好市多 (COST) 2003 Q3 法說會逐字稿

Good morning.

My name is Deborah and I will be your conference facilitator today.

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

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

After the speakers' remarks, 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 keypad.

If you would like to withdraw your question, press the pound key.

At this time, I would like to turn the call over to Mr. Richard Galanti, Chief Financial Officer.

Thank you.

Mr. Galanti, you may begin your conference.

Thank you, Deborah.

Good morning to everyone.

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

To begin with, our third quarter operating results for the 12 weeks ended May 11th of this year.

As you read this morning, we reported 33 cents a share earnings per share, results for the third quarter.

Up 5 cents or 18% over last year's Q3.

These results were above the 30 to 32 cent EPS guidance I provided you in early March on our Q2 conference call, and 2 cents above first call estimate of 31 cents.

In terms of comp sales for the quarter, they came in at very close to 6.5, rounding to a 6, 5% for the 36 weeks fiscal year to date.

Other topics of interest I'll review with you this morning, recent openings.

We've opened a total now of 20 net new locations since the beginning of the fiscal year last September 3.

Thirteen of those were in the first quarter, 4 in the second quarter, 3 in the third quarter.

In addition, in the third quarter we closed temporarily our Inglewood, California location as we are rebuilding a new building on the same site.

So that's going to be closed for about 4 months, 5 months.

Of these 20 locations that we've opened to date, 17 are in the U.S. and Canada, a little over two-thirds of them in existing markets consistent with what our plan was for this year.

I will also go over our upcoming expansion plans, ancillary business results, our recent new initiative Costco Home, Costco Online as well, Executive Membership results, balance sheet for third quarter end, and lastly, I will review guidance for Q4.

Overall, third quarter was a good quarter for us.

Earnings were certainly helped by good comps and strong margins, particularly strong margins in our ancillary businesses.

As with every conference call, I'll start by stating that the discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements involve risks and uncertainties that may cause actual events, results and/or performance to differ from those indicated by such 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 reports filed with the SEC.

With that said, let's start in here.

Sales for the quarter, total sales were up 11% to 9.3 billion, up from 8.4 billion a year ago.

Again, comps very close to 6.5% for the 12-week second quarter.

As you know, we report calendar monthly comps on a retail calendar, the third quarter, of course, includes part of February, all of March, all of April, and part of May.

On a calendar basis, February, March, and April were 6, 8, and 6.

For the quarter, our comp results also included the benefits of two factors that have continued to help our comp figures, our total sales figures over the last several months.

These are the relatively weak dollar in the quarter that represented about 137 basis points of benefit versus had we looked at everything on like year-over-year currencies.

And also the significant increase in gas prices that represented about 131 basis points.

With that level of improvement relative to gas we've seen declining of late as the prices of gas have finally started to come down.

In Q3, if we look at the combination of how did we get to our 6% comp, of course, as usual, it's a combination of the increase in the average transaction size plus the increase in the average frequency.

The 6% comp relates, our average transaction was up 4%, year-over-year in the quarter, that's versus about 2.5% up in Q2.

Average frequency was up a little over 2% versus up a little over 1% in Q2.

So both frequency and average ticket helped to get to the 6% comp for the quarter.

In terms of sales comparisons by geographic region, many of you forgot the template for this already, Northwest in the third quarter was up 6%, that compares to being up 2 and 3% respectively in each of quarters one and two.

California was up 5% compared to 3% in the first two quarters each.

Northeast was up 3%, compared to being up 2% in the first and second quarter.

Southeast remained consistent, up 4%.

Midwest was up 12% versus 12 and 11 in Q1 and 2.

So all told, U.S. was up 5% versus, essentially, a 3.5 in Q1 and Q2 each.

We're getting a benefit in Canada relative to the strength of the Canadian dollar.

In local currency, Canada in Q3 was up 2%, similar to Q2, although again because of the strengthening Canadian dollar on a U.S. reported comp basis our Q3 comps in Canada were up 10% compared to being up 4% on the U.S. dollar basis in Q2.

Similarly, in Other International in the third quarter, going into our total U.S. dollar comp calculation, Other International was up 18% compared to up 9% on a local currency basis.

Still a good improvement from Q2, when on a local currency basis Other International was down 2%.

So again, up 9 on a local this quarter.

All told again,, a Q3 total company comp of 6%, versus a relatively weak 4 in each of Q's 1 and 2.

The one number, of course we don't include in our consolidated comps, would be our Mexico operations since we don't consolidate those figures into our numbers. [INAUDIBLE] the peso has weakened, relatively speaking, so that in dollars, in pecos, our comps in Q3 were up 10%.

Converted to dollars, they were down 6%.

In terms of merchandise categories, Food and Sundries was up 3.5%, pretty much similar to Q1 and Q2.

Hard Line showed some nice improvement, up 4.5% compared to 2.5% and 1% in each of the first two quarters.

Soft Lines, minus 1% compared to a plus 3 in Q1 and a plus 1 in Q2, so a little down there.

Fresh Foods continued strong and pretty consistent.

Q3 was up 10% compared to 8 and 11% respectively in Q's 1 and 2.

Ancillary continues to be the outlier, in particular due to the fact that gasoline prices have been up higher year-over-year.

Ancillary business comps in Q3 were up 20%, 8% if we exclude gasoline, so still healthy, even without the inflationary trends in gas.

Q2, by comparison, Ancillaries were up 13, including 7% without gas.

A little color in Q3's 6% comp sales increase.

Within the 3.5% Food and Sundries comp, Tobacco was actually in negative mid single digits, a result of roughly 6.5 dollar per cart reduction on many of the branded cartons.

This is a department that is 8% of our total company sales and 16% of Food and Sundries sales.

So certainly, the 3.5% comp for all of Food and Sundries is a little more impressive if you take that out.

Within the 4.5% Hard Lines comp, Office, Toys, Sporting Goods, and Lawn and Garden were strong, offset by relatively flat comps, plus or minus 1% in Majors and Automotive.

Within the minus 1% Soft Lines comp, Housewares, Domestics, and Media were positive single digits, offset by slightly negative comps in Apparel, Jewelry, and Photo.

Fresh Foods continued to be strong, at 10% for the quarter, as I mentioned, with particular strength in Meat and Produce.

Continuing down the numbers, on the income statement, membership fees reported in Q3, 199.1 million or 2.12% of sales.

This is up 10% in dollars or $18 million, and down one basis point year-over-year.

Again, while these figures saw a slight one basis point decline in member fees as a percent of sales, that was to be expected, particularly given our strong comps for the quarter.

We continue to view these figures as just fine.

Overall we continue to put up good membership numbers, helped by strong renewal rates, new openings, and continuing conversions, although to a lesser extent now that we're completing our third year of the executive membership increases of some of our $45 Business and Gold Star memberships to the Executive membership.

In terms of membership renewal rates, again these rates continue strong at our all-time high renewal rate percentage, pretty much consistent with last quarter.

Our business membership renewal rate, 92% for the third quarter, Gold Star 84 for company average of 86.

We did have a nice little increase in the number of members at Q3 end.

By comparison, at Q2 end, Gold Star totalled 14.8 million.

It was up about 300,000 to 15.1 million at Q3 end.

Primary Business up about 100,000 from 4.5 to 4.6 million.

Add-ons remain consistent at 3.6 million.

So, a total of 23.3 million at Q3 end.

That compares to 23 million at Q2 end, and 22.6 million at fiscal year end.

Including spouse cards we have about 41.6 million people with a Costco membership card.

At May 11, third quarter end, paid Executive memberships was right at 2 million.

That's an increase of about 86,000 in just the last 12 weeks, or about 7,000 a week.

So again, we've seen that number start to dwindle, the rate of increase to dwindle, as we would expect now that we're completing the third year of the 2% reward program.

Still about 7,000 a week compared to 10,000 a week in Q2.

In Q3, Executive membership sales represented 26% of our sales in the U.S., versus 21% of sales last year, again with a comp above the rest of the membership base.

Regarding Amex, continues to do fine.

A little over 2.3 million co-branded card holders, in just under 25% of sales being tendered with the co-branded or regular Amex cards.

Going down to the gross margin line, which as I'm sure all of you are waiting to hear a little bit more about, in Q3, particularly strong 44 basis points gross margin increase, helped by particularly strong gross margins in our Ancillary businesses, and in particular, our Gasoline operations.

If you would, as I ask you to usually, to jot down some numbers.

We take the 44 basis points and segment them into 5 different categories, the core business, the 2% reward, Ancillary businesses, International, LIFO.

The core business in Q3 was down four basis points, the 2% reward represented a 6 basis point detriment to total gross margin.

While still a detriment, a continued trend towards less of a detriment as we start to see that program even out a little bit.

Ancillary was 38 basis points.

International was plus 8.

LIFO was plus 8, for a total of plus 44.

I'll go through each of these in detail.

In terms of the core margin, which was down 4, I know that some of you had some concern out there when, in the Q2 we also reported that the core was also slightly negative.

What that is, it's a combination of what the actual margin in those businesses are, plus what the effect on the changing sales penetrations of that department, or the core businesses are.

As comps in Ancillary businesses outpace the core, you see a detriment to the core number.

So as an example, the minus 6 in Q2 that we showed you in our chart here was a minus 2 at the core level, but then at reducing penetration of the core business, made the minus 2 a minus 6.

Similarly, the minus 4 in Q3 was actually a plus 7 at the core level.

So again, if you recall in last quarter's quarterly conference call, I indicated that we weren't terribly concerned whether it was plus or minus a little, hopefully that allays a little built of the concern you had.

So again, the minus 4 is a function of reduction in penetration, plus the effect of the actual margins in the core business, which were actually up 7 basis points in the quarter.

In terms of the core gross margin components, Food and Sundries was up slighty as was Hard Lines, with Soft Lines in Fresh Foods down very slightly.

The next gross margin component, the 2% Executive member reward, again, pretty straightforward.

Essentially, we started the program with the 2% reward, which has the effect of reducing gross margin and increasing membership fees, as you might expect and ultimately increasing sales.

It was about a 12 basis point effect, in '00, an incremental 17 basis point effect in '01.

On top of that, an incremental, about 13 basis point effect in '02.

And this year, it was 9, a 9 basis points detriment in Q1 and Q2, and as I mentioned, 6 in Q3.

I would expect it to continue to drop to 5, 4, and 3 over the next several quarters as we again see the rate of increase in the number of Executive members starting to even off.

With regard to Ancillary businesses, again, 25% top line sales growth helped by 51% gasoline sales growth.

That was due to two things: Higher prices year-over-year of course, as well as finally getting some positive comps in our gallonage.

Recall, it was a year ago that we eliminated Mastercard and Visa at the pump, which, at the time represented about 40% of our gasoline transactions being tendered with Mastercard and Visa.

We did that given the dramatic difference in merchant fees we had to pay on those versus other forms of tender at the pump.

That's worked, we think to our benefit.

We're just anniversarying that, so we see some help there as well.

Generally, all Ancillary businesses performed well, increased profitability with one slight reduction in profitability in our Photo, as we'd expect, as we're transitioning from the photo processing world to the digital world.

We, like many other retailers, are making a fairly sizable investment in new digital equipment to afford our members the opportunity to purchase other digital-related products as well.

Good Pharmacy and Optical and Food core profits.

The big winner, of course,was Gasoline, both gasoline margins and also with gasoline profitability.

I looked at one of the first call notes this morning from one of the South Side analysts indicating that they suspected that, finally, with the decline in gas prices, that, given that we turn it so fast, they imagine that some of the strength in margins was just that, spiking gasoline margins.

That's correct.

While we'll continue to see some of that, not nearly the amount that we see in Q3, so some of that is an anomaly.

We do expect Ancillary businesses to contribute again in Q4's gross margins but we consider Q3 again a little higher.

International, 8 basis points better, in line with the plus 9 basis points pick up in both Q's 1 and 2.

Again, due to accommodation of margin improvement in these businesses, as well as increasing sales penetration of the International -- I'm talking about International being non-U.S., non-Canada, that International component.

Next, in terms of LIFO, LIFO contributed 8 basis points to third quarter margin.

Last year we had a $2.5 million LIFO charge, or representing 3 basis points of sales, this year we have a $5 million LIFO credit representing 5 basis points of LIFO credit.

That's the 8 basis point year-over-year change.

Given that we continue to see slightly deflationary trends in our LIFO pools, essentially across all categories, the $5 million LIFO credit was taken in Q3.

Based on current trends, we'd expect a fairly healthy LIFO credit in Q4 as well, if not certainly more than the 5, but probably not as much as last year in Q4.

Recall that last year, we had an aggregate LIFO charges, not credits, but charges, of 7.5 million in the first 3 quarters, 2.5 million a quarter.

And then a $21 million LIFO credit in Q4 resulting in a LIFO credit for the year of 13.5 million.

Again, this year to date through the first 3 quarters, we now have a $5 million LIFO credit this year net versus a 7.5 million dollar LIFO charge last year.

So, we're already 12.5 million year-over-year higher.

My estimate for this year's Q4 would be a credit somewhere below the $21 million we had last year, but nonetheless a decent number.

Before going to SG&A, let me briefly go over our Ancillary businesses.

At quarter end, we had 326 pharmacies, up 5 from the prior quarter; 390 food courts, up 3; 386 mini labs, up 3; 371 optical, up 3; continued 11 print and copy shops; 1 additional hearing aid center, now up to 120; and 4 more gas stations to be at 185.

In total, Ancillary business sales, comps, again, were up 20%, up 8% without gasoline.

Moving on to SG&A, while still higher year-over-year, the trend is actually a little more encouraging than meets the eye at first glance, particularly giving the rising trend in healthcare and workers' comps cost.

Again, if you could jot down the following components of SG&A, and note that I've added the new line item, that is stock option expense.

As you know, we are one of a few companies that have opted to really get ahead of the game here, since we anticipate it happening anyway, and we believe it's the right thing to do.

To expense stock options, we typically make annual grants to those people in the February, March, April time slot, which tends to then, the impact will start hitting us now.

In terms of the components, as you know, SG&A for the quarter year-over-year was up 32 basis points, the core component was worse, or higher, by 16 basis points, I'll call that a minus 16, minus being bad.

By comparison, in Q1 and Q2, core was worse by 27 and 25 basis points, respectively, so an improvement, at least in the right direction, to being only higher by 16.

Central was higher by one basis point compared to essentially flatter, higher by one in each of the first 2 quarters.

Ancillary, similar trend, minus 3 basis points, higher by 3.

International, higher by 8.

Again, that's a function of opening up several new international warehouses on a relatively low base.

It was just a little less than a year ago that we opened 3 units in the U.K., and we also recently opened in Japan.

And then stock options, our new line item, was just a shade over, I think $4.1 million which represented 4 basis points, to SG&A.

So you add the 16, the 1, the 3, the 8, and the 4, you get to the 32.

Now, the core warehouse SG&A, which again, was worse year-over-year by 16, higher year-over-year began still a better trend versus the minus 27 and minus 25 basis points in each of Q1 and Q2.

Of that amount, about 11 basis points was related to first year warehouses.

And again, I would -- that's a lower number of detriment than we've seen.

If I look back over the last 4 quarters, as an example, that component represented something in the mid to high teens in each of those quarters.

And so again, as we change the mix and we anniversary a year, and even two years, in some of the new market units, the high propensity of new market units that we had done, a high proportion of new market units, we should see that number continue to fall a little bit, but still be a little negative.

Another 19 basis points of the total 32 related to employee healthcare benefits and workers' comp costs at existing warehouses.

This is similar to what happened in Q1 and 2, actually a shade higher as we have upped the accrual at the beginning of Q3, given, recall, the increase in workers' comp and healthcare that we encountered in Q1 and Q2.

I'm hopeful that we can continue to see these numbers improve.

At some point, get to an afflection point.

We still think that's in the latter part of fiscal '04.

Next, on the income statement is preopening expense, $200,000 lower year-over-year, 1 basis point better, at 5.9 million versus 6.1 a year ago.

Pretty much as expected, even though 2 fewer openings year-over-year.

Last year in the third quarter we opened 4 openings, this year we opened 6, including 3 relocations, but nonetheless, 6 total openings.

I think part of the reason that the number itself was down a little bit is because relocations don't cost as much to open, in terms of preopening as some of the newer units.

In terms of the next line item on the income statement, the provision for impaired assets and closing costs.

For the third quarter, these costs totaled 6 million pretax, compared to 4.5 million last year in the same quarter.

While 1.5 million greater than last year, nothing out of the ordinary here.

If you add up everything we've talked about so far, all told, operating income in Q3 was up nicely, up 15% or up 33.3 million over last year's Q2 figure, coming in at 249.6 million this year, versus 216.3 last year.

Below the operating income line, reported interest expense was essentially the same year-over-year, 8.6 million last year, 8.7 million this year, no big surprises there.

Interest income and other was lower year-over-year by 400,000, coming in at 9.2 million versus 9.6 a year ago.

Actually, interest income was up by 1.4 million, while the other was lower by 1.9 million.

Some interesting things happening in the other.

Because of the, in the case of U.K. and Taiwan, increasing profitability, since we consolidate those figures, flows through the entire income statement, with the offset being the profitability of our partners goes on this lines.

As profits in those two countries increase, it creates a bigger negative on this line as a slight offset to that.

Similarly, Mexico, while profits in pecos are fine, due to the weaker peso, that's actually a reduction because we account for that on the equity method, and simply add our portion, our 50% of the profits, to this line.

Then there's a litany of other little things, nothing to be terribly concerned about on this line, but those are the reasons.

Overall, pretax income was up 15% or 32.8 million from 217.3 last year, up to 250.1 million this year.

With a lower tax rate this year in Q3, 38.5% this year versus 40% last year, net income and EPS increased by 18%.

Quick rundown of our balance sheet as of May 11.

Cash and cash equivalents, 1.289 billion.

As I try to always point out, that number includes a little over 400 million of debit and credit card receivables from the weekend.

We close our fiscal periods on a Sunday night.

Those are considered cash equivalents, but we don't get the use of the money until that Monday.

That number is always a little overstated for that reason, but on the balance sheet it is 1.289 billion.

Inventories, 3 billion 251.

Other current assets, 660m.

For a total current assets right at 5.2 billion.

Net fixed assets of 6.902 billion.

Other assets of 497m, for total assets of 12.599 billion.

Short-term debt, 92 million.

Accounts payable, 2.885 billion.

Other current, 1.739 billion, for a total current of 4.716 billion.

Long-term debt of 1.298 billion.

Deferred and other liabilities of 175m.

Total liabilities of 6.189 billion.

Minority interests of 124m.

Stockholders' equity of 6.286 billion, again, for a total of 12.599 billion.

A couple of normal things I point out on the balance sheet, again, plenty of financial strength, still a debt-to-cap ratio of about 18%, under 20.

Our accounts payable, in the third quarter, what we reported at third quarter this year-end was an 89%, by comparison last year it was a 94%.

So while that's down, it really reflects a lot of construction and progress accounts payable, not in merchandise accounts payable.

We had a higher level of that a year ago than we have now, given the multitude of openings that were in process at the time versus now.

If you take out that adjusted merchandise AP to merchandise inventories, this year it was 79% versus 80% last year, essentially the same, given a seasonally low period of time here.

One of the things I will mention is the average inventories for warehouse, as of third quarter end this year, it was 8 million 273 compared to a year ago, it was 8 million 199, up about $84,000, or a little under 1%.

I bring that up because I've read in the last several weeks, as retailers have been reporting numbers, there have been some concern out there that average inventory levels are higher out there year-over-year, and of course that could possibly lead to higher markdowns in the future.

Actually, our inventory levels are just fine.

While they're up, on average, in dollars, about 0.9 of a percent, they're actually down, the average inventory per warehouse is actually down about 1% in local currencies.

Or down about $100,000 per warehouse in local currencies.

So inventories are fine, we feel quite good about that.

Of course, structurally we had the benefit of selling the 20% of the items that represent 80% of the sales.

In terms of capex, in fiscal '02 we spent $1 billion, 30 million.

Our original budget for this year was to spend about 1.1 billion.

This was originally for 30 to 32 planned new openings and 7 planned relocations.

It looks like the 30 to 32 will finally come in with 25, I think we said 25 to 26 last year.

One of those additional -- I think we have a few left.

One of those may slip into September, to 24 or 25.

In the 7 relocates it will be 5.

So the slight reduction in openings, our capex for '03 should come in about 100 to 150 million lower than budget, or somewhere in the 950 to $1 billion range.

That, too, given the timing of some warehouses, could even be a shade lower than that.

No big deal, just in terms of timing, where we are at year end.

In terms of Costco Online, turning the table here, continues to be profitable and continues to show good sales growth.

Recall that last year sales totaled $142 million.

The first half year to date I indicated on the last conference call that sales increases of 67% year-over-year in the first half, in the third quarter, sales increased 102%, so year to date now stands at up 78%.

In terms of Costco Home, again, it sounds like a broken record, still a test.

As you know, we opened Costco Home, many of you have actually been out here to see it in December.

It still continues to beat our expectation.

It's profitable, it's doing fine.

But it's by no means anything that we want to roll out yet.

It's still a test, and will continue to be a test for the remainder of this year.

And no other decisions on that at this point.

Next on the discussion list in terms of openings, as I mentioned, we have opened, through actually, through not just the third quarter, but through May 23, through May 28 rather, we've opened a total of 22 new units and relocated 5.

Looks like we'll open 3 more to be at 25, and again, 1 of those may fall.

One of those may slip into September, but I think, it's probably going to be 25.

Possibly 1 more relocation.

I mentioned it looks like will be 5, 1 of those will be August or September.

For a total then of 25 most likely new units this year, and 5 or 6 relocations.

Plus 1 additional unit in Mexico, with 2 more in Mexico coming in the early part of fiscal '04.

If we look at the 25 net new units this year on a base of 345 to start with, that represented 7.3% unit growth, and given that the new units tend to be higher square footage and also some of the relocations and remodels tend to add square footage, that would translate into about 8.3% square footage growth.

Before I discuss guidance for Q4, the fiscal year, I'd like to respond to one other question we've gotten a lot recently, that is this new emerging issues task force #216, EITF 216.

I think the formal title of EITF 216 is, Accounting by a Customer for Certain Consideration for Vendors, aka, how do retailers account for rebates, add revenues, sliding allowances, and other kind of vendor incentives.

Some retailers, as many of you know, have indicated sizable one-time impacts as they change their accounting to conform with EITF 216.

A couple of comments I'll make on our side.

First as you would expect, our outside auditors have reviewed our accounting for such incentives during the current quarter, in light of the requirements of EITF 216, and noted that such incentives earned and taken into margin in the quarter were completely appropriate.

Second, the impact of EITF 216 is really a question of timing as to when such allowances will be taken.

As you might expect, what it does is defer some of those allowances into the future, based on when the underlying inventory is sold.

Any impact on Costco is mitigated greatly by two factors.

One, we turn our inventory much faster than traditional retailers.

We turn our inventory around 12 times, other retailers in the 3 to 8 time range.

Secondly, we believe that we purchase a much higher proportion of merchandise based on debt net pricing, rather than the loss of allowances .

We certainly have our share of certain types of allowances, but nothing like traditional retail.

We're in the process of calculating what financial impact that may have on our fiscal '04 figures.

I would guess that it would be relatively small, not nearly as impactful as what we've seen in some of the other retailers' press releases.

Again, it will be simply a question of timing.

Most of our timing issues will be intra-quarter, not intra-year, and more to follow, but again, very small impact on us.

Some direction for Q4, really the direction is the same as reported last time.

I think that we gave guidance of 54 to 56 cents last time.

I know some of you are sitting there saying, well, if you beat this number by a couple, why not next quarter?

A couple of comments I'll make on that.

One, the 54 to 56 is a tough number to begin with.

We tend to always be guilty of not sandbagging the numbers and giving you numbers that we will try to reach for.

There will be a slightly higher options expense in the quarter, probably 6 basis points worth instead of 4.

We'll have, as I mentioned, a good LIFO credit but not as much as in Q4.

Again, also with Ancillary business profits and margins, notably, Gasoline, while still being positive, not nearly as big as we saw in Q3.

And the last thing would be the higher tax rate.

Last year, we had it for the year, a 38.5 tax rate, but the way that went was that Q's1, 2, and 3 was a 40%, and in Q4, we trued up the year to 38.5, realizing a 35.5% tax rate in Q4.

This year, it will be 38.5, we expect it to be 38.5, as it was in Q's 1, 2, and 3.

So again, with all those factors, we think the current range is appropriate, and still remains a challenge for us.

So we feel good about going into the quarter and we'll see how we do.

Finally, before I -- I guess that's it.

I'll turn it back over to Deborah for Q&A.

Deborah?

Hello?

Yes, sir.

At this time, if you would like to ask a question, please press star, then the Number 1 on your telephone keypad.

Your first question comes from Bob Drbul of Lehman Brothers.

Good morning, Richard.

Hi, Bob.

Nice quarter.

Excuse me.

On the SG&A line, on the options expense, you mentioned sort of what your thought process is on Q4.

Can you give us a little bit more of insight into how you're looking at FY '04 related to the options expense on the SG&A line?

I'll go back to the press release several months ago.

I think it was -- doesn't have a date on it, probably 6 or 8 months ago when we announced that we were going to expense options beginning in -- actually, it was probably about 10 months ago when we were announced we were going to expense options.

And recognizing it's a function of stock price and stock performance volatility and all kind of other things.

Our best guess at that time was, is that the impact this fiscal year would be about $13 million spread completely in the second half of the year in Q's 3 and 4.

I think that we're still on target to be somewhere around there, maybe a million less.

Part of that is a function of, as the stock prices coming down.

Interesting the way the black shelves model works is, the lower the stock price, the lower the value per option.

So, but that's the impact there.

Next year we would have the impact of a full one-fifth of this year's grants, plus a portion of -- call it a little under one half of next year's grant.

Our guess is that the impact on fiscal '04 would be something in the 2.5 to 3% range.

So again, going from 1% this year to 2.75, let's say, next year.

So, that would be an incremental impact, but spread more evenly over the quarters.

In Q1 and 2 evenly, and then increasing in Q3 and 4, recognizing we tend to do grants right around mid fiscal year.

Okay.

That's helpful, thanks.

In terms of some of the sales numbers and productivity levels, can you talk a little bit about how May's gone for you so far?

And secondly, can you talk approximate about -- I'm sorry?

I didn't heart first part of that question?

Can you talk about the productivity levels of some of the newer stores versus the older stores?

And can you give us an update on how May went, or how May is going, so far?

Well, I think the productivity in new locations this year, there's fewer new locations, so our overall, our budgets tend to be a little more predictable as we've gone into more existing markets.

I don't think that the -- as I look at the whole group of all of our units that we've opened this year, relative to budget, there's more difference related to timing when we opened something, if it opened two months later or a month earlier, than how we're doing.

That's not a big delta, either plus or minus on the bottom line.

As we relate to May, of course, is it next week?

Next Thursday we will report comps.

I think, as we stated, as Bob stated, in the conference call, that when he does a recording each month now for comps, the direction that we gave 3 weeks ago was 4 to 6%, and we stand by that.

Okay.

Great.

Thank you.

Your next question comes from Daniel Barry of Merrill Lynch.

Good morning, Richard.

A little bit more color, too, on expenses.

I think you said before you thought you might actually have some leverage on SG&A if you got a 7 to 8% comp.

Is that still true?

Well, I've learned to be a little more cautious and bat shy as it relates to try and predict that.

One of the comments I made in the Q2 conference call to try to give some people at least what data points we have, was that, in the second quarter of the 3 4-week periods that comprised the second quarter, the first 4 weeks, which was essentially week 4 of November and weeks 1, 2, and 3 of December, we had like a minus, we had like a 1 or 2 comp, a plus 1 or 2 comp, that had GAAP SG&A up a little over 60 basis points.

Recognizing that the could be anomalies, plus or minus 5 or 10 basis points, but that was, at least, a data point.

In the next 4 weeks when we had comps internally, our internal 4 weeks that we, essentially the last 7 or 10 days of December and the first 20 days of January, we saw an 8% comp and a GAAP SG&A number up just a few basis points.

So, I think that's where that 7 to 8% number came from, recognizing there could be a few anomalies in our ability to get down there with that.

I've got to believe that when we get up there towards that 7 or 8, we start to see, as we get closer to that inflection point, that I could be off 5, 10 basis points.

Okay.

And by the way, we are clearly getting there, excluding healthcare.

And as we reduce the detriment of new warehouses, which we're seeing that trend, finally, as we change the mix a little bit.

And I've got to believe the healthcare workers comp is not going to continue at this kind of rate.

Since I haven't had the question yet, I will address that a little bit.

We are looking at all the heathcare workers comp costs.

As some of you have suggested, we tend to be a little stubborn in protecting our employees and the success we've had in our employees.

We will ultimately make some changes, but we're going to do it and mitigate them as much as possible on the backs of the employees.

And that's what we're going through, that process right now, which is a 7-month process.

I would guess that any improvement or reduction in the growth of that in expenses in healthcare, really won't be until way into the early part of fiscal '04.

And again, it could just be a slowing of expenses, not a reduction in expenses.

So, we are addressing those issues, and it's kind of like some of the conversations I've had with many of you over the year as we address margin.

We do get some extra margin where we can.

It takes us a little longer because we're not going to just knee-jerk react.

I think the same could be said for some of those expenses.

A follow-up on that point about healthcare and workers comp, if you can't continue it, hypothetically, at 6% comp for the next, say 8 quarters, could you show some positive leverage in SG&A, say, by the end of fiscal 2004?

I think so.

Okay.

Great.

Thanks.

Actually, I think so, and Bob is shaking his head "Yes."

So that's even better than, "I think so."

That's terrific.

Thank you.

Your next question comes from Bill Dreher of Deutsche Bank.

Thanks a lot.

Good morning, Richard.

At the gross margin performance, historically I guess you guys always follow strict market requirements, such as not selling below cost, or not pricing above a 50% margin.

Is that still true?

Yes, it is.

In fact, the one area -- two points of clarification.

There are a couple of businesses, an example might be the bakery where we include in the cost of sales, direct labor and supplies cost.

And so technically, do we mark up an apple more than 14%?

Yes.

Not an apple, I'm sorry, a baked good.

Do we mark up a baked good more than the cost of our materials?

Of course we do.

But in terms of a kind of calculated gross margin including those, that would still be below that percent.

The one change, actually that we've made over the last year, probably a year ago, we, for a number of years we had a 14% cap on markups, or margin, and a 15% cap on private label, theory being that we actually developed some of those products ourselves and there's a cost associated with it.

We actually brought the 15 back down to 14, as well about a year ago.

So, we continue to be strict on that.

You brought it down, I mean, with the benefit of, sort of, a calculated and a true landed cost, and what the effect this could have on gross margin?

Yes.

Recognizing when we switch from our branded goods to a private label, in many instances you're replacing a branded, commodity branded item that you might be working on 4 to 8%, with a private label item that you could work on 12 or 13 or 14, and still be the same gross margin dollars, if not a little better, but provide the customer at the same time with a 30 or 40% savings.

How about vendor deals?

Are you still reflecting all deals that vendors offer into the cost to good sold to reduce the price?

We still reflect everything in terms of what we mark up.

Finally, I'm curious about the consumers trading up.

Have we seen much in the way of consumers trading up to purchase higher end merchandise rather than focusing on, say, the opening price points?

That's our whole religion.

Everything we've done in life is to trade the customer up.

Despite some of the issues right now, with the French products, we had a limit of 2 and 3 bottles on the French Bordeau's, and typically were sold out within an hour or two each morning that something arrived.

We've always gone towards the higher end, if there's price points of $40 to $200 on a Cuisinart or a Kitchenaid Mix Master, we're going to tend towards to offer you the higher end of the price points, but still a great savings.

Perhaps you would argue that given our strong comps, part of that is that people like quality still.

That's great.

Thanks, Richard.

Your next question comes from Adrianne Shapira of Goldman Sachs.

Thanks.

A question, Richard, about the slippage in openings, could we expect you to pick that up in '04 as far as what your plans are in square footage growth in '04?

Looking at the schedule right now for '04, I count 20 -- I count 26 locations.

My guess is that 2 or 3 of those fall off just from timing delays or whatever else, even though they're all approved, go-forward locations, virtually all of them have zoning done, but you look at a list, there are 4 or 5 in July, August, some of those will be delayed.

My guess is there's another 5 or 6 to go on the list, so somewhere between 25 and 30.

And which would be a pick up from 25 this year.

But it's hard to say at this point.

By the way, that's not a reflection that we've become more mature.

Some of you have suggested we're becoming more mature and more discretionary -- more discerning in our opening schedule, it's really a function of just trying to get deals done.

I think our goal would still be to be close to 30.

I think the reality, it will be 25 to 30.

Okay.

So pretty much 7 to 8% square footage growth is where we should be looking at, and maybe that moderating over time, sticking with about 30?

I would guess and hope that would still incrementally increase from that level a few a year to maintain the square footage growth, if not increase it slightly, but time will tell.

The other point of note on our opening schedule is, I think that whereas this year about two-thirds of the units will be existing markets, I would say that number would continue to climb to have a higher proportion of existing markets in each of the next couple years, both as a strategy to do that, as well as the fact that some of what used to be called new markets finally become existing markets, like a Chicago, like an Atlanta, what have you.

Right.

And my next question, geographically, we saw some, a slight pickup in the Northeast, could you talk about what you're seeing competitively in the Northeast, some comments there?

Well, in terms of direct competition, we certainly compete continually with Sam's and BJ's, as both of them have stated, new strategies over the last 6 months to be more competitive, I think BJ's strategy, we've seen some lowering of prices, but again there's a lot of non-like items, and they've got a greatly expanded item base, different sizes, different brands, what have you.

And again, we -- I'm sure they compete with us every day too, we compete with them, but we haven't seen any dramatic delta on those numbers.

On the Sam's side, we've seen, they, too, again, several months ago, 6 or 8 months ago, announced that they were going to become "The lowest price" on a bunch of key, you know, 1500, I think, key wholesale items.

We watched them as diligently as we ever have.

They have become, not just in the last week or month, but over the last 6 or 8 months, a little more competitive in different markets.

We still see that we have, when we do our own price shops, that we feel that we have still a relatively healthy umbrella between us and them, and don't view that as a major issue.

But again, nothing that we've seen there has changed in the last month or two, it's really been more over the last six to eight months.

Keep in mind, we can both be the lowest on a lot of items.

When we price 100 like items, typically we find 50 of them the same, same price.

Well, we're both the lowest on that.

So half of the items in the 1500, in my view, in their 1500, we're the same on.

Another high percentage of their items could be a different brand, a different pack size, you know, one of us is selling one brand of canned goods and the other is a different national brand.

We're also selling private label and different things like that, different price points.

So again, I think we can -- we're not -- we continue -- as Jim would say, we continue to be in a healthy state of paranoia, as it relates to going out there and comp shopping.

But we feel that we've maintained our price leadership.

As it relates to other forms of pricing, of competitors out there, notably supermarkets and category dominant retailers, like the office and home improvement retailers, we really have not seen a dramatic change at all.

Our market baskets, the umbrella that we have over those types of competitors on the items that we sell is significant.

Most significant on, not again the commodity basic branded good, you know, a 12-pack of bulbs or a 24-pack of toilet tissue, but on everything else.

Okay.

And then the last question on membership.

You've told us in the past to expect, perhaps, a membership price increase every 2 to 3 years.

We're pretty much there.

What's Jim's latest thinking on that?

I'm sorry, your message got a little -- oh, membership fee.

All I can tell you at this point is we haven't talked about it.

All that means is that it's at least a few weeks away, it could be a few years away.

And I don't mean to -- history has shown we do it every 3 to 4 years.

Three years would be September of this year, 4 years would be September of next year.

Given we haven't talked about it yet, I wouldn't put it in your budgets for next year, but time will tell.

The good news is, our renewal rates remain ever strong, and I would assume that we will do it at some point, and we'll go from there.

Thank you.

Your next question comes from Theresa Donahue of Newburger Berman.

Ms. Donahue, your line is open.

We will proceed to the next question from Chuck Cerankosky of McDonald Investments.

Good morning everyone.

Richard, in looking at the comp sales breakdown between categories, hopefully I've got the numbers right.

You have comps up 4.5% for Hard Lines, Soft Lines down 1%.

Can you talk about that, what we're seeing in the mix there, especially with regard to consumers willingness to buy discretionary items?

Because those are two largely discretionary categories moving in opposite directions.

Well, I would say I'm more impressed with the Hard Lines number, up 4, particularly given the fact that Majors, which is the biggest component of Hard Lines, was essentially flat.

And within that, you know, Computers down slightly and some other things up slightly.

You know, most of our Toys and Sporting Goods, and Lawn and Garden, that's all discretionary, and we've seen that very good strong sell through with that.

We benefit by the fact that we tend to be in seasons earlier than people are used to seeing it.

They see it, they buy it, I think that's helped us.

On Soft Lines, you know, a little bit of the negative, slightly negative comps in Apparel relates to the year-over-year anniversary of our direct relationship with Levi.

Photo is another area, you know, while digital camera sales are up 20, 30, 40%, that's still the tail wagging the dog as it relates to the proportion of digital versus traditional photo processing.

I think, you know, between one hour photo and overnight processing we do close to 50 million rolls a year, that's down in the mid to high single digits.

So that is typical.

My understanding, in fact, it was presented two budget meetings ago here, that our numbers, if our numbers are down in the mid to high singles, the industry is in the mid teens.

And so we're doing better than the industry, but nonetheless that's an area which there's a structural change going on.

And I think we'll continue to see that.

Jewelry, it's up a little, down a little.

It's down a little this month, this quarter, but I don't think that's anything to worry about.

So what does that tell you?

I'm not sure.

We tend to, you know, we're getting more traffic, we get more positive press.

You know, we like to hear about all this stuff, I know.

We were on Mr. Phil, or Dr. Phil did a segment on us where he was behind the return desk at a California location interacting with our members, which was great publicity.

We had -- we continue to get great press around the country from the local news consumer advocates, particularly on gas and pharmacy and our pricing, and that stuff does help.

The dates succeeding those types of things, we see some strength.

I think that, you know -- I don't think the economy's getting any better any faster, at least that's what I read in the paper, but certainly the value proposition plays well, and we've played it pretty darn good so far.

Thank you.

The next question comes from Chin Ying of Rock Hill Partners.

Good morning.

Hi.

I have a quick question regarding the convertible bonds.

In your last call you mentioned you'd rather redeem cash than force conversion.

At the time the stock was around 27.

Now it's at 37, I just want to check whether there's any plan or changing your decision making?

I think my response last time is the same, but the fact that it's moved up implies that there's no likelihood that if we were to call it, it would be redeemed for cash.

We have no plans to do anything currently, although those could change.

Okay.

Thanks.

Your next question comes from Robert Toomey of RBC Dain Rauscher.

Hi, good morning.

Richard, I just want to make sure, you mentioned some changes in basis points in some of the comps earlier in your discussion, and same-store sales of comps in the quarter, ex-gasoline, was about 4.5%.

Is that about right?

Well, for the quarter, we were at 6.5, like a 6.4 something.

I think we said it was about 137.

So ex-gas, if gasoline, on like prices, on gas, the 6.5 would have been a 5.

About 5%?

Ex--gas and currencies, the 6.5 would have been a 4.

Okay, great.

That clarified it for me.

Secondly, can you go over the renewal rates, or the total members again?

I kind of missed some of those numbers.

Sure.

Basically, at Q3 end Gold Star 15.1.

Business primary, 4.6.

Business add-on, 3.6.

Total 23.3.

Add spouse 41.6.

Keep in mind, all these numbers we report this way, we include you in the membership base for, until your first anniversary of nonrenewal, recognizing that people do dwindle in in months, certainly in months 1 through 4 or 5, but even in months 6 through 10.

When I say we have an 86% renewal rate, if we took these numbers times 86%, that's what I would call our active membership base.

Okay.

And those compare to what a year ago?

I don't have the Q3 a year ago, but at year-end -- you could find it in the annual report, by the way, but at fiscal year-end, Gold Star was 14.6.

Business primary was 4.5.

Business add-on, 3.5.

Total, 22.6.

With spouse, 40.5.

Okay, great.

And then, I don't want to belabor the subject, but you gave an explanation of the reduction in core margin.

And I wasn't quite -- I didn't quite understand that.

Can you go over that again real quickly for me?

Very simply, when your margin of anything is up or down a little bit, the thing that affects our little matrix is the penetration of that respective department.

So that when the core business as a percent of total sales continues to fall a little, simply because comps and Ancillary businesses are rising at a greater rate, and International is rising at a greater rate, the core business, if you had exactly flat margins in the core, because the reduced sales penetration, you would still see the effect of core on the total gross margin coming down a little bit.

You know, I don't want to get into a 3-D matrix, so again, typically when margins have been up 10 or 15 basis points in the quarter, maybe it was up 20, but, you know, again taking out the other effect, or adding in the effect of the changing sales penetration, that 15 can become a 7 or 8.

Similarly, a minus 4 is really a plus 7 if you look just at the core.

But given the strength in the Ancillary and the International, that tends to weight average that, the contribution of the core a little bit less, too, which affects my little matrix.

Okay, that helps.

And the last question I have is, anything significant in terms of changes, with respect to merchandising in any of your major categories?

Or I guess, what would you think is most significant about any new merchandising initiatives or merchandising in general?

I think what's most significant is that there's lots of little things.

You know, I mean, Fresh Foods we continue to add new stuff.

You know, the list of vendors that the buyers are directed to go get, buy direct from, who historical haven't sold to us direct, I think we've been helped.

Particularly in this weak economy, where some of these manufacturers are willing to sell us, and we'll continue to add to the list.

There are some ones that I can't talk about yet, but we'll continue to add.

Those are all small, incremental positives.

We continue to test the special order kiosk area.

So again, I think -- you know, private label continues to improve a little bit.

I think all -- it's more of 'all of the above' than one thing.

Okay, great.

Thanks very much.

Your next question comes from Emme Kozloff of Sanford Bernstein.

Hey, Richard.

In terms of the 54 to 56 cents guidance for Q4, can you give us a sense of how the mix in terms of gross margin in the SG&A rate break out?

Especially since you mentioned a part of the gas business gross margin improvement is an anomaly?

You know, I can't.

My securities attorney is sitting here saying, "No."

That's a little bit more detail.

Clearly, we're not going to see the kind of margin improvement we saw in Q3.

Hopefully, we'll see that trend in SG&A continue to improve a little.

Still be higher year-over-year, but improve a little.

Okay.

Looking back at the last quarter's call, you said on a long-term basis that we should think about a 10 basis point average improvement in gross margin?

I think historical I've said 5 to 10, just to imply that we are continually, we to continue to be confident that we can eke out a little bit more margin, but it's going to vary quarter to quarter.

As Jim has told me time and again, businesses don't run in a straight line, but I can tell him that, well, okay.

We continue to -- the -- what I historically have said, we continue to feel that 5 to 10 is the number, it's simply saying that we think it's still net positive, and we still have opportunities that we don't see ourselves jeopardizing our competitive edge.

Okay.

Your next question comes from Bob Dunn of S.A.M Investments.

It's been answered.

Thank you.

Your next question comes from Deborah Weinswig of Smith Barney.

Richard, in terms of cannibalization where one new club is opening in existing markets this year, can you quantify that for us?

I'm sorry, what was that?

On cannibalization for the quarter year-over-year?

I don't have the number right in front of me, but I recall from the last 3 months, it's right around 80 basis points.

I'm within 5 basis points of the correct number, I'm sure.

Okay.

Is there anything that you've learned at Costco Home that you can, or you are applying to the Club?

Yes, there are but we're just in the process of making some decisions and we want to -- there are some things that we'll expand in terms of road shows, in terms of some new small additional items, but nothing on a major basis yet.

Okay.

And then lastly, can you just talk about the private label penetration in the quarter?

And I think you said historically the long-term goal was 20%.

You know, where might we be next year in terms of penetration?

Right now we're about 13, trending towards 14.

I think the long-term expectation is 18 to 20.

I don't know if that's a goal or more of just a kind of eyeballing the trend and recognizing we have a department that constantly looks at what else they can do.

And where it makes sense, we do it.

There have been a few instances where we backtrack a little.

There have been times when we had a private label diaper, then due to some technological problems, we opted out of it because we felt that the branded good was a better quality.

But I think that, you know -- my guess is it's -- you know, it went from 0 to 10% probably in 6 or 7 years, and then from 10 to 13 or 14 in another 5 years.

My guess, it's another 5 years before the 13 or 14 goes to 16 or 17.

Okay, great.

Thank you so much.

Your next question comes from Cecil Godman of Highland Capital.

Yes, Richard, how are you?

I just wanted to touch base a little bit with the mix as talked about with gross margin, SG&A, and I know it's kind of been beaten up, so I'm sorry.

But it looks like to me, with where your corporate goal is, and where your gross margin is today, there's actually more room for you to deal in gross margin, to continue to pick some up, and just to fight in having to work to stabilize your SG&A numbers, as a percentage of sales.

Is that really more kind of where things are going in the next few quarters?

Well, I would think that the -- that's where it has been going, so far.

My guess is that will continue for a while, although we will continually beat ourselves up to try to get more SG&A improvement.

Some of that will come defacto by the fact that some of these numbers have risen so much.

Again we tend to be a little stubborn and take our time on certain key items, like healthcare, because it does impact our employees.

At some point we'll show some improvement there.

At some point, the mix change will be completely mature such that, you know, this year we're still feeling the negative effects of a bunch of new market openings from last year that were open for half a year last year and open for a whole year this year.

Next year we've anniversaried more of those.

So I think that -- I think that as I've said in the past few quarters, that margins should -- I won't say will, but should continue to show slight improvement.

Membership fees should, at some point, see that improvement yet again from an anticipated price increase, but, you know, again, my guess is it's not 4 or 5 months from now.

And so, therefore, I don't know when it is.

And at some point, hopefully by the middle to end of next year, we should find our inflection point in SG&A.

And I hope I'm not sitting here a year from now saying it's three more quarters.

I understand.

But clearly you've made progress in the last three quarters from the trend line in the last six quarters, in trend line on SG&A, particularly at the core level from what we've seen.

It just seems like to me, given the level of service in your stores, and the level the people expect to continue to keep those people there, SG&A would be an easier thing to try to manage as best you could.

But gross margins seems like where you have 100 basis points that could be captured over a two-year period.

You know, it sound like some of the things that I've said myself, and as I would reiterate, that the company philosophy and Jim's philosophy is, that's why they call it work.

We're not going to take the easy way out.

We do get some more margin, and we'll continue, I think, to work at improving that.

But we've got to get the expenses going in the right direction, too.

Given our own internally generated constraints of, we're not going to do wholesale detriment to our employees.

Right.

Thank you.

Your next question comes from Tom Haynes of Georgetown Management.

Yes, good morning.

I think most of my questions have been answered, but I did have a couple of housekeeping items.

I wonder if you could give me the share count as of the end of the quarter?

Balance sheet?

And the capex for the quarter, and depreciation for the quarter.

I'll tell you what, just in the interest of time, since I don't have those right in front of me, if you would call Jeff Elliot at 425-313-8264 ten minutes after the call, he'll give it to you.

Great, thank you.

Your next question comes from Sandra Barker of Montag and Caldwell.

Hi, Richard.

I just had one question.

I didn't, I guess I just didn't hear it well.

When you talked about gross margins and the Ancillary, you said it was up 38 basis points.

What would it has been without the influence of gas?

Well, we don't get to that level of detail, but, you know, probably a little more than half.

I don't have the numbers right in front of me.

Okay.

It's more -- I know it's more than half, yeah.

Thanks.

There are no further questions at this time.

Thank you.

See you later.

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