好市多 (COST) 2006 Q1 法說會逐字稿

Good morning.

I will be your conference facilitator.

At this time I would like to welcome everyone to the Costco Wholesale Corporation's first quarter 2006 earnings announcement. [OPERATOR INSTRUCTIONS] Now, I would like to turn the call over to Richard Galanti, Chief Financial Officer.

Thank you.

You may begin your conference.

Good morning to everyone.

And 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.

And that these statements involve risks and uncertainties that may cause actual events, results and/or performance to differ materially from those indicated by such statements.

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

This morning as usual I would like to review with you several items.

To begin with, our 12 week first quarter fiscal 2006 operating results.

We came in as you know, at $0.45 a share, up $0.05 over last year's first quarter of $0.40 a share.

These results were $0.01 above the top end of the EPS guidance that I had provided you in early October on our fourth quarter year end earnings conference call.

And even with this week's First Call estimate of $0.45.

As I will review with you later today, this quarter's $0.45 figure was negatively impacted with a charge of approximately $7.6 million pretax or $0.01 a share which, is our estimated retention cost of hurricane Wilma that impacted Florida this past fall.

Needless to say that was not included in our assumption, to start with.

So excluding Wilma we would have reported $0.46 a share, $0.02 above the top end our estimate and $0.01 above the current $0.45 First Call estimate.

In terms of sales for the quarter, our 12 week comp sales figures showed an increase of 9%.

And in terms of the three retail reporting months that essentially coincide with those - - with the first quarter, September, October, and November our reported comps were 11%, 10%, and 6% respectively.

Of course, the strength in September was particularly strong given the Katrina hurricane and what it did with gas prices both from an inflationary standpoint with gas, as well as I think some of the positive press that we got nationally.

Other topics of interest I'll review this morning;

Our recent openings.

We have opened a total of 12 locations since the beginning of the fiscal year on August 29, nine in the U.S., including one relocation, one new location in Canada, our 66th in Canada, one new location in the U.K., our 17th, and one new location in Mexico, our 28th.

Of course, Mexico we account for on an equity basis.

And we're still on track to open 28 plus net new locations for the fiscal year.

And when I say net new, I mean net of relocations and excluding Mexico, which are not consolidated into our figures.

I will also discuss ancillary business results, Costco online, membership trends, our balance sheet, and lastly provide you a little updated direction and guidance for Q2 and the fiscal year overall.

So with that said, sales for the year's - - for this year's first quarter were $12.7 billion, up 12% from last year's Q1 of 11.3.

On a 12-week to 12-week comp basis comps were up 9% for the quarter.

And for the quarter our 9% reported comp sales results were a combination of an average transaction increase of about 8% for the quarter and an average frequency increase of about 1% for the quarter.

I might add that cannibalization was a little higher year-over-year, impacting this quarter by about 70 basis points.

If you look at the average transaction of 8%, that included about 0.75% improvement due to FX year-over-year, the weaker U.S. dollar, and about 1.5 percentage points due to gasoline inflation, although, that has subsided quite a bit as we ended the quarter as prices have fall from raising in September.

In terms of sales and comparisons by geographic region, and I guess the Northwest and the Midwest stood out as well as California not being far behind in terms of being better in the quarter versus last year.

Every region, in fact, but the Southeast, which was impacted by the hurricanes, of course, we had up to ten units closed for anywhere from one or two to several days.

Comps for the quarter, every region the comps in the quarter were better than they were last year.

In terms of merchandise categories; again, each major department showed improvement versus last year, both food and sundries, hard lines.

Soft lines was about the same as last year in the quarter.

Fresh foods up versus last year.

Ancillary, particularly strong again, even without gas, a double digit comp number.

In food and sundries, no real outliers.

All nine subdepartments of food and sundries were positive.

Eight single digit numbers and one actually above 10%.

Hard lines, certainly the strength in the subcategory was majors, with comps in majors being in the high teens.

Helped dramatically by all the cool electronics stuff and plasma and LCD screen TV's and digital cameras and what have you.

In soft lines, we saw strength in domestics, housewares, small electronics and home furnishings, with weakness in media and apparel.

Gas sales by the way were, as I mentioned, very strong, but about a 45% comp with 9% of that being gallonage.

And again ancillary businesses, even without gas, were up low double digits.

Moving down the line, items of the income statement.

Membership fees, we reported $262.6 billion, or 2.07% of sales in the first quarter.

That's up 10% in dollars and down 3 basis points as a percent of sales but still up almost $25 million.

A very good showing given our strong comp sales results.

And in terms of dollars, we were quite pleased with that.

In terms of membership, we continue to benefit from strong renewal rates that remain at our historical high of 86%, increasing penetration of the $100 a year executive membership and new market openings.

In terms of number of members at Q1 end, Q1 end and I'll give you a comparison at year end back in August as well, gold star 16.5 million versus 16.2 million at year end.

Primary business remained the same at 5.1 million.

Business add-ons both at 3.5 million.

The total, 25.2 million versus 24.8 million at fiscal year end.

Including free spouse cards, 45.8 million cardholders at quarter end versus 45.3 million at fiscal year end.

At first quarter end November 20, our paid executive members approached 4.6 million.

It was an increase of 330,000, or 7.5% since fiscal year end just 12 weeks ago.

So, an average weekly increase of about 28,000 conversions or new executive members.

All of last year, by the way, the executive membership base increased about 19,000 a week.

So, we had a push on that during the first quarter.

We did quite well.

Executive membership, which the number of members which had increased 30% in all of fiscal '05, again increased another 7.5% of our base in the first quarter of '06.

Going down the gross margin line.

Q1 gross margin was lower year-over-year by 11 basis points, coming in at 10.54 versus a 10.65 last year.

This is much improved in terms of year-over-year comparison as compared to the Q4 year-over-year comparison just three months ago.

Recall in the fourth quarter of '05 year-over-year we were - - our gross margin reported was 37 basis points lower year-over-year.

If you jot down the following numbers I can give you a little bit of editorial here.

We have five line items, merchandising, 2% reward, LIFO, EITF 310 and total.

And then the three columns would be; first column would be fiscal year '05 in its entirety.

The second column would be Q4 '05, just those 16 weeks.

And the third column would be first quarter of '06, the 12 weeks ended November 20.

Looking - - and this again would be basis points as a percent of sales - - gross margin as a percent of sales year-over-year comparison of those numbers.

In merchandising going across line one.

In '05 year-over-year for the year it was -3 basis points, in Q4 '05 it was -24 basis points.

And in Q1 '06 it was -2 basis points. 2% reward. again this reflects the increasing penetration success of that program, -10, -9, and -9.

LIFO, -1, -4, and 0.

EITF 310, which is now well anniversaried but for all of fiscal year '05 it was +5.

And the next two columns, 0 and 0.

So all told for all of '05 gross margins as a percentage of sales were down nine basis points year-over-year.

For the fourth quarter they were down 37 basis points, and for the first quarter, down 11.

As you can see, And the first thing to point out, of course, is the merchandising gross margin that was lower year over year in the first quarter by just 2 basis points compared to 24 in the fourth quarter.

The -2 basis point figure was actually a little better than I had thought back in early October when on my October 6 year end conference call I said; in terms of our fiscal '06 gross margin outlook we expected reported gross margins would probably be down a little to start the year due in large part to the gas/non-gas sales penetration issue.

So how did we get to -2 basis points here?

First, lower year-over-year penetration of our core merchandise business.

That's food and sundries, hard lines, soft lines and fresh foods, which have a much higher gross margin than gasoline gross margins.

This reduced sales penetration of the core areas of merchandising, hampered the margin a little bit.

As well, while food and sundries, which is over 40% of our total sales showed higher gross margins year-over-year, gross margins of hard lines, soft lines and fresh foods were a little lower year-over-year.

No real change in competition.

We did see in the apparel area a little bit higher markdowns.

That impacted margins by a few basis points.

We also saw what we call D&D, damage and destroyed, at higher returns.

And part of that has to do with mix.

We've had tremendous strength in consumer electronics.

And you've got $1,000 and $2,000 and $3,000 television sets going home.

Where not every customer understands how to install it and what have you, and given our generous return policy, we would have expected that.

And that did hit us a little bit in Q1 as well.

Also, on a lot of these big ticket items you tend to have a little lower margin because it's a competitive area.

But in terms of competition with our direct competitors, we haven't seen any major change there.

All told, those 80% of total sales had slightly down year-over-year gross margins.

And while the gasoline gross margins were actually up in Q1 year-over-year, which certainly helped our reported gross margin.

This year's Q1 saw significantly higher sales penetration of this lower margin category, as I mentioned.

Finally, as our other ancillary business overall contributed slightly to margin improvement.

Looking beyond the merchandising component of margin.

Our Q1 gross margin was impact, as I mentioned, negatively by 9 basis points from the higher sales penetration of the 2% executive member program.

This 9 basis points is consistent with Q4 '05's year-over-year comparison - - gross margin variance.

Again, we had a little bit of a push on executive membership programs during the first quarter and saw great results from it.

In terms of LIFO, note that we took no charge in either this year's or last year's first quarter.

As of Q1 end we were ever so slightly deflationary, believe it or not.

Overall, I look at Q1 gross margins as being pretty good.

A much improved variance year-over-year in Q1 versus the variance year-over-year in Q4.

In terms of our outlook continuing into '06, our reported gross margins again, we'll probably continue to be a little down year-over-year.

And due in very large part to the gas/non-gas penetration issue.

The impact from increasing executive memberships should still be a small hit to it.

LIFO, notwithstanding, no charge for LIFO in Q1.

I would still assume a little inflation this year and therefore a possible LIFO charge during the course of the year.

Although, we did have LIFO charges in each of Q's 2, 3 and 4 last year.

But I would have said the same thing three months ago and we came out a little deflationary.

So, we'll see.

And we believe our core merchandising groups from, a competitive standpoint, are fine and we feel fine about where we're going with that.

Before moving on to SG&A let me briefly go over our ancillary businesses.

Pharmacies, we ended first quarter with 382.

That's up eight from fiscal year end.

Food service, or food courts, 435, also up eight.

One-hour photo labs, 432, up nine.

Optical, 424, up 10.

We remain at 10 copy shops - - print and copy centers.

Hearing aid centers, we added six to be at 174.

And we added eight gas stations to be at 233.

In total for Q1, ancillary business sales comps were up 26% and up 11% without gasoline.

Moving on to SG&A.

Happy to report again positive trends in SG&A leverage.

In Q1 of '06, as you will see, our SG&A year-over-year was lower or better by 5 basis points, coming in at a 993 versus 998 as a percent of sales last year.

Again if you'd write down a few numbers here.

Again, I'll give you three columns and six line items.

The line items would be operations.

The second one would be central.

Third would be stock options.

Fourth would be EITF 310.

Fifth would be quarterly adjustments.

And lastly would be total.

And again we'll look at the fiscal '05 year as column one, Q4 '05 as column two, and Q1 '06 as column three.

Going across, and again what positive numbers here mean, lower SG&A basis points year-over-year.

In terms of core operations, fiscal '05 was a +14, Q4 '05 was a +17, Q1 '06 was a +9.

And as I'll show you in a minute, while still plus, a little less plus than last year.

Last year was the first year of some of the significant benefits in healthcare as we made some changes to our healthcare plans.

But we're still seeing good leverage in core operations.

Excuse me.

Central; 0, -1, and +2.

The -1, of course, would mean for all of - - for Q4 of '05 central expenses as a percentage of sales were higher by 1 basis point.

Stock options, -6, -7, -6.

EITF 310, -5, 0 and 0.

Again, that had the impact in the first half of '05.

Quarterly adjustments, -1, 0, and 0.

What the quarterly adjustment simply - - and that's part of SG&A is the hurricanes.

Interestingly we also had hurricane charges in Q1 last year of $6.4 million related to three or four different hurricanes that hit Florida.

Again, the 7.6 million this year, that was all related to Wilma.

And it hit the first quarter of '06.

In terms of a little editorial on SG&A I'll point out the following.

As we were hurt, if will you, in our gross margin percentage from mix changes with regard to strong gasoline sales, those same strong gasoline sales arguably helped us a little in SG&A this year.

Also, we benefited in lower Q1 over Q1 SG&A.

An improvement in our largest expense categories.

Payroll improved year over year in Q1 by about 8 basis points.

And our Workers' Comp and benefits expenses are also continuing to show improvement year-over-year.

The one line item that impacted us negatively by a few basis points is utility expenses.

I don't have to tell you what's going on with that.

The 2 - - moving down the line the 2 basis point improvement in SG&A central, again was helped by strong comp sales.

Central costs, we feel are well in check.

Finally stock option expense, which higher by 6 basis points year-over-year in Q1.

The thing I'd like to point out, of course, is beyond fiscal '06 we don't expect a big incremental negative impact to SG&A from option grants.

Regarding the expensing of stock options, as you know, we began expensing stock options at the beginning of our fiscal '03.

So, we now have - - as of the beginning of this fiscal year we had three years of gradual expensing under our belt, if you will.

Under previous accounting rules, FAS 123, given that our option grants vest ratably over five years, we have seen the expense grow each year such that by fiscal '07 we would have included in our income statement 5/5, if you will.

Or essentially a full year of stock options. 1/5 of each of the five year grants that they vested.

In that regard, our pretax expense to earnings in fiscal years 2003, 2004 and 2005 were $12 million, $37 million, and $68 million respectively.

And under FAS 123 we would have budgeted an '06 pretax expense of about $100 million.

Now, recently a revised FAS 123, called FAS 123R came out.

And we now have fully adopted this effective the first quarter this year.

What it affect does, it gets you fully - - your income statement is being hit fully for what I'll call the 5/5 answer. 1/5 from each of the last five years.

As I indicated at the October call, the impact from 123R would be an additional $12 to $15 million this fiscal year.

This was in our budgets and in our guidance, both on this call and on our previous October 6 call.

In terms of SG&A outlook for the remainder of '06, I'm encouraged what we are seeing in each month's results in terms of payroll and benefits and what have you.

Again, offset a little bit by utility costs.

But we do have - - and again, we do have this year a slightly higher stock option expense year-over-year as well as our ramped up expansion plans.

But really no change in direction from our prior discussions.

And again I point out with regard to the incremental increases we've seen each year that now accumulate probably 20+ basis points into SG&A over the last four years.

After fiscal '06 we won't see any big incremental changes as a percent of sales in that number.

Next on the income statement is preopening expense. $2 million or 1 basis point higher coming in although 12.4 million or 10 basis points.

Higher preopening related to more warehouses opened.

Last year in Q1 we opened seven openings with no relocations.

This year, nine openings with one relocation.

No surprises.

In terms of revision for impaired assets and closing costs, with Q1 '06 these totaled $1.2 million.

That's actually 1.6 million lower than last year's first quarter closing cost line of 2.8 million.

So all told, operating income in Q1 '06 was up $25 million over last year's Q1 figures.

Or up 8% to $325.5 million this year versus $300.6 million last year.

Again, both of those numbers were impacted by hurricane charges.

Below the operating income line.

Reported interest expense was substantially down by about $6 million year-over-year.

Last year in the first quarter interest expense was 9.6 million, this year 3.7.

This reflects both the June 15 payoff of a $300 million debt amount.

And lower interest expense on our convertible debt, as more of its holders converted into our dividend paying common stock.

In interest income and other was significantly higher year-over-year as it has been in recent quarters.

Coming in at 25.5 million this year, up right around $10 million from 15.6 million last year.

Virtually all of this increase was due to much higher investment income, higher cash balances earning higher average interest rates.

Although our cash balances, as I'll talk about in a minute, have come down a little bit relative to where they were as we continue to buy back some stock.

So overall pretax income was up 13% versus last year's Q1.

From 306.6 last year to 347.3 million this year.

In terms of our effective tax rate, it was 37%, even with last year's Q1.

For all of fiscal '05 it was at what I'll call a normalized 36.2% for all of '05.

We did have some additional one-time benefits last year.

But again, in trying to do apples to apples it was 36.2.

And it came in at 37.86 in the first quarter this year.

A little higher than my estimate that I gave you in October when I said it would be about 37 going into the fiscal year.

For the remainder of the fiscal year we would budget somewhere in the high 37's or 38.

For a quick rundown of our other usual topics I'll start with the balance sheet as of November 20.

Cash and equivalents 3.289 billion.

Inventories, 4825.

Other current, 728.

Total current assets, 8842.

Net PP&E, 7916, other assets, 624.

Total assets, 17,382.

On the right side; short-term debt 62.

Accounts payable 4859.

Other currents, 2534.

Total current liabilities 7455.

Long-term debt 547.

Deferred and other 254.

Liabilities total, 8256.

Minority interest, 60.

Stockholders equity, 9067.

And total on that side of course 17,382.

In terms of our balance sheet, again, very - - needless to say a lot of strength.

Debt to capital of sub 10%.

In terms of one of the things that we look to measure ourselves is our accounts payable ratio - - or accounts payable as a percent of inventories as a percent of accounts payable - - I'm sorry, accounts payable as a percent of inventories.

We reported at Q1in 101%, so we had more accounts payable than inventories.

And that's up about 2 percentage points from last year, reported number of 99.

Now, in fairness both of those numbers account include accounts payable for construction projects.

If you want look at true merchandising accounts payable to inventories, we're also up 2 percentage points from last year.

Last year in the quarter that number was 83%.

This year 85%.

And a reflection of improving our turns, doing what we try to do every day.

Average inventories per warehouse were up $265,000, 10.677 million per warehouse last year versus 10.942 million.

At Q1 end you're always going to see, first of all, the highest average balance per warehouse as we - - that of course is four weeks shy of Christmas.

And so right in the thick of things in terms of Holiday inventories.

The 265 actually is a relative improvement, I guess.

It's only 2.5% up year-over-year, a little lower than we've seen in the past.

Not bad, particularly given our 9% comp sales figures.

Reasons for being higher, we finally have seen a turnaround in the FX, so really no FX impact.

As the dollar has strengthened, particularly relative to Canada from where it had been.

The higher consumer electronics by about 100,000 a warehouse.

Again, that business is on fire.

And higher year-over-year jewelry and toy inventories totaling about $130,000 per unit.

So, most of it was in those three areas.

Again, all seasonally related.

No worries.

Our merchants feel our inventories are clean in terms of anticipated postseasonal markdowns.

But as I mentioned earlier, we did have some extra markdowns in the first quarter related to some of the longer warmer weather before it turned.

But as I had indicated when I discussed that markdowns were a few basis points higher in the quarter, not a big deal there.

In terms of CapEx, in '05 we spent 995 million.

Of course a chunk of that relates to Q1 openings.

Our projections for this year are 1.2 to 1.3 billion.

This is for the 28 to 30 planned new openings.

In Q1 '06 we actually spent 272 million.

Next topic, Costco online, is actually going great guns.

For the quarter, sales increase was up 61%, significantly ahead of our budget.

Next one in discussion, expansion.

Again if you want to just jot down numbers.

In terms of new openings, in all of '05 we opened 21 net new - - not net new but total new openings.

That included five relo's.

So total net new openings last year were 16.

We also opened three in Mexico last year.

Now, looking at the four quarters this year I'll give you my best guess right now.

In Q1 we opened nine net new - - I'm sorry, nine total, including one relocation, so eight net new.

Plus one in Mexico.

In Q2, we have opened already, and planned that will be it, as we've now pretty much done for this calendar year.

Two new, none of which were relo's, so a total of two.

Zero in Mexico.

In Q3 six new, including one relo, so five net.

And zero or one in Mexico.

In Q4, 14 new, including one relo.

So 13 net new.

Plus one to two in Mexico.

That would give you 31 total, including three relo's, or 28 net new, plus two to three in Mexico.

You may ask that; given our recent results of opening fewer than expected openings in each of the last three years.

And given that fiscal '06 is a little bit back-end loaded with 14 in Q4.

Why should you be comfortable with getting all these opened?

Well I think first and foremost, we feel more confident about it this year than we have in the last couple of years.

But lastly, of those 14 total new openings in Q4, only four of them are currently planned in August.

And even on those four we feel a little better than we have felt in the past in terms of what may be back-end loaded.

So, we're well on our way.

And I think that our original guidance this year was 28 to 30 net new.

This 28, by the way, includes I think 26 or 27 that was in that original group, plus two that we added.

So, we've lost a couple and added a couple.

I think we're going to be very close to what I said at the beginning of the year.

If it falls, it falls one or two, not 10 or 15.

So, if you use the 28 net new on a base of 433; that would be 6.5% unit growth and about 7.5% square footage growth.

Significantly ahead of the last several years.

Lastly, I want to talk about our stock repurchases.

As you probably know, we have had in place an existing common stock repurchase program authorization allowing to us repurchase up to $500 million of Costco common stock.

During our fiscal fourth quarter, actually beginning in early June, we repurchased during the quarter approximately 9.2 million shares at an aggregate purchase price of about $413 million or just under $45 a share.

So, we still had repurchase authorization under that program of about $87 million.

On October 6, when we announced year-end earnings we also announced a new program that was authorized by our Board.

That would allow to us repurchase up to an additional $1 billion of common stock.

Since that time and through yesterday, we have purchased an additional 6.6 million shares at an aggregate purchase price of about $315.6 million.

So all told, since the beginning of - - since the beginning of fiscal '05 Q4 back in June - - back in late May, we repurchased a total of 15.8 million shares at an a purchase price of $728.8 million or a little over $46 per share.

Finally, before I turn it back for Q&A some direction on earnings.

As you know again looking at Q1, in Q1 we had $0.40 a share last year.

At the time of the October 6 conference call, First Call estimate was $0.44.

I had indicated on that conference call that we expected that was at the high end of our range.

I'm happy to report of course that we came in on reported basis $0.45, $0.46 if you exclude hurricane Wilma impact.

The First Call estimate for Q2 is $0.60.

Again, I'd like to stick with what I said last quarter.

That this is the high end of our comfort range and we'll see what we can do but there is a range.

And I would leave untouched our fiscal year estimates that we had.

While it's come up $0.01 from October 6 to now for the year that's basically $0.01 extra that Q4 moved last week from $0.44 to $0.45 in the First Call averages.

That's - - both of those numbers are in the range.

So we still feel that we'll be essentially in the 10% to 13% or 14% earnings growth range.

And we'll see what we can do.

With that I will turn it over for questions and answers.

Thank you.

[OPERATOR INSTRUCTIONS] Your first question is from Deborah Weinswig.

I think you said you'd assumed a little inflation this year.

Can you talk about what product categories and give us any additional details there?

Paper goods, nuts, well certainly petroleum-based products like plastic bags and what have you.

But I think it's still, if you will, a buyers' market.

Relative to what's out there I would imagine the purchasing power that the Costco's and the Wal-Marts, Safeway's and the Albertsons have has helped.

Clearly, our purchasing power, given that we are not necessarily always brand - - multibrand needy I think we've been able to keep a lot of those costs down.

Which of course, keep costs down for our members and makes us more competitive.

Every day we see announcements even from our vendors about prices going up on paper goods.

That being said, as you may or may not know earlier this year we - - one important paper product is disposable diapers.

We basically went from the two leading brands of disposable diapers to one leading brand and a private label of what we believe is a very good quality.

And where the price point on it is 20% lower.

Now, 20% deflation if you will, doesn't go into the pricing because it's a new item.

But an item that maybe was going up a few percentage points stopped going up because it was taken out of the mix.

So I again, we just to have assume we're going to see a little.

I said, all we said three months ago we were feeling the same way and we saw it go the other way.

Recognizing - - if you had talked to us four weeks into the quarter it was certainly a different picture because of the craziness in gasoline prices.

That has subsided tremendously as well.

And then I think that you mentioned that on the ancillary businesses you saw double digits excluding gas.

I would assume that was driven by pharmacy.

Can you talk about what's driving that and what your expectations are going forward as well?

Well, it was several of the ancillary businesses including that.

But we didn't - - I think in pharmacy, we get great press.

And if anybody wants to see the 400 clips that we have from different news stations around the country, we'd be happy to show them to you.

The prices - - certainly the consumer advocate topics du Jour is gasoline and prescription drugs.

And as it relates to prescription drugs, a week doesn't go by where one or two or five or six stations around the country, news stations, are talking about where's the cheapest place in town to buy your prescriptions.

We're batting essentially 1,000%.

And It's not just that we're beating by a little.

These numbers are absolutely extreme.

I think that continues to - - that value proposition, if will you, continues to help us.

Okay.

And then last question on payroll, you said it improved eight basis points in the quarter.

Were there any new initiatives in place or was it just better labor scheduling or can you give us any additional color there?

I'm sorry, on what aspect of it?

Is it payroll?

Yes.

Well, I think payroll - - well I bet you of the 8 basis points, a few basis points of it, maybe not 5, but 3, 2 or 3 of it, is the fact that we had gas sales higher.

So, the same gallonage, same labor.

And arguably labor and gas business is lower on a variable rate anyway.

So, that's certainly helped us.

But even taking that out we showed improvement.

I think we've just, we've gotten a little better at what we're doing and we're still showing good comps.

That helps.

If I look back over the last year we've probably done a little better job of the discipline that Jim insists on with SKU count.

I've told some of you the story about; in our case, if we've got - - our goal is to have roughly 4,000 active SKU's in a warehouse.

As it creeps - - and it constantly does, as it creeps up to 4,250 he starts to offering his assistants that if his buyers don't want to do it, he'd be happy to sit down and do it in about 15 minutes.

Well, the difference between 4,000 and 4,200 even, is probably 300 items that have to share a pallet position and therefore have to be hand stacked.

And we've gotten better at that.

And when you get better at that, you've got less hand stacking.

You've got more stuff on the floor, where you're not having to restock it during the day.

Which requires in the case of moving pallets, three people, a forklift operator plus a person in front and back.

We're now well over a year and probably 1.5 year anniversary from when we dramatically increased the labor at the front end.

So, I think it's basic blocking and tackling.

It's nothing new in terms of technology.

Thanks so much, Richard.

Your next question is from the line of Robert Drbul.

Hi, good morning, Richard.

Just a couple questions.

The first one is can you talk a little bit, the sales that you saw slow down in November and the expectations for the December sales?

And can you just elaborate a little bit more on traffic has sort of been flattish or up slightly?

Can you talk about those two things?

I'll talk about traffic first.

If you look back over the last, whatever, 12 or 16 or 20 fiscal quarters, whether we are reporting a six comp or a 10 or 11 comp, traffic was always in the %0 to 2% range.

It was never big.

So, and we did see in Q - - in the third month of the three months it was 0, I think, close to 0, 0 to 0.5, versus 1, 1.25 in the first couple of months.

I'm not terribly worried about that.

The weather had a little bit to do with it.

But as you'll note, I'm more responding to your answer we try not to talk about it, but there I talked about.

In terms of the difference between the three months, the 11, 10, and 6, the 11 we knew what it was.

It was, in my view it was Katrina, it's what did it to gas prices.

And we were on national local news every night as being the best place to buy gas in many markets.

And FX, that was the other thing.

FX in September, I don't have the exact number in front of me, was 100 plus basis points in terms of the impact of our reported comp.

In the third month in November, it was actually -17 or -19 points.

So, it's finally switched.

And so there's 100 plus basis points right there.

And then I kind of look at it that the - - if I take out the FX, if I take out the excess gas, that arguably September, if you want to say the 6 was a 6 in November, the 11 was probably an 8.

And that extra 2 was because of gas, the fact that we got so much pressure, more people in the parking lot coming in.

So, I would have - - if I had to look through the three numbers and again, this is a little bit of Kentucky windage here, I would say the 11 was arguably an 8 excluding gas, excluding FX.

But 8 was still better than a normalized 6.

And the 6 was a 6.

But I would have hoped the 6 would have been a 7.

When I look - - and I know - - Bob's little audio call that he does, recording for reported sales, the comps, the trend in the four weeks was good.

The first two weeks were I think in the 3 or 4 range and the third and fourth weeks were in the 6 or 7 range.

In a way we're already back a little bit.

And now why was it a little weaker in those first two weeks?

I think in looking at it, and this is again, more looking for answers afterwards.

We did have no extension of winter wallet or summer passport.

But there were some additional merchandising and marketing initiatives in store a year ago that continued into the first couple of weeks.

Like fence promotions and some vendor promotions that were more - - there were some handouts.

In fairness, that was less than 1 percentage point.

But again, if I'm going to look for excuses or answers that was a little piece of it.

So we're - - yes, it's fun when you have 10's and 11's.

And 6's aren't so bad, particularly when the 6 is a 6.

And in terms of December, would you expect some - - would you expect the higher end of your range or the lower end your range, from where you've seen so far and then the rest of this month?

Well I would say this, assuming we were sitting here the day that our last four-week reporting period ended, when we saw a 6 and a 7 in those weeks in three and four.

The trend is your friend.

I would expect that if it had had been the other way around, where weeks one and two were six or seven; and weeks three and four were three and four or three and five, I would have said I'd bring it down a little bit.

That's giving me some encouragement.

I would say the guidance - - and I'm going to purposely give you some wide guidance, 5 to 7 would be a fair guess.

Okay.

And then Richard you didn't really mention the membership fee increase or potential membership fee increase.

We've seen both of your competitors now increase their fees.

Can you give us an update on that?

Sure.

First of all, just so everybody knows what all of us charge.

We currently charge for both gold star and business member $45 in the U.S.

Sam's, I believe, up to now is 30 and 35. 30 for the business and 35 for the individual.

And BJ's is 40 and 40.

So, with regard to BJ's we're $5 higher at both.

With regard to Sam's we're currently 10 and 15 higher on both.

As we go through out - - and not to sound arrogant, but assuming that historically we've done $5 increases from 25 successively up to 45 over the last 16 or 18 years, That at some point if we do, in fact, increase it, logic would say the 45 goes to 50 at some point.

We frankly - - certainly the fact that the other two have announced effective January 1 they are going up $5, so our 45 currently will be the same as BJ's.

And instead of 10 and 15 higher than Sam's, it will be 5 to 10 higher.

You put that on the positive factor side of the column saying, okay, that's a little less.

I can honestly say in that our previous discussions we've always assumed that they stay where they are.

So, I don't think that's a big impact.

And I've heard from some of you both sides of that argument in terms of trying to get information out of me but also trying to theorize here; that the by the fact that they've increased, it gives us ability to do it sooner.

I would argue that by doing it, it gives us pause to say, hey, let's wait awhile.

I think personally our competitors have been waiting for to us do something and got tired of waiting.

Whatever reason, it doesn't matter.

We are currently at 45.

We at some point I'm sure will change it.

It's not necessarily going to be January 1 or January 2.

But it's not necessarily going to be a year later, either.

We'll see.

We haven't made any plans yet.

Okay.

Thank you, Richard.

Your next question is from Emme Kozloff.

Emme, your line is open.

Anybody else?

Okay.

Your next question is from Mark Husson.

Richard I just wanted to ask about gas.

We saw a number of other retailers who report gas margins separately, blow out cents per gallon in the $0.09 to $0.20 range.

And you're normally in that sort of $0.02 to $0.08.

What did you do in the quarter?

I'm sorry, could you repeat that?

Yes,gross profit cents per gallon.

Other retailers who would normally do say $0.08 to $0.12 have been reporting $0.10 to $0.20.

You normally do something like $0.02 to $0.08 per gallon.

What did you do in this quarter?

Well, actually if you got that out of us I don't know how you did.

We don't really talk about cents per gallon in general.

It's truly been all over the board during the quarter.

It was a little better than average.

Okay.

Can you talk about currency now and currency trends?

Obviously against the pound and against the Canadian dollar and the impact that had on earnings?

And what's your outlook for that?

Well, slightly negative against the pound and about flat with the Canadian dollar.

Recognizing that's big improvement in both.

My guess is as good as yours.

If you look back two or three years ago, I think there was one month where FX improved our reported comps by 300 basis points.

And all of last year I think it was 135 basis points, or 130 basis points.

So, again, it was -15 or -20 this past month and still up slightly for the quarter.

Jeff?

And so if you look at that, my guess is we'll still show some slight negative trends year-over-year for a few quarters here.

Okay.

And then the final question is on pharmacy, Medicare Part D. Obviously the people that care a lot about how much prescriptions cost are people that have to pay for it themselves, which tend to be folks who are considering enrolling in Part D. Is that going to have an effect on the amount of people using the pharmacy at Costco?

First one.

And do you have a moral hazard in suggesting to people that they shouldn't sign up because you're just so cheap as you are?

In some cases that's the case.

I don't think we're going to go out of our way to show them that or to try to talk them into it, to be accused of anything here.

We're happy to provide them the cost of what they buy from us and they can do their own comparison.

Having helped my parents - - having somebody in our pharmacy business here help my parents try to consider what they want to do with the Medicare prescription drug programs, you need to be a Ph.D. at something, in mathematics, to figure this thing out.

It is the most convoluted, complicated system.

And I guess technically, and legally pharmacies are not allowed to tell or recommend one program over another.

When you do all the numbers and all the machinations.

In one case one of my parents, who is spending about $600 on prescriptions drugs at Costco's prices.

The worst of the 12 alternatives that they have under Medicare will get it down to $4,600 or $4,800.

And the best about $4,400 or $4,500.

So, nobody is going to necessarily really wrong with any of these programs because of how this Medicare program works.

On average it's a slight negative because it's an alternative.

And under the Medicare program, you're essentially going to be paying the same on some of those items here versus Walgreens, as an example.

So on the one hand it's a negative.

On the other hand, we've got great loyalty.

We've seen a pick up in business to us offering third party plans to be a source for them.

There are instances where we've had large employer groups come to us.

And this is a relatively new phenomenon over the last six or nine months.

Come to us and actually, because we're so cheap, that they actually incent their employees that if you get your drugs at Costco, it's a lower copay because they're saving money.

The company who is writing the check.

So we're seeing - - arguably Medicare is not a net positive for us.

But we don't think it's a big net negative because some of those people are still going to come to us, a lot of them.

And we're finding ways to continue to grow that business.

We think our business is solid and will continue to grow.

That's helpful.

Thank you.

Your next question is from Maribeth Holland.

Hi.

I just wanted to double check what your comment about the comps in all the regions were stronger this year than last year.

Is that including the Southeast region?

That obvious was hit by the hurricanes.

No.

I'm sorry, I thought I mentioned that.

The Southeast was slightly lower.

Recognizing that Southeast has been in the low double digits, so it's still a decent number.

But I think it was 2 or 3 percentage points lower in the quarter.

And again, if you took out Wilma, it was as good as it had had been.

Thank you.

Your next question is from Adrianne Shapira

Richard in your comments you mentioned that you're comfortable with the competitive landscape and what's going on out there.

But just last month we obviously saw Sam's comp better than Costco.

Probably the first in a long time.

And we had heard they were pretty aggressive on blitzes and that was probably the first time they had engaged in some doorbuster activity.

Can you just give a sense of what's been going on there since the holidays?

Yes.

Getting back to pricing we feel very good about our pricing.

I can't tell you anything else.

As it relates to their number, I think they should be happy with it.

I don't know about your newspaper but in many national newspapers around the country they had an eight-page full color insert that looked like something from Bergdorfs.

Very nice looking ad.

But I'm sure - - and they opened at 5:00 a.m.

I think, on Friday.

So they did some things.

And as we all know, and as Jim has told us in the past, it's arguably some of our marking, while it's direct marketing, not advertising.

And advertising works.

It works the first time and it works a little less good the second time.

We like it when our competitors do national print ad advertising.

Okay.

And then can you just talk about post holiday, it sounds as if a lot of new merchandise coming into the stores shortly after the holiday winds down.

We're hearing a big push across furniture, particularly in Thomasville categories.

Can you talk about that and what you're doing this year versus last year?

In terms of as to Christmas?

Yes.

Well, I think needless to say we have two Costco home stores now.

We'll have another one near the end of the fiscal year, early into '07.

We're learning from it.

And certainly that's a category that we like and we think we can do some things with.

I don't think specifically Thomasville, by the way, but just in general.

And again, it's both furniture and home furnishings.

I can't really tell you anything more specific.

We'll be mailing shortly, the winter wallet that will give you some idea.

I think that comes out in a couple of weeks.

And everybody here has been sworn to double secret probation secrecy.

Thanks.

Your next question is from Dan Geiman.

Can you talk a little more about the components of the higher than expected tax rate that you saw during the quarter?

And also the outlook for the year?

I think part of it is under Sarbanes-Oxley and everything else in life today, we're all a lot more conscious of not only looking at all kinds of accruals annually but quarterly.

And this is not a change.

This is more of an evolutionary change over two years.

And also I think - - I know that there was one specific item as it relates to some state tax audits.

Not necessarily income but property sales use taxes, excise taxes, things of the like.

And where - - based on audits, the threshold for being deemed likely has lessened - - or strengthened.

Meaning that things are more - - things that weren't deemed likely yesterday and we still - - again, our opinion of the particular claim hasn't changed.

But you actually put something on there.

And so I know we took in Q1 just on what I'll call the more likely category, and again nothing - - the circumstances haven't changed, just kind of the rules of engagement have changed a little bit of how you account for it.

We had about a $4 million tax hit to the income tax line. 4 million on pretax, yes.

And offsetting that there was a couple million going the other way but it was a net negative.

So I think what you're going to find is, is that not only with us, but with all companies, you're going to see - - if we get direction of something in the mid 37's for the year, it, frankly, will range up and down a little bit from that number each quarter.

I can track that to last year.

And again, taking all the truly one-time benefits that we had.

Because we had some very big benefits in taxes from some appeals and what have you.

If you look at last year, a part of what I'll call normalized was what we call state apportionment.

You don't know until the end of the year what each state income tax is because every state does it differently.

Some do it based on the profits in that state.

Some do it as a percentage of certain ratios.

Fixed assets to total company fixed assets.

Payroll to total company payroll.

Income in that state to total company income.

And then some averages.

We're now doing that on a quarterly basis and fine-tuning it more.

So even something like that, which had it - - actually at the end of last year had 1 full percentage point boon to us for the year, we won't see that this year.

And so I think there's really nothing more than that.

Good.

That's very helpful.

Thanks.

Your next question is from Christine Augustine.

Good morning.

Thanks.

Richard, I'm wondering on the fourth quarter for this year, do you think that we could see a full reversal of that - - those 24 basis points of merchandise margin erosion that you experienced?

Because I think most of that probably was gasoline, wasn't it?

A good chunk.

But again, if you look to the four core categories, which is 80% of our sales, in Q4 year-over-year they were up a little.

In Q1 year-over-year they were down a little.

And I do mean a little in the aggregate.

Single digit basis points here.

But - - and again, some of it was - - we had about 3 basis points higher markdowns in apparel versus our budget.

We're definitely getting a little more what we call D&D, or damaged and destroyed when we're getting some of the - - Some of the boon to our electronic sales is also a little bit of a bane, if will you, that's coming back.

But that's again planned.

We knew about it.

We expected it.

But it hits us.

But certainly you would see some recovery because that is - - part of that hit was gasoline?

I'm sorry, yes, getting back to your question.

We would indeed expect to see some recovery.

The other question I have is just with regard to your long-term 4% pretax margin goal.

First of all, are you still comfortable with that?

Second of all, one of the ways you get to that is through gross margin improvement.

And so I wanted to ask you about private label and kind of where that was, and is that going higher?

Well, private label is going higher.

I don't think we've really changed our direction. 10 years ago it was 5% of sales and last year it was 15% of sales.

We would expect it to be in the low 20's five years from now.

Certainly, taking $100+ million out of branded diaper and putting it into a private label diaper where we can provide the customer a 20% savings compared to the branded.

And actually make more gross dollar margins per unit because everybody and their brother football diapers out there.

So those are the kind of things that help you.

And again, while it's a tough competitive landscape our there right now, as Jim said a couple years ago we're smart enough to figure out how to do both.

I guess the one change I would make, yes, do I feel comfortable with 4%?

Yes.

Good news and bad news was; is for the first five fiscal quarters after we said that we did exactly that or even did a little better than that.

Then, of course, we've had a couple quarters where we did about flat year-over-year.

So, we didn't see that kind of 20 basis point annualized pick-up.

I think you have to adjust it for stock repurchases because we have changed our view on that versus two years ago, needless to say.

So, maybe you need to look more at the operating income line.

And we haven't gone through that process, but recognizing, to the extent that pretax comes down a little because stock option exercises.

Earnings growth goes up a little because it's accretive.

So it's actually a net positive wash.

But philosophically, the answer is exactly yes.

And I asked that to Jim last week and that's what he said.

And if it takes seven years instead of six, so be it.

We're running our business.

We feel good about our fundamentals.

And again I look at this quarter, recognizing relative to our guidance for the year, three months ago and for the quarter, we feel we did just fine.

Got there a little differently.

Not a lot differently.

And - -

Are you seeing any changes in how the executive members purchase?

Is there any change to their basket size or their traffic trends?

Well, we don't disclose the exact amount.

But clearly if you take two pools of existing members, call it the pool of members that are five to eight years and tenure with us and spend X to Y in dollars each year.

And if you look back over the last two or three years, each of those groups, 50 - - each of those groups spent the same amount every year and grew the same amount every year on average.

And then half of them become executive members.

In that first year as an executive member their comp dramatically increases.

In the second year, it's slightly less than the other ones.

But still for the two year aggregate it's still a decent good increase.

And then it stays at that level going forward beyond that.

That's what we see.

So, it does work.

What's particularly nice and gratifying is, is for those of you who have followed us for a number of years.

Four years ago when we first initiated this, 2% reward, what we saw in the first year was adverse selection, and we felt it cost us I think 16 or 18 million pretax.

Because who is the first person who is going to sign up?

It's the small restaurant owner or small business owner that's already spending 25,000 a year with us.

And they say, "hey, for 55 extra dollars, or at the time for 60 extra dollars, I'll get a check for $500 at the end of the year".

That's a no-brainer and it doesn't change their buying habits because they're already there.

But there were a lot of members that were 10,000.

That were maybe buying 10,000 from us and 10,000 elsewhere and they're now buying 18 of that 20 from us.

The difference now is that big influx of people we had now, there's a higher percentage of those people that are either a little below or a little above break even on this thing.

In other words, they're spending - - to break even technically on $45 versus $100, you've got to spend $2,750.

We have people that are spending 1,800 to 2,200.

Affinity programs work.

They see their sales go up because they want to get there.

We see more people today in the 2,700 to 3,500.

They, too, go up relative.

So, it does work.

It's not without risk.

We're beyond the risk now and we're pleased with the report.

It certainly has helped our comps and our renewal rates.

Thank you.

Your next question is from Emme Kozloff.

Can you hear me?

Yes.

Okay.

A question Richard about the membership fee.

I know you're not going to comment obviously on the timing of it.

But Sam's they announced theirs in October and with that announcement they said they would be reinvesting the additional fee income in lower pricing and additional services.

So, I wanted to know have you come up against this in the past?

And is there a risk that if you do end up raising your fees you'll end up having to give a lot of it back to the members in order to remain competitive on pricing with Sam's?

So that we may not see the same improvement to the bottom line that you have gotten in the past?

We don't look at our membership fee - - we don't look at our membership fee increase that way.

Recognizing money is fungible.

We talk about the fact that we have roughly an 11% gross margin, which is the mark-up on goods.

And roughly a 2% membership fee.

We have a total gross profit margin of 13%, which pays for everything.

All I can tell you is we will continue to remain competitive irrespective of membership fees.

We don't look at membership fees per se as something giving us the ability to do anything other than that the value - - when we were at 45 and our competitors are at 30, 35, and 40, we still think that we're the best value out there as evidence by sales per unit that are 2 and 3 x our competitors.

And we will remain competitive.

If that's the way they choose to use it, good for them.

I don't believe for a minute though, that they're doing everything to be fiercely competitive, as we are, before that increase.

So, money is fungible.

They'll do with it what they want.

We don't look at it the same way.

Okay.

And then I have another question.

What kind of foreign exchange outlook and gas price outlook is factored into your guidance?

Because the beneficial impact of sales from the weak U.S. dollar seems to be diminishing as the Canadian dollar's appreciation has slowed.

You mentioned some of this, I think currency was actually negative in November.

So, how should we think about comps and earnings for the rest of the year?

Could there be a slight drag just from these factors?

It's really not going to have a major impact.

Maybe it's 100 basis points.

But when our original budget was on comps was I think we said 5 to 7 originally on the call and it was right in the middle there.

And so maybe if the middle was 6, it's 5.5 versus 6.25.

We really don't look at it that way.

We're just trying to drive sales.

And I don't mean to be simple and stupid about it but that's not a big concern of ours.

Frankly a little inflation helps us.

So, while we hope for the economy we don't have any.

A lot of inflation doesn't thrill us because other things happen to multiples and what have you.

But a little inflation would be positive for us.

Okay.

Thanks.

Your next question is from Lloyd [Bightman].

Could you tell us if you have any programs in place to better control utility costs given the expectation that they're probably not going to come down to a great extent any time soon?

Well we - - back when the energy costs were a topic du Jour about two or three years in California when all the scandals happened with the providers of energy and what have you.

We did a lot back then.

We benefit, of course, from a lighting standpoint that we've got lots of skylights.

And that helps us a lot, in terms of controlling energy.

But we also have a lot of refrigeration and frozen.

And of course, in the summer in L.A. and Phoenix, you have air conditioning.

In the winter in the east and the north, in Montana and New York and Boston you have lots of - - and Canada, you've got lots of heat.

I don't see this doing a lot to mitigate it right now.

We have three or four dedicated people that were actually put in place three years ago when that first tranche happened.

And I think we've done a lot over the years to mitigate costs.

It's not just energy management systems.

It's the materials we're using to build our buildings.

The RF factors of the metal building walls that we're using.

So, we're doing a lot of things to improve that.

So, I think we've done a very good job of mitigating it.

And what I call the three basis point increase year-over-year right now is just that.

It's - - there's not a lot more efficiencies to wring out of that stuff.

Thank you.

Your next question is from Mitch Keeler.

My questions have been answered.

Your next question is from David Schick.

Good morning.

If I look back to my notes from last quarter, gasoline had a negative impact to gross margin of 35 basis points.

Mix was 20.

And lower gas margin itself was 10.

Could you give us that overall and that breakdown for this quarter?

I don't have that level of detail in front of me.

I would say gas was higher but not by as much as the hit last time.

And as I mentioned, the core business which was up a single digit amount of basis points was down a little bit, a like amount, in this quarter.

So that's - - that was a decent chunk of it but it wasn't nearly as dramatic as Q4.

Okay.

So just so we can walk away with some sort of thought around it.

If there was - - forgetting the freight costs, which were the highest, there was 30, should we think of that combined impact as something like maybe half of that?

Is that kind of the way - -?

Yes.

In fact, freight was about half of it.

So flipping to a positive though however.

So, it was positive by half the amount that last quarter was negative?

That's a pretty good estimate.

I don't have the detail in front of me.

And freight I know which was -5 in the Q1, in Q4 I think it was like -2.5 or -3.

We expected that.

We said it would diminish in Q1.

And I suspect it will be a little less even in Q2.

Okay, that's helpful.

Thanks.

Your next question is from Teresa Donahue.

Hi, Richard.

Just on share repurchase, it seems as though you're about a third of the way through the new authorization.

Would it be fair for us to assume that there will be more at a continuing pace from now on?

Well, again, Terry, we'll take every day at a time.

I think our message, at least what you've seen in the tea leaves over the last six months is; is that we'll we seem to be buying on a somewhat regular basis.

And would be opportunistic if the event arose.

Although, we don't want to have necessarily that opportunistic event.

Meaning stubbing our toe in a big way.

But in terms of - - we still have about 800 million left because the additional 87 of that was from the other program.

Thanks.

Sorry.

There are no further questions at this time.

Okay.

As I mentioned to you, you can hear this again if you'd like on costco.com.

As well we'll post on to costco.com within the hour what we call additional first quarter information, which talks about LIFO detail and opening schedules, balance sheet cash flow and how we calculate EPS with all the convert and the treasury stock and options and everything.

Thank you very much.

Good night.

Thank you for participating in today's conference call.

You may now disconnect.