had said -- you had said at one point, I thought that the number of incidents had gone down?

The number of incidents per thousand hours of labor improved in fiscal '02 by about 5%.

Okay, so you don't think there's anything more you could or should do in terms of insuring total compliance?

Like I know, for example, Home Depot said they find anybody, you know, with a -- you know, with a -- engaging in a meaningful violation, it's a fireable, you know, episode now.

Right.

Well, you know, they've -- they've had more incidents, too.

Look, it's something that is, you know, our HR department is working with the operations everyday.

We have very stringent rulings.

I can't say -- what's fireable and what's not.

Don't be on a forklift unless you've gone through our oversafety certification program in terms of knowing how to ride and drive a forklift.

You know, we have stringent rules on any -- any time a forklift has to be on the floor during work hours.

Three people are involved, the forklift driver and two other employees to be in front or back of it and to close off the aisles on either side of where they are working.

And the rule is you can't be there most of the time during the day.

So, you know, that being said, when you've got, you know, 3,000 average transactions a day, seven days a week in every location, or a million transactions a day, there are unfortunately going to be accidents.

I think we have a very good safety program.

We put a lot of money in what we call floor walkers, which are people that are walking the floor several times a day to simply look for safety issues, to look up and be sure pallets are, you know that, the end of the pallet is sticking four inches over the end or three inches, whatever it is, over the end of the steel.

Over the last couple of years, in part because of some of the incidents in some of the home improvement centers that were exposed on national TV shows, we went back and reinforced our steel with additional bars in the middle, so that in the case of an earthquake -- going as far back as the earthquake here a year and a half ago.

Any merchandised damage was not pallets falling out of the racks.

It was pallets of, you know, vinegar bottles at the floor level.

Not stuff falling out of racks.

So, we do a good job, but it is a never-ending process.

I think going forward, you know, what I said is that the 14 or 15 basis points we saw in -- in impact Q2, similar to the impact in Q1, I think that's the part that's going to continue this year and I can't say it's going to be flat lined after that for the new, higher level, I doubt it's another 15 a year on top of 15 a year, but we will have to wait and see.

I can tell you that, and if somebody wants, they can call me afterwards, the California Insurance Commissioner has been out and about the last few days, in front of the media in California, talking about a system that doesn't work and talking about a system of abuse.

It has, again, the absolute highest average cost per claim and the -- historically, one of the lowest benefits to the employee per claim because it's all going to lawyers and medical practitioners and the employee isn't seeing it.

So, from that perspective, you know, we understand that it's a well-meaning plan, but there's -- it's definitely impacting companies in California.

And, of course, 37% of our companies are in California.

The $26 million goes back the last two quarters, Richard, or does it go back further than that in terms of timing?

It goes back the last seven or eight years.

Okay.

What I mentioned as a caveat, though, a little under, I think something in the mid-2s; about what impacted Q2.

Okay.

Even with that, we'd still be in the 42 cents.

Okay.

Thanks, Richard.

Your next question comes from Chuck.

Hello, Richard.

Hi, Chuck.

Okay.

Making sure you could hear me.

I want to look at the worker's comp issue from another perspective.

Can you tell us what the actual cash outlay for the claims were in the first half of fiscal '03, compared to the first half of fiscal '01 and what you might be quarterly?

Or annual forecast might be going forward?

Chuck, I can get that for you if you call me back, I don't have it in front of me.

Recognizing that the increase -- or the charge that hits, not the reserve, but the charge that hits each quarter is a combination of what we accrue each month which includes what we pay out.

All right.

Thank you.

Yeah, but keep in mind, the cash charges are irrelevant.

Clearly, the paid charges over the last six months are up on a per incident basis than the paid charges a year ago.

All right.

Your next question comes from Sheri Eberts.

Hi, Richard, Sheri Eberts.

A couple of questions.

In terms of just for the worker's comp, just to qualify, this is a California issue rather than a union issue in California?

It has nothing to do with unions whatsoever.

Okay.

It's a nationwide issue, those costs have been rising but again, the level of increases -- first of all, the absolute amount is, you know, is two and a half times per incident in California and that percentage is rising at a higher rate than most other states.

And for us, again, you know, a third of our workforce and over 2/3 of the expense of worker's comp relates to California for us.

Okay.

And just to touch on again, in the third and fourth quarter, you indicated you're more comfortable with those.

I was trying to understand what assumptions you're using there in terms of same store sales as well as gross margin and SG&A as you look to the back half?

You know, I mean that level of detail is -- is hard.

I mean comps have been a little better.

And so we're assuming better comps than we have had.

I don't mean -- I don't mean to imply better than the six reported in February, but better.

I mentioned, you know, margins we feel can be up a little.

I would say that SG&A is still going to be higher year-over-year that, doesn't take a lot to figure that one out.

But the trends, hopefully, will start to show some promise there.

So, it sounds to me like it's really a comp issue.

If the comps ended up going back to the 4% range, there --

Well, it is a comp issue, but again, you know, you know, some components of margin like, even like LIFO is helping us a little.

Some components of margin like the detriment of [INAUDIBLE] executive membership, that's starting to diminish.

Within, you know, SG&A, again, we have another thing, the healthcare costs in the last couple of quarters, but the effect -- the impact of -- of other things in terms of, you know, changing the mix is helping us.

We are looking at the various costs related to healthcare and wage, although we're going to be very cautious of how we approach that from the standpoint we've got great relations and with our employees and great culture here.

Okay, and then last question, as I'm sure you know, BJ's came out yesterday, talking about the long-term growth rate in the 10 to 12% growth range, this was on a three to five comp and 10% square footage growth, obviously there's a lot of company-specific issues there that don't apply to Costco, but I wondered if you could update your thoughts in terms of Costco's long-term growth rate at this point.

As I look out over the next two or three years, we still -- and that was the fact that the original budget of 30 to 32 units is more like 25 or 26, the fact is that we've got plans over the next three-plus years to open at least 30 units a year.

When I look at the list and, again, with a vast majority of those being in existing markets.

And a small minority being outside of the country.

So, I -- you know, there's no slowdown in the opportunities we see and that's been reinforced by some of the openings we've done in the Bay Area and the Puget Sound and other markets.

So, real straight growth, you're saying still in the 8 to 9% range.

I would say yes?

Okay.

And how should that translate to an EPS growth rate?

Well, you know, it's -- coming off of year of -- or year and a half of, you know, inpredictability, it's hard to say, Sheri, I go back to what Jim said in the past, we deserve to make more money, we're not going to do it in a knee jerk reaction, we're not going to slash healthcare benefits because healthcare costs are on the rise.

We're going to look at it and be prudent about it.

We feel and have shown examples of like merchant fees, where if we deserve to make a little more to cover the permanent changes, we will.

Again, that's going to be...

You know, I would say there are, I mean if you ask Jim and he's not here, that -- I mean our five-year goal is still to achieve towards that mid-teens growth rate.

Clearly that was our goal a year ago, we're not doing it this year.

We're also in a terrible economic environment.

I still believe that, you know, whether it's one and a half quarters or two quarters or three quarters that,, you know that,the one impact of SG&A will start to show some promise for us and the other things I'm not concerned about, membership and margin, and we certainly, I don't think anyone is concerned about our ability to generate sales.

Okay, great, thank you so much.

Your next question comes from Christine Augustine.

Hi, thanks.

Would you be able to discuss the traffic trends that you've seen at the clubs broken down between the business members and the gold star members?

Just sort of over the last even six months and what your expectations might be for those two -- those two sets of members, going forward?

You know, the only -- the only perimeter I have to look at each week is the percentage of business and the business member versus the gold star member in terms of breaking that out in front of me.

We have not seen any dramatic trend changes in the percentage of business on a weekly basis going to the business member.

It continues in the, you know, 54 to 58% range -- 54 to 58% range generally week in and week out in the U.S.

I would think that, you know, keep in mind, our business member is buying office supplies and while some business has slowed, there is a lot of business out there.

It's still, you know, our restaurant member is not Morton Steakhouse which may have been impacted by business travel, it's the diner down the street where you're still stopping for, you know, eggs and a cup of coffee in the morning.

A few of you aren't, but we haven't seen a big drop-off in that type of business relative to the more upscale restaurant or food scale business.

And now, the longer the economy, you know, is in the tank, the more it's going to be impacted.

And how about for your -- your gold star, your individual members?

I think the same thing.

The same thing.

You know, the percentage of the mix is remaining pretty steady.

We have not seen a dramatic change there.

If I could just ask a follow-up on Costco Fresh, could you just let us know why the plans were terminated?

Yeah, well, first of all, you know, what we've said is we put it on hold.

Now, hold can be six months or 18 months or forever.

But right now, it's -- you know, my guess is for the next year.

In simple terms, we turned around and what we find is for this "test" which involves a lot of our fresh foods and food and sundries people, and -- and senior and middle management all the way down to buyer level, what we found is that for this one test, many people were spending half their time working on the food -- on the fresh concept when frankly we have 400 locations to worry about.

And Jim said, you know, we have a lot going on, let's hold off for the next year.

So, that's -- it's really that simple.

Thanks.

Your next question comes from Mark Miller.

Hi, good morning.

Richard, can you update us on the performance of stores in new markets, I guess as you look back at those added over the last couple of years, both from sales and earnings perspectives?

Also, interested in further elaboration on why you have pulled back on new market expansion?

Okay, well, in terms of the new market openings over the last few years, I don't have the details in front of me, but I know looking back at '01 and '02, we generally came in a little under budget, about the similar -- pretty close in sales and a little lower on bottom line losses than anticipated.

I know that in a couple of comments -- when I did have the detail in front of me, you know, the impact for the course of the whole year of that class of openings was less than a penny a share Delta.

So, not a big change.

In terms of reduction in openings, the reduction is, again, has been halftiming in the couple of units we decided not to do tended to be in new markets, not where, you know, where we've had some slow growth and why add insult to injury instead of letting the units we have there mature.

We've had no slow down in existing markets.

In fact, if anything, there's been, over the last six months, you know, more reinvigoration of what our real state activities are in the areas.

I look at a list that's got the U.S. and Canada broken down and there's 150-plus active projects on the list, knowing full well some of them are two and three years out.

Knowing full well that some of them could be six and eight year projects like Clover City or Westbury, Long Island, you know, with zoning and difficulty in finding land.

But the fact that we have more on our plate today to look at in terms of direction than we did a year ago.

As it relates to existing markets.

Given your comment about how close to budget the stores in the new markets have been, I guess I'm still not clear why the refocus in the existing markets, I mean is it a desire to generate, you know, stronger earnings for shareholders here in the near-term or is there some other constraint there in terms of, you know, ROI or competitive overlap or management?

Well, you know, I think it's -- it's a simple fact that it is, you know, the indigestion related to new markets.

You start off -- you lose money for two or three years, as planned, but nonetheless lose money.

We're in tough economic environment, a tough energy cost environment, as well as, healthcare costs.

It was just, you know, it's trying to be a little bit better, the balancing act.

You know, we started the process three years ago when we nearly doubled our rate of expansion and put a majority of it in new markets for two full years.

I think we're catching our breath a little bit on that.

There is no change and part of it also -- by the way, some of the markets, we've opened a few units, now let's see how they do.

Okay.

Thanks.

Your next question comes from Patty Edwards.

Actually, my question was answered, thank you.

Your next question comes from Elizabeth Armstrong.

Yeah, thanks.

Question on the SG&A trend, in the quarter you had mentioned that they were up 62 basis points if I recall in the first four weeks when sales were swamped and down at the end of the quarter.

Is that purely a function of sales?

Were you able to do anything to lower SG&A?

And what's your thought on SG&A dollar trend?

Okay, keep in mind that in the last eight weeks it was still up, but up less.

Right.

You know, you can do your little algebra calculation and come close to what that is.

It was mostly sales in fairness.

Okay.

And expectation on SG&A trend on a go-forward basis?

Well, the -- the plan is it should be better and, the question is when do we hit the wonderful inflection point where it will be flat year-over-year?

We actually got close a little bit and -- in the last -- in the last two periods, we also, you know, in terms of our own fiscal four-week periods, one of those was a 7 or 8% comp and we got darn close to flat.

Needless to say, we can't assume that we're going to get an 8% comp on a regular going forward, we need to do better than that.

Do you have any thoughts, though, I know you talked about trying to bring benefit costs down on labor, but that seems to be taking time.

If you look at it, what do you think is the rate of inflation in your SG&A costs right now?

Well, in terms of benefits cost, I -- I'm --

I mean include everything, obviously benefits are very high, but overall if we look at the costs?

I guess I'd have to look at the details and come back at you.

You know, I mean energy costs are only going to go up.

You know, we've actually seen deflation in a lot of services that the warehouses use as we've gone back and, if you will, put into place national programs from everything from, you know, parking lot maintenance to aprons, to uniforms and aprons to, you know, literally, I think in the last budget meeting we looked at a $6 million annual charge for some of those items going to $2.5 million.

And that's, you know, again nobody pays attention to something on a national basis until recently.

But there are, you know, there aren't a lot of examples of that.

Okay.

And one last question, just on options?

I know that you guys had used a fair amount of them over the past few years.

The vast majority, I think would be out of the money.

You know, any thoughts?

I would say 100% of the last three or four years of options would be out of the money, speaking as a recipient.

The fact is, we've had good years and bad years.

You know, we talk about -- we all talked to friends who have seen stock options granted at a price and the stock goes down 80%, ours hasn't.

That's why they have a 10-year life.

We've been fortunate to have a lot of people here.

We're going to continue to use options as an incentive and I would expect us to continue to do that.

Okay.

Thanks, Richard.

Your next question comes from Kevin Cornett.

I wondered if you could discuss the reserves for the customer rewards program and what the rate of growth in those has been or at least the size of the reserves and where they were last quarter and a year ago?

Actually, you know, I don't have those numbers -- I don't have the numbers in front of me.

Let's go to the next question.

I have somebody looking for that right now.

Thank you.

Your next question comes from Kirk Woodling.

Yes, hi.

You mentioned that cameras, photo, I believe, had been up and I just wondered if you, maybe I missed this, could -- could say how much of total sales is in film and what is the trend you see in terms of film developing?

One -- film developing is actually down a little bit.

And -- but, you know, digital camera sales is way up.

It's still the tail lagging the proverbial dog here in terms of how many people still use print film and print cameras.

But, again, that's changing.

We're also testing, by the way, to keep the photo processing business going, you know, testing new digital enhancement alternatives.

I know we have in our headquarters here, stuff in the lobby for our employees to test, you can your -- your disk or card, put it in and create everything from, you know, holiday cards to wallet-size photos to photos to send to the grandparents.

I think there will be more stuff to do with it that will help that business, but, you know, we'll see.

And so what's the ballpark of total revenue in terms of film developing?

Hold on now.

4 or 5%?

I think, no, the total photo business...

Film developing is about 1% of business.

1%.

And then film sales and film -- and camera business is another 1.5 to 2%.

Okay.

Thanks very much.

In terms of -- let me just answer the previous question.

As of the end of the second quarter, on our balance sheet, as a current liability, the 2% rebate liability is $103 million, that compares to year-end at $94 million, recognizing that we've -- that there's been more than -- that difference in those two numbers, $9 million, we certainly generated a lot more than 9 million in rewards over the last six months, but as we send them out, they're cashed as well.

That increase is just net of what's been earned minus what's been used.

Your next question comes from Lloyd Zekeman.

Hi.

This is Lloyd Zekeman of Bernstein.

I would just like to clarify something, your gold store membership was down about I believe $100,000 quarter-to-quarter.

Was that taken up on the executive side?

Two things, yeah, I think in the -- in the -- at the end of the first quarter, I had said 14.9.

It literally went in within a few thousand of each other.

One was 14852 and the other was 14848 or something.

It was down 2 to 5,000 members.

Some of that has -- as we put them into -- a lot has to do with the fact that a year ago, we had a lot more new market openings and we put the members, when free, into the membership base, but the renewal rate on those are a lot less.

So, I don't see any big trend changes in the total number of members other than that.

Then, we opened a few less units this year than last year on a year to date basis.

And on the executive side, did it go from 1.8 to 1.9 or was it a close number quarter-to-quarter?

On the executive side, hold on a second.

Let me get back to my pages here.

Hold on.

Page 6.

Page 6?

Executive members were 1,914 million, a 121,000 increase in the 12 weeks.

So, it went from 1.8 to 1.9.

Hold one moment, sir.

Can you hear me?

Hello?

Yes, sir, hold one moment.

Mr. Zekeman, your line is now open again.

No, my question was answered, thanks.

Thank you.

Your next question comes from Sandra Backer.

My question has already been asked.

Your next question comes from Karen Young.

Hi, I wanted to better understand just the kind of angle -- what the normal cost trade would be in store operating costs or SG&A on a per-store basis?

And I think some other -- some of the previous questions have been attempting to get at that, but maybe if we just take the biggest component, I'm assuming would be labor and you can talk about what, you know, what -- over a long time period what kind of growth you would expect in that component and how important it is as a percent of the store operating costs?

Well, labor and benefits are about 70% of SG&A.

Benefits as a percent of labor is about 38.5%.

Close to 41% including the worker's comp.

Okay.

And that's, by the way, when I say benefits, that's healthcare, vacation, sick, you know, dental, vision, FICA, you know, Social Security.

You know, Social Security is 7.65 percentage points of that 41% number.

You know, having opened a lot of new units at lower volumes has impacted that a lot.

Once -- and having opened a lot of new units in total over the last two or three years has impacted that.

Because we have a fairly steep slope to our wage scale increases in the first four years of an employee's employment.

And so once we have most mature units, that rate of increase, once employees hit top of scale, is much more reasonable growth.

I think in the last few years, if you've been on top of scale, your increase is in the 3% range, 2 to 3% range.

Uh-huh.

I don't mean -- I'm trying to answer what I know -- what I have in front of me here.

In terms of looking at what's the total cost per warehouse going up?

Clearly they're going up more than sales because the top line in sales, that percentage has gone up.

Uh-huh.

When does that, given the maturity of the store boats, when does the slope start to flatten out, so to speak?

No, we have not seen that.

If I look even at the comp sales this year, for the first half of the year, you know, you know, California is up 3% in a very, very weak economy and that, by the way, includes where all the cannibalization has been.

In the Bay Area, we opened three or four units in the last year, all of which took 50, $60 million from nearby units, very high volume units.

The Northwest has been up 2 to 3%, most recently 7, although, you know, we will see how that continues.

You know, and all of last year, all of last fiscal '02, northwestern California was up 6%, committees rate with the company up overall 6%.

These are on average $120, $130 million units, 10 or more years old.

Okay.

The other question I had related to, just your pricing --

One last question -- comment on your -- on the SG&A and payroll.

Payroll has been up just a few basis points.

It's been benefits driven and healthcare driven in the last several quarters.

Okay, thank you.

Payroll is up in the low single digits.

Okay.

The other question I had, I guess is around your pricing philosophy and strategy and thoughts behind the membership fees.

I think you had said that the last time you raised membership fees, maybe four times in the last 12 years.

The last time being in September of 2000.

I mean what -- what studies have you done and what is your -- what is your thinking behind where those fees should be?

And, you know, I guess it gets really back to pricing strategy?

Well, I mean our philosophy has been that if we continue to enhance the warehouse experience, recognizing we're the judge of that, but so is the member in the sense that the -- the renewal rate continues to increase, despite the fact that we've raised the fee three years ago and despite the fact that the economy has been bad the last couple of years, that people like what we do.

I mean history would indicate that if and when we do an increase, it will be for $5, we like simple, round numbers.

We've done it, you know, four times in the last 12 years at $5 increments.

You know, I think the studies, I think it's more people sitting around the table discussing it, talking with the operators in terms of their confidence level in doing something relative to what's out there.

Seeing where the renewal rates have been.

Recognizing that if you're an executive member, it doesn't impact you.

Now, if and when we raise the executive membership fee, that will be an impact, but the fact -- but we, you know, every instance before we roll it out, about two months prior, we test it in two or three markets and see how it does.

But we've -- in my view, we've already made up our mind and the tests always affirm that.

Are you evaluating a membership increase?

We have not even discussed it yet, but as history would dictate it doesn't take us long from discussing something to doing something.

We -- you know, this is not a long-term thing that we have to analyze for a year, but we haven't even talked about it yet.

Okay.

Last question is: In terms of -- what does your research tell you about, I guess just your -- what your consumer is doing in terms of their purchases, are they purchasing more from you or less from you?

What, if any, research have you done about the consumer recently?

Well, we keep -- I guess -- I don't have any detailed research reports in front of me of what our buying and marketing teams have done, but, you know, what I see out there and hear in the budget meetings every month is that we keep increasing the size and improving the quality and it works.

We keep striving for getting the nonfood products where the manufacturer won't sell us and it works.

You know, our view is more more at lower prices is better and we keep doing that.

And, you know, again, and if you -- if you look at our comps and look at the fact that our comp sales increase, whether it's been 2% in the month or 7% in the month, and virtually every month, I don't think we've seen a negative as either of the two components of that comp being average ticket or average frequency.

And so we get more people in and they're buying more each time.

And that's good enough for us.

Okay.

Thank you.

Your next question comes from Todd Slater.

Hi, thank you.

Just a quick question on -- on comps.

In February, how much of the comp was driven by what you -- you know, so-called stocking up issues, if any?

I know you talked about gas and other things, was there any stocking up that you thought contributed?

And secondly, how should we look at the March/April comp in light of the Easter shift?

Thanks.

You know, if I look at the Northeast where the impact was the most -- the effective of the duct tape and water buyers, if you will, the Northeast, you know, if I look at the two outlying weeks, the Northeast was a solid 5, 5 plus.

If I look at the snow week, a minus 14.

The duct tape week it was up 14.

So, but that was not as impactful in other parts of the country, frankly.

It was a positive impact, but not nearly as impactful as there.

In terms of the Easter shift -- I'm just asking the question here, Todd, in terms of the Easter shift, have we looked at that?

I -- yeah, that's in April.

That's long-term for us.

I'm sorry, I don't have the answer in front of me.

Okay, so, but just in terms of February, the overall issue, if you think the duct tape issue was a relative --

I would say the duct tape issue was a positive.

It was not as impactful as -- it was probably as impactful as the winter storm issue in the Northeast, but not overall.

Okay.

Got it.

Thanks.

By the way, Todd, on Easter, we're going to pick up a day in March and lose a day in April.

So, it's a --

It looks like we're going to lose a day in March -- pick up a day in March, correction, but lose some business based on it being at the end of March.

And April, yeah, in April, we lose the day and pick up the business of when it is.

So, it's about a wash.

Sounds like a wash.

Okay, thanks.

Your next question comes from Daniel Barry.

Good morning, Richard.

Monday, Sam's announced they were going to open some units in three cities in Ontario and three more sites later in the year.

Do you know what their strategy is in terms of how close they're putting the units to you?

Are they putting them far enough away not to impact you?

I think their strategy is to, you know, shoot an arrow across the bell here.

They, no doubt believe that -- they no doubt believe that -- that if you look at all of Canada, their view, I assume, is that Ontario, while we're -- we're serving well all markets in Canada, that's a market that had the best prospect for them.

No doubt their success in Canada with the Wal-Mart concept, and as I understand it, it's the Canadan Wal-Mart people that are -- that are going to be running -- that's my understanding.

I could be wrong there, that they're going to run it.

They feel we're going to make it as least hospitable as possible for them.

We plan on opening two or three units a year in Canada.

There is nothing next door.

In terms of the sites we're aware of, they're in the 5 to 10-mile range.

That's great.

Thank you.

Your next question comes from Cecil Godman.

Yes, Richard, how are you?

A couple of things, would you go back in the gross margin issue for just a moment and go over a couple more -- drill a little deeper, if you can in the core being down 6 basis points and just kind of help understand between the first quarter is 22 and the second quarter is negative 6.

Was there anything that happened between those quarters or buy-ins or whatever that really caused that decline?

Not really.

I mean most of it -- it's timing issues, it's -- if I look at -- I was just looking at, you know, last year, the core component of gross margin, you know, this is '02, you know, in Q1 it was minus 16, and Q2 it was plus 10.

Q3 it was plus 30.

Q4 is plus 36.

Q1 this year was plus 22, compared to the minus 16.

Q2 was minus 6.

My guess is, you know, our budget is for it to be up slightly in Q3 and Q4.

Uh-huh.

And -- I think it has more to do with timing, again, there's been no shortage of deals, I think more of it has to do with timing than anything else.

Okay.

By way, a little bit was December.

As I mentioned, markdowns were, you know, -- were, you know, 4 or 5 basis points, maybe 6.

I think it was four or five.

Okay.

And having December sales slow, I think that impacts us as much as anything.

Okay.

Also, if I could, I know a lot of people have asked you, regards to pricing issues, when SG&A turns, et cetera, I know Jim's constant vigilance on SG&A it the right way truly seems to be as a customer and as both your client base is, gross margin looks like where we're going to have to get it more in the SG&A because the store, the merchandise, the layout, the service, that's what your clients want and why the customers come.

If you can get it through gross margin, you're not hurting the customer by doing that.

That's what the customer expects when they walk in there, to see those things.

We are, and I feel comfortable and I even said this in front of Jim.

He says when there are permanent changes, we have to cover that.

There's no shortage of margin opportunity.

There is a -- a governor on this engine and the governor is Jim and we're going to do it the right way.

I don't look at Q2 as being an indication that the party is over, it's only 7 basis points.

7 basis points is still up and I -- every time it's been up 20 basis points in the last three quarters, I remind people that our estimate is up about 10.

The 7 is up about 10.

I think we're looking at up about 10 for the foreseeable future and feel that we can accomplish that.

So, we're going to get there.

It will, you know, some quarters will be better than others, but I feel good about that.

Thank you.

My last quick question, SG&A, the matrix you gave us for Central, was that a plus one for the first quarter and zero for second quarter?

You read them so fast, I couldn't get them.

Let me get to that.

I know it was one.

Minus one.

So, higher by one and zero.

Higher by one and zero.

Thank you.

I will take two more questions, Melissa.

Okay, the next question comes from Bill Tennel.

Yes, Richard, I had one question about the -- one of the questions that was asked earlier regarding the convertible and you had indicated, if I understood your response correctly, your preference is to redeem the convert instead of having the actual holders converted into stock.

Is that the gist of your comment?

Yes.

I guess what I didn't understand is if it's in the "money" and we're all counting it in our diluted share count anyway, what is the difference?

I mean it...

I think that if we had an opportunity to know that it was going to be redeemed it would be, if it was redeemed it would be accretive to us.

If it was converted, it's as is.

Right.

So, you're looking at it -- saying if you could make it an accretive event, you would do that?

We have the cash to do it.

Right.

And -- you know, again, you could also ask, then, why don't you just call it and when it converts, use your money to buy back the stocks.

Right.

The question is, that wouldn't be as accretive and it's also the uncertainty of knowing where it's going to go.

I see.

And again, it's frankly, again it's already in the calculation, there is less pressure to try to engineer something that's not 100% definable up front.

And it's not costs you any cash interest out --

It's a cash positive.

The way the zero convert works is we create 3.5% interest rate.

On $500 million, that's 17 or $18 million of pretax interest expense to our income statement.

Noncash charge, but we get a cash tax deduction for it. 20% of that in the form of cash flow each year.

And you earn carryoff, okay.

That's a fair comment.

The other question I had is with regard to the receivable, the volume discounts, et cetera, it's obviously been much pressed about what's been going on with certain retailers, wholesalers, with regard to playing around with the numbers and my question is how much control do you have decentralized with regard to, you know, individual store heads or whatever, being able to manipulate the numbers, or is it all simply controls?

It's all centralized.

The stores, the warehouses have no control over -- over those types of items.

The buyers, you know, the key is getting the buyers both in the headquarters and the regional buying offices to be sure that when they get a deal, they're booking it.

They're not holding it in their cookie jar, if you will.

This goes back not just the last two years around here, but the last seven or eight years.

Jim wants to be sure that every deal, when you get it, you book it that day and we monitor from the accounting department standpoint, we monitor every day, every week, rather, you know, what deals are hitting and showing, as an example, the end of each fiscal period we have internally, we -- you know, we -- we can provide Jim and Dick and other merchants a list of what rebates are hitting each day and if there's anything else unusual.

There is no cookie jar accounting around here, there wasn't seven years ago and there's more stringency today than ever before.

I feel extremely comfortable.

I know that's what the CFO at A-hold said today, too, probably.

Extremely comfortable that we're doing everything more than right.

Our view is to be as conservative as we can, recognizing you can't be too conservative.

That's not fair, either.

We have very stringent rules.

We have two departments here that look at merchandising deals that when a contract is signed for a new deal, it's looked at from the accounting standpoint and within the accounting department, as well as, someone in the merchandising department and we all agree on how any rebates or extra dollars will be booked.

It's dictated by the contract.

Anything the buyer wants to do has to be dictated by the contract, recognizing that the vendor lives by the same contract for accounting purposes.

I tried to back into it.

You didn't indicate exactly what the receivable was.

You mean our receivable?

Yes.

As I look at our year-end balance sheet and again, you will get a detailed balance sheet shortly in other -- within other current assets, which I think I said were about $670 million or something --

Right.

453 is receivables.

Of the 453, 175 is vendor -- vendor rebates, now, let me give you a simple example.

Let's say we do $200 million with a vendor and the deal, in addition to any terms and discounts and extra money up front, there's a 5% rebate paid at the end of the year, a 4, 5, 6% rebate paid at the end of the year based volume.

If we do $200 million a year and the deal might be structured that if you do 190 or less it's a 4% rebate paid at the end of the year, if you do 200 to 209, it's a 5% and 210 or more is a 6%.

We may accrue four or five based on our comfort -- our buyers comfort level that we're going to accrue each period.

On the day before we get the check, using 5% on $200 million, there will be a $10 million -- or $9.9 million receivable on books for the vendor knowing we're getting the check tomorrow.

A week later, the receivable is zero.

So, a lot of that is the normal course of business.

Again, you know, we work on deal -- all types of deals.

So, I mean it's conceivable where you come up at the end of a quarter, at the end of a year and you're pushing up against maybe going over 5%, 6% and say okay I'll just wave in some more inventory to get me over the 6% and I will get the higher rebates.

The rebates department which reports up to merchandise, one of the things they monitor is every deal and as you in come into months 8, 9 or 10 of a deal year a given item, part of their job is to alerting the buyers that they're up against a step rebate increase.

If they can buy, you know, just an extra 13th month of inventory a month early, they will get an extra percent on everything dating back 12 months from now.

Certainly we will do that.

That's part of their normal course of operations.

Thanks.

Okay, last question.

Your last question comes from Dan Binder.

Hi, good afternoon.

A couple of questions.

First, based on what you know today, what level of comp do you think you'd have to achieve in let's say '04 to get to the inflection point on SG&A?

Would it still be 7 or 8 or does it come down?

Well, it definitely -- I say definitely, it should come down.

It's, you know, I'm a little bat shy in terms of answering that because I've been wrong in the last few quarters.

My guess is as we see the continued trend, the mix change in warehouses, I got to believe there's going to be some, you know, some inflection point, if you will, on rising healthcare worker's comp costs relative to the increases you're seeing this year.

I would be hopeful that that number could be four or five.

I think that's -- that's not just being hopeful, wishful thinking, but reasonably hopeful.

We're going to have to see.

How much was the one less day in the quarter worth on sales?

Well, if it's one day on 12 weeks, 12 times 7 is 84.

So, it's probably a little over 1%.

Well, I think given the week that it fell in it was a hard-volume week typically for retail.

Would it be more than that?

Does the 1.2% be 1.4 instead of .9 it could be.

But I don't think the 1 becomes a 2.

Okay.

Fine.

I don't know if you mentioned this already, but did you break out the -- the SG&A increase from new market activity versus other?

Yes, I believe it was 14 basis points.

14 basis points.

And then given the fewer clubs open this year --

That just helps you a little bit.

Do any of them get shifted to next year or just coming off the list?

A couple of them came off the list and a couple of them shift.

It gives me more comfort that if we say 30 to 32 next year, we're more likely to hit it.

In some markets where your competing with BJ's and they're taking down food [INAUDIBLE], are you seeing an impact?

Not really.

A lot of, in our view, are similar to Sam's and they've talked about lowering prices, you know, they've already lowered prices when we're across the street from each other, competing with each other.

A lot of that is not felt by us directly.

You know, where we compete with BJ's is when we're within a few miles of one another on Snickers bars and Tide, but on a lot of items you think are national brands, we're not necessarily competing, we might have Foldgers coffee and they might have Maxwell House.

We may have Del Monte, they have Libbies.

We might have private label and they have a brand and vice versa.

There's a lot of ways for both of us, frankly, to be the lowest price or lower our prices without being impacted.

I can tell you that week in and week out, with the new pricing studies, were the most competitive out there.

And with regard to rising healthcare costs, one of the ways to -- to mitigate that somewhat is to pass on more of the cost to the employee.

Is there any plan to -- to do that or phase it in...

There's no current plan to do that.

You know, our philosophy has been that yeah, we have to be mindful, we can't just give everything away, we have to be mindful that we have created a very strong culture and trust with our employees and we, you know, in the past there's been aspects of our medical care that we've enhanced and aspects we've modified and so we're looking at everything.

Recognizing that, you know, we all have a boss named Jim and yes, we can look at it but will see what else we can do.

And we're going to try to mitigate any services we have to make.

Realizing lastly, realizing it's early on the home concept, I mean if you were to be successful in other markets as you are currently in Kirkland, I mean ballpark range, do you have any idea of what the country could support if this proves to be a very viable concept?

I don't at this point.

You know, our -- our, basic statement is that we're going to keep this open for a year and see how it does and I could -- if it's successful and continues to be successful, would we open a couple more to see how they do?

Yes, my view is we won't be able to give any direction on that for at least -- under that scenario, it will be a year and a half before we can give direction on saying, hey, this thing is bigger.

Common sense says, can the Puget Sound support one or two, probably not three or four.

Can the Bay Area, you know, support two or four, probably not 8 or 10.

You can go around the country and say ultimately, like our business center concept, if it continues to work, could we open, you know, 40 or 50 or more?

Yes, but we don't know if it's 30 -- first of all, we don't know if it's 2 or 6, but we don't know ultimately if it's 30 or 100.

It's way too early to know.

Great, thanks.

Thank you, everyone and, you know, Jeff, Bob and I will be around to answer any questions you have.

Thank you, Melissa.

You're welcome.

Everyone, this does conclude today's conference call.

You may now disconnect.