好市多 (COST) 2006 Q3 法說會逐字稿

Good morning.

My name is Crystal, and I will be your conference operator today.

At this time I would like to welcome everyone to the Costco Wholesale Corporation's conference call to discuss third quarter earnings and May sales results.

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

After the speakers' remarks there will be a question-and-answer session. [OPERATOR INSTRUCTIONS]

Thank you.

I will now turn the conference over to Mr. Richard Galanti, Chief Financial Officer.

Please go ahead, sir.

Thank you, Crystal.

Good morning to everyone.

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 release as well as other risks identified form time to time in the Company's public statements and reports filed with the SEC.

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

To begin with, our 12-week third quarter of fiscal 2006 operating results.

Briefly we came in at $0.49 a share for the 12 weeks ended May 7, 2006 up 14%, or $0.06 a share over last year's Q3 EPS figure of $0.43.

These results were 1% below the top end of the range of EPS guidance I provided you in March, and, of course, First Call throughout the quarter has remained at $0.50, so $0.01 below that figure.

As I will discuss with you in a few moments, a pretty good result given weak gasoline profitability and a higher than estimated tax rate.

In terms of sales for the quarter our 12-week comp sales figures showed an increase of 7%.

In terms of the three retail reporting months most closely aligned with the quarter, February, March and April, our reported comps were 8, 7 and 7%, respectively, which brings me, of course, to the strong four-week May comp sales figures we're reporting this morning of 10%.

I will speak more to that figure in a few minutes.

Other topics of interest that I will review this morning, our recent openings.

We have opened a total of 17 locations since the beginning of the fiscal year last August 29th, 13 of these are in the U.S. including one relo so a net of 12 net new openings in the U.S. to date.

Four new locations in Canada including one relo, so a net of three in Canada.

We now have 68 in Canada.

One new location in the U.K., our 17th, one new location in Mexico, our 28th.

The latter in Mexico, of course, we count for on an equity basis and for the remaining 14 weeks of this fiscal year we expect to open 12 more locations including one relo and one in Mexico.

All told, this would put us at net new locations, excluding the two in Mexico, of 26 for the fiscal year and plus those two, of course, in Mexico.

The 26, by the way, reflects two openings planned for August that have slipped into early September, the first month of fiscal 2007.

I will also discuss this morning our ancillary business results, our online results, membership trends, our balance sheet, update on recent stock repurchases and, lastly, provide you with a little updated direction and guidance both for Q4 and fiscal '06 overall and well as our expansion plans for '07 which should be in the mid 30s.

So with that said, sales for the year, as I mentioned, total sales were up 11% from 11.7 billion last year in the third quarter to 13 billion this year.

On a 12-week to 12-week comp basis Q3 comp sales were up 7% for the quarter.

For the quarter our 7% reported comp sales results were the combination of average transaction increase of a little under 6%.

About a 0.5 percentage point of that was due to FX and an average frequency increase of about 1% up for the quarter.

Cannibalization, as you know, we've continued to in-fill more than new markets, and that continues to increase.

Cannibalization, the impact in the third quarter was 135 basis points hit to the quarter.

That compares to about 120 basis points year-to-date and something I believe in the high double-digit basis points for last fiscal year.

So again, increasing penetration of existing market openings we would expect to see that [inaudible] higher.

Also included in the average transaction increase of a little under 6% is about 90 basis points due to gasoline inflation year-over-year in the quarter which effect, of course, was even higher in May.

I'll talk about that in a minute.

For the four-week month of May our 10% reported comp sales results resulted from an average transaction increase of a little over 8% for the month.

About 175 basis points of that was due to FX.

We've seen particularly strength in the Canadian dollar relative to the U.S. dollar which is where about 12 or 13% of our sales come from.

So the difference between the Q3 comp of 7 and the May comp of 10, about 1 percentage point of that was the relative increase in FX from an impact in the quarter of about a 0.5 point to the impact in this, an impact in the month of 175 basis points.

The average frequency increase was a little under 2% up for the month and cannibalization, which I mentioned again, in the quarter was 135 basis points.

For the month of May it was 180 basis points.

Again, a little under a 0.5 point higher impact than Q3.

Also included in the average transaction increase of a little -- the average transaction increase of a little over 8% is about 200 basis points due to gasoline inflation year-over-year in May.

As you know, prices rose pretty dramatically in May.

If you take these three items which we have talked about, try to give you some numbers on each month, FX, cannibalization and gas inflation, these three items represented about half of the delta of the 7% comp in the quarter versus the 10% comp in May.

In terms of sales comparisons by geographic region, all regions in the U.S. showed good improvement.

In Canada we had not only the impact of the strong Canadian dollar but the underlying local currency as well.

Canada sales comps in U.S. dollars for the quarter were up low single-digits, or low double-digits, rather, with about 4% in local currency.

That improved to about 20% in May and about 7% local currency.

So we've seen nice improvement in Canada even in local currency.

Other international continues to do well also.

So again, total comps for the quarter, 7 and for the month of May, 10.

In terms of merchandise categories, basically the three major ones, food and sundries, hard lines and soft lines were all up nicely.

Hard lines showing the biggest rate of improvement.

Fresh foods was in the high single-digits.

Pretty much in line with the past, a point or 2 down from where it had been the last couple quarters.

Ancillary businesses continuing to be strong.

Within food and sundries there was one outlier, tobacco.

Tobacco is about 6% of our total company sales and about 14% of our food and sundry sales.

That was down 4% in these reported numbers, a result of a year ago when there were pending tax increases on tobacco both in the U.S. and Canada.

That drove up sales last year in the month of May before those price hikes went into effect a year ago.

Hard lines, consumer electronics still the driver with it coming in in the mid to high teen comps notwithstanding the fact that the price points continue to decline on a lot of products within consumer electronics.

Soft lines relative strength in housewares, home furnishings and both men's and women's apparel.

Gas sales, by the way, during the quarter were 23% comp with about 5% of that being gallonage.

For May, food sundries, again, strong all nine subdepartments positive including tobacco ranging from 3 to 13% each.

Hard line, strength in hardware, garden and majors, soft line, strength in housewares, men's and women's apparel with offset in the area of media being negative.

Moving to the line items on the income statement, I'll start with membership fees reported in the third quarter.

Membership fees were $276.2 million, or 2.12% of sales.

That's up 11%, or $26 million from a year ago, down 1 basis point recognizing the strong comp sales and total sales figures.

Again, the same story, strong renewal rates, increasing penetration of the $100 a year Executive membership and new market openings.

As you know, we announced recently a $5 increase in the basic Gold Star and Business memberships and I'll talk about that in a second.

In terms of the number of members at Q3 end, Gold Star, 17 million households up from 16.8 million a quarter ago.

Primary business, 5.2 million up from 5.1 million, Business add-on, 3.6 up from 3.5 for a total of 25.8 versus 25.4 at Q2 end.

Including add-on cards, a total of 47 million up from 46.4.

At the May 7th third quarter end paid Executive memberships just barely topped 5 million which is about 20% of our total membership base.

During the quarter we saw an increase of 239,000 accounts go to Executive member.

That's a 5% increase since Q2 end or about 20,000 new sign-ups a week to Executive member.

Year-to-date that represents a 760,000 increase in that base of 18% in the 36 weeks.

So Executive membership, which increased in terms of total number of members 30% in fiscal '05, is up another 18% in the first three quarters of this fiscal year.

And those 20% of our members, of course, represent around 50% of our sales with about four-fifths of that 50% being rewardable sales.

Of course we don't reward tobacco, alcohol, and gasoline.

In terms of membership renewal rates, they continue strong exactly the same as each of the last two quarter ends, 91% on the Business side, 84% on Gold Star averaging 86% overall.

As I mentioned to you about almost two months ago on April 6th we announced that we would increase our basic business in Gold Star annual membership fees by $5 from 45 to $50 in both the U.S. and Canada.

That went to effect for new sign-ups effective May 1st and July 1st for renewals, which will be the bigger impact, of course.

Recognizing no change planned in the $100 Executive membership, we estimate the $5 increase will impact about 15 million of our members and make the breakeven of making the decision between base membership and Executive membership more favorable to a larger group of people.

Going down the gross margin line, in Q3 our gross margin was lower by 11 basis points, 10.48 during the quarter versus a 10.59 a year ago.

As usual jot down a couple of figures to help the explanation here.

There is only four line items, merchandising, 2% reward, LIFO and total.

Three columns, Q1, Q2 and Q3 '06.

And so this would be the variance year-over-year in terms of basis points of gross margin and the components of it.

In terms of merchandising in Q1 year-over-year it was 2 basis points down minus 2.

Q2 minus 9 basis points and Q3 '06 minus 4 basis points year-over-year for the quarter.

2% reward minus 9, minus 12 and minus 10.

LIFO 0, plus 2 and plus 3.

And total, minus 11 in Q1, so in other words in Q1 '06 year-over-year gross margin was reported was down 11 basis points, in Q2 minus 19, in Q3, minus 11.

As you can see our overall merchandising gross margin was lower by 4 in the quarter.

Again, this compares to the minus 2 in Q1 variance, and the minus 9 variance in the Q2 year-over-year.

A very similar story to the last couple of quarters.

The minus 4 basis points figure is pretty much in which line with what I discussed with you all the way back in early December.

When on my December 8th Q1 conference call I said that in terms of our outlook for '06 gross margin, reported gross margins would probably continue to be a little down due in large part to the gas non-gas sales penetration issue and to some extent increased Executive membership penetration.

That's exactly what you see here.

Of the minus 4 basis points figure, by the way, minus 11 basis points was gas related.

As well, lower year-over-year sales penetration of our core merchandise businesses, food and sundries, hard lines, soft lines and fresh foods, these four major categories represent 80% of our total company sales.

These, of course, have higher gross margins than our gasoline business.

The reduced sales penetration of these businesses hurt us a little.

In fact, the aggregate gross margins of food and sundries, hard lines, soft lines and fresh foods were higher year-over-year in the quarter by 14 basis points but were a drag on total company gross margin.

Again, as I mentioned, gasoline gross margins not only was the increase penetration -- was penetration higher, but with the rapid rise in gas prices we saw a detriment to the gross margin even within gas.

Looking beyond the merchandising component, our Q3 gross margin was again negatively impacted by 10 basis points from higher sales penetration of 2% Executive member program, again applying that 10 basis point increase year-over-year would apply 5% increase in sales penetration of those rewardable sales year-over-year in the quarter.

In terms of LIFO, note that we took no charge in this year's Q3 versus a $3.5 million charge in last year Q3.

This helped reported gross margin by 3 basis points.

Overall gross margins were okay.

Actually good in the core businesses.

We think that's a very positive sign for us.

In terms of our gross margin continuing into - our gross margin outlook continuing into the fourth quarter, really the same commentary as I indicated both three and six months ago.

Reported gross margins will probably continue to be negatively impacted a little due to gas/non-gas penetration issue.

We are seeing a little improvement in actual gas margins over the last couple of weeks.

But, as we all know, that can be fleeting but we'll hope that it continues for a little bit.

As well the impact from increasing Executive member business should be a continued hit to reported gross margin but should start to trail off a little bit over the next couple years recognizing that now 50% of our sales are to those members.

LIFO, again we had no charge in Q2 and Q3, and we would assume little or no impact from inflation in Q4.

Any inflation that we're getting in some general merchandise categories like paper goods and the like is being offset dramatically by consumer electronics deflation.

Most importantly, we believe, again, our core merchandise groups are doing well.

And once we anniversary the current increases in gas sales penetration and hopefully the increased sales penetration of Executive membership, not hopefully, but we'd expect that to slow a little bit, we would expect the negative impact to margins for these to be greatly reduced.

And gasoline, while volatile to our margin and P&L these past few quarters, we estimated about a $0.02 earnings per share impact in Q3.

It's a great business for us in terms of bringing in the customer, in terms of the customer trust and loyalty and the value to our member and again profitability over any 12-month period continues to have been pretty good.

Before going on to SG&A, in terms of ancillary businesses we added eight pharmacies to be at 392 at Q3 end.

We added six food courts to be at 443, six mini labs, one-hour photo labs to be at 440, six optical to be at 432.

We actually closed one print center so we have nine instead of 10 now.

We added seven hearing aid centers to be at 183 and six gas stations to be at 241.

Again, in Q3 ancillary business comps were up 16%, up 9 without gasoline.

Now moving to SG&A, again, I'm happy to report positive trends in SG&A leverage during the quarter.

In Q3, as you will see, our SG&A year-over-year was lower or better by 12 basis points coming in at 979 in this year's third quarter versus 9.91% of sales last year in the third quarter.

This is our best quarter-over-quarter improvement in the last seven fiscal quarters.

Many of you who have known us for a long time during the three years of '02, '03 and '04 we saw that going in the opposite direction and we've seen some nice trends over the last couple years here.

Again, to jot down a few numbers to give some elaboration to these numbers, the line items would be operations, central, stock options, and total.

Again, three columns, Q1, Q2, and Q3.

In operations in Q1, plus 9 basis points, Q2 plus 7, Q3 plus 12.

Plus here means good, by the way, or lower SG&A year-over-year.

Central plus 2, plus 3 and plus 3.

Stock options, minus 6, minus 8 and minus 3 for a total in Q1 year-over-year plus 5 or lower by 5 basis points.

Q2, plus 2 or lower by 2 basis points, and again Q3 plus 12 basis points or lower year-over-year by 12 basis points in the quarter.

In terms of a little editorial on these figures, again, as we were hurt, if you will, a little bit in our gross margin percent from mix changes strong gasoline sales of course helps SG&A a little bit.

We benefited in lower Q3 over Q3 SG&A due to improvement in our largest expense categories.

Payroll improved year-over-year by 3 to 4 basis points.

Our worker's comp and benefit expenses are continuing to show improvement as well by a few basis points.

The 3 basis points improvement in SG&A and central again was certainly helped by our strong comp sales results.

And finally, our stock option expense, which was higher by 3 basis points year-over-year, a little less of a hit than in prior quarters due actually just to the timing by several weeks of this year's stock grant.

Nothing major there.

Regarding the expensing of stock options, as you know, we began expensing stock options in '03.

So we now have 3.75 years, if you will, of gradual expensing under our belt.

Under prior rules, given our option grants vested ratably over five years, we've seen the expense grow each year such that by '07 we would include in our income statement five-fifths, or essentially a full-year of stock option grants.

One-fifth from each of the prior five years.

This past year FAS 123 was revised to be FAS 123R.

We adopted that, of course, the beginning of this fiscal year.

Basically it took years four and five of this expensing procedure into this year.

That's why we see a little bit of an impact this year.

By the end of this year we'll have effectively a full amount of grant in there and while it may increase a little over time we wouldn't see that be a big impact to SG&A.

In terms of outlook for SG&A, again, we're encouraged with what we're seeing in each month's results, certainly we depend on good comps, and hopefully these positive trends will continue.

Next on the income statement is preopening.

It was up $900,000 to 10.4 million in Q3 versus 9.5 a year ago.

Same number of basis points, 8.

Last year in Q3 we had four openings including two relos, there was also a couple million dollars of international preopening.

This year we had six openings, no relos but a little more remodel ancillary activity as well and no big surprises in that number.

In terms of provision for impaired assets and closing costs, in Q3 '06 these costs total 1.2 million pre-tax.

A year ago they totaled 3 million.

Nothing unusual here, as well, simply our ongoing relocation efforts whereby costs associated with closing to be relocated units are expensed up front once the decision to relocate is made.

All told, operating income in Q3 was up 12%, or $39 million over last year's Q3 figure, up to 354 million this year from 316 last year.

Below the operating income line reported interest expense was substantially down by 5.8 million.

Last year in Q3 interest expense was 8.5 million.

This year 2.7 million.

This reflects both the June 15th payoff last year of $300 million debt amount and lower interest expense on our convert as more of its holders convert into our dividend paying common stock.

As you know, our convert is substantially in the money by a factor of 2.

Interest income and other was higher year-over-year notwithstanding our repurchase since last year, last June of nearly $1.5 billion of common stock in the market.

During the quarter interest income and other was 33.8 million, up about 3.6 million from 30.2 million last year.

Virtually all of this increase was due to much higher investment income principally reflecting higher average interest rates which more than offset a slightly lower cash balance.

Overall pretax income was up 14% from 337.8 million last year to 385.5 this year.

In terms of our effective tax rate, as you know, last year in the third quarter it was 37.9% as compared to 38.93% this year in the quarter.

The 38.93% figure this quarter is higher than the 37.5% estimate I gave you on the last conference call.

About three quarters of this variance relates to truing up prior estimates for tax benefits related to unremitted earnings as we repatriate a significant amount of money from Canada back to the U.S.

You'll recall in fiscal year end '05, three quarters ago, we had a sizable tax benefit that reduced our Q4 tax expense and benefited Q4 earnings by about $0.04 a share.

Similarly, we recorded small tax benefits in Q1 and Q2 of this year related to unremitted earnings.

Basically truing up that now that the final Canadian returns have been filed and impacted again this tax rate, again, about three quarters of the variance versus our direction impact related to that.

For the remainder of the year in Q4 we would expect the tax rate to be back in the 37.5 to 38% range.

For a quick rundown of other topics let's start with the balance sheet.

Cash and equivalents 3.302 billion, inventories 4.416 billion, other current 629, total current 8347.

Net PP&E, 8274, other assets 663, total assets 17284.

Short-term debt 369 million.

I might point out that 309 million of that is the current portion of long-term debt which will be due, I believe, in March, so within the next 12 months.

Accounts payable 4.439 billion, other current 2.684 billion, total current 7.492 billion, long-term debt 230, deferred and other 261, liabilities, total liabilities 7.983 billion, minority interest 62, stockholders equity 9.239 billion also totaling 17,284.

Later today on our website we'll have our standard quarterly Q&A which highlights things like LIFO, opening schedules, EPS calculations, some of the detail as well as balance sheet and the cash flow statement which we're just finalizing this morning.

Pointing to a couple things on the balance sheet, again, quite a strong balance sheet, plenty of financial strength.

In terms of AP percentage, reported this quarter, simply AP divided by inventories was 101% versus 102% a year ago at the end of the third quarter.

A more appropriate number which is not on the balance sheet would be merchandise APed inventories.

That was 85% in the quarter versus 84% a year ago, so up a percentage point.

Average inventory per warehouse, 9.835 million.

Last year at Q3 end 9.462 million, that's up $373,000 a warehouse or up 3.9% compared to a 7% quarterly comp and, of course, a 10% May comp.

Areas higher, again, the strong FX was about 65,000 of that.

Consumer electronics inventories notwithstanding deflation continuing to put out more stuff, $70,000, slightly higher year-over-year jewelry inventories about 50,000, and pharmacy about 90,000, a third of it being in RX and two-thirds of it being health and beauty aids.

Again, that increase in inventory is below the sales increase in that area.

Again, merchandising feel very good about our inventories.

Merchandisers, they're clean and of good quality.

In terms of Cap Ex, as you know, in '05 we spent a shade under a billion dollars, 995 million.

Our projections for this year were 1.2 to 1.4 billion.

This was for quote unquote 28 to 30 planned net new openings.

Year-to-date for the first 33 weeks we're at 752 million.

Of course, Q4 is our longest quarter and we've got a lot of openings planned.

My guess is we'll come in right somewhere around the mid-point of that previous projection of 1.2 to 1.4, probably right around 1.3 billion if not a little higher.

A big slug of that is openings not only in Q4 but those costs of land and initial construction costs for those associated with a lot of expansion just after fiscal year-end.

In terms of Costco online really doing well this year.

For the quarter sales at costco.com were up 62% and up 67% year-to-date through the third quarter.

Sales in that area should exceed $900 million this year.

Next on the discussion list expansion.

Basically in the third quarter we opened seven units which included one relo for a net new of six.

The net new in Q1 and Q2 was eight and two respectively, so a total of 16 to date through the third quarter end.

In the fourth quarter we have 11 new units including one relo, so 10 net new plus one more in Canada.

That would give us a total openings of 29 less the three relos of 26 and our consolidated figures plus the two in Mexico.

For '07 we would expect, again, net of probably four or five relos somewhere in the low to mid 30s, and if you talk to our real estate people, they would suggest it's even a little higher than that but knowing how we are in the past, a number in the low to mid 30s would be a nice bump not only from this past year but significant increase from '05 as well.

The two that slipped, by the way, since some of you keep track of this, basically a couple slipped from August to September, La Quinta, California and Raleigh, North Carolina.

Nothing magic there, just timing.

But if you took the net 26, net new consolidated on a base of 433 that we started the year, that would equate to 6% unit growth and 7% square footage growth.

Lastly, talk about our stock repurchases.

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

Since that time we have had two additional board authorizations that increased the $500 million amount to 1.5 billion, so an increase of a billion.

And then another increase of a billion to a total of 2.5 billion.

Beginning in June 7th of '05 near the beginning of our Q4 of '05, and through the end of fiscal '05 we repurchased 9.2 million shares at an aggregate purchase price of 413 million, or 44.89 a share.

Since that time and through yesterday we have purchased an additional 20.5 million shares at an aggregate price of 1.42 billion, or $50.79 a share.

So all told, since the beginning of Q5 '04 we repurchased a total of 29.7 million shares at an aggregate purchase price of 1.455 billion, or a little under $49 a share.

Under these previously approved authorizations, we can repurchase an additional 1.45 billion of stock.

Again, as I mentioned last quarter, you should expect continuing stock purchases and hopefully future increase authorizations in the future.

Before I turn it back to Crystal for Q&A, some minor direction for Q4 and fiscal '06 overall.

I believe First Call dated 5/30/06 is at $0.77 and, again, as I said the last couple quarters we're comfortable with that at the high-end of a small range.

That would imply First Call for the year at 2.33 and, again, that being at the high-end of our range, 2.30 to 2.32 to 2.33, up in the low to mid-teens for the year.

I would hope we could do that or a little better but we'll keep our expectations where they are and see how the quarter goes.

Certainly we're off to a nice start with sales.

With that I'll turn it back for Q&A.

Crystal?

[OPERATOR INSTRUCTIONS] Your first question comes from Debra Weinswig.

Good morning, Richard.

In terms of the inflationary or deflationary categories in the quarter, can you go through those and also the total impact on the top line?

When you add it all up, it's basically zero.

In terms of anecdotal stuff, the biggest increase is looking down the list of the top 20 increases for the last four weeks.

I mean crazy things, gasoline of course is about 20% up both leaded and unleaded.

Tuna was up 14%.

I'm just going down the list here and give you some of the big ones.

A few of the nut categories like walnuts and pine nuts up in the low 20s.

Coffee up slightly a few percentage points.

You know, really it is all over the board, nothing major.

Canned salmon, 20%, olive oil, 35%, pistachios, 31%.

So just a potpourri of things.

Nothing that stands out big.

Again, the biggest impact was clearly gasoline and the two gasolines, leaded and unleaded, regular and premium unleaded gasoline.

In terms of deflation, nearly the whole darn list is electronics.

You know, things like the little 1-gigabyte media disks, memory disks, you know.

In terms of deflation, year-over-year down 40 plus percent.

TV's, certain specific TV's down 20 to 25%.

Again, nothing really earth shattering there other than the big categories are consumer electronics.

Okay.

But again, the overall impact to the Company, you look at it even with inflation, despite the fact that you have significant deflation in at lot consumer electronic categories, consumer electronics comps, total sales comps are up in the mid to high teens the last several months.

Again, that's a function of more availability and even though the price points on a given item are down, there's more items with higher price points like plasma and LCD TV's, 1-gigabyte memory chips instead of 512 megabites or whatever it was.

Okay.

With regards to, can you update us in terms of where you are on global sourcing right now either percent penetration or where you are from a benefit standpoint and with the opportunities still remains?

You know, I don't have an exact number, Debra, to give you.

We're doing a lot of it.

I am not trying to be vague or cute.

I don't have an exact number for you.

We're doing -- some of these I've mentioned in the past several quarters certainly we've seen big impact in things like produce.

We've seen impact in things like certain branded items in Japan that we got certain Japanese manufacturers attention.

I am not talking about electronics, I'm talking even some food, basic food items when we indicated we'd be interested in selling some of those items in key West Coast markets in the U.S. so it greatly expanded the availability of those.

Okay.

Great.

Thanks so much.

Your next question is from the line of Charles Grom.

Good morning, Richard.

On gross profit margins for the fourth quarter, assuming gas stays where it is today, which I realize is a big leap of faith, would you expect the merchandise component of your GPM to improve year-over-year given the easy compare you have from last year?

Given those assumptions, yes, but we've got that built into our numbers with a little cautious optimism.

Hopefully we can do a little better.

But yeah, given what you just said, sure.

Okay.

Second question is on pricing.

We haven't seen a lot of material price investment from either BJ's or Sam's.

Is this consistent with what you guys have seen and are you anticipating more competitive pressures in the near-term?

Well, you know, it's hard and I know you and others as well do pricing studies and certainly we do pricing studies every week in every market.

A couple three years ago particularly with respect to Sam's, with their changes over there in management and strategies, you know, we all seen a higher level of competitor pricing.

Its remained at a high level.

I think what we've shown is we can do both.

We can improve margins while being very competitive.

What I've said and, of course, what Jim Sinegal has said for twenty years is we're never going to be anything to compromise our competitiveness.

I stand by that, and I don't think we've seen any big changes either way.

You know, the fact that we're opening more units in existing markets clearly existing markets have a little better margin versus the Company average than new markets.

That helps you a little.

More of my view comes from buying better and perhaps a little bit from private label as well.

I've given a couple of examples in the past of even things like taking half of our diaper business, disposable diaper business and going to private label or Gatorade a couple years ago.

The athletic drinks, not Gatorade, but the private label athletic drink, the increase in health and beauty aids and things like vitamins and analgesics and things.

So all those things help, and certainly, in our view distinguishing what we do versus our competition in terms of higher end items and new and exciting items.

The one thing I don't lose a lot of sleep over at night is there are merchants continue to be out there on the offensive.

And then just one last one to clarify, the 10 openings in the fourth quarter, that's going to be 10 that you're going to actually open, those do not include the two that are going to roll into September, correct?

That's correct.

Thanks a lot.

Yep.

Your next question comes from the line of Bob Drbul.

Good morning, Richard.

Can you talk on the May sales, can you talk a little bit about any trends that you saw sort of week-to-week?

And I was wondering if you could just elaborate in terms of utility costs and how that's playing into your business at all right now?

The only trend -- we try to get away from giving daily and weekly numbers because it drives us crazy and it drives you guys more crazy.

Week one was the weakest of the three with all the other three weeks being quite strong, and talking to the head of merchandising, Craig Jelnick, he pointed out two things.

There was a little bit of timing of a couple of mailers that we had done.

He felt the bigger impact also was from a switch in Mother's Day, just in terms of how that fell from one week to the next year-over-year, again, not a big difference but, clearly, pretty good numbers for the quarter, for the month rather.

I'm sorry, what was the second question?

Utility costs like how you're managing utility costs and how it's impacting your business overall right now.

For the quarter it hit us, the core warehouse businesses, utilities and telephone which is mostly utilities, was higher year-over-year by 2 basis points, so that was an impact negatively to SG&A.

Okay.

And then, Richard, can you talk a little bit about the profitability levels of your Canadian business?

Well, that's actually something that is in our segment analysis, our segmentation footnote because Canada is big enough that it's a separate entity.

I think we have U.S., Canada, other international.

It's pretty much in line as percent of sales with the U.S.

I don't think there's any big dramatic difference.

Canada just I think might be just ever so slightly lower percentage, but it's de minimus that difference.

Thank you very much.

Your next question comes from the line of Christine Augustine.

Christine, your line is open.

Hi, Richard, I'm sorry.

Can you hear me now?

Sorry about that.

Can you please talk about private label penetration, where you think that might go kind of '07, '08, and are you able at all to discuss some of the new markets that you might be targeting for club openings?

Thank you.

Okay.

In terms of private label, it's kind of the same old story for the last 10 years.

Today it's about 16, 17%.

We think it will continue to grow gradually as a natural progression.

Five, eight years ago when it was at 8%, we said over the next five or ten years it probably will grow into the mid teens.

Now that it is in the mid, or slightly high teens we're saying it will grow probably to 20 or a little over 20.

We still want to be a supplier of branded goods where our customers can see and compare and compete on those items.

Certainly there's some items that we're not going to do, but I think what we have found even on something as loyal as a branded high quality disposable diaper that we think there's a market where we can find it.

So we'll continue to expand it.

Again, I am not trying to be cute, but the tea leaves would say that a number that's currently in the mid to slightly high teens will probably have a two in front over it, I don't know whether it is two years or four or five years from now, but over the next few years.

In terms of new markets, really, what we're, if I had to look at the list over the next 50 locations over the next year-and-a-half, my guess is there's just a few that are -- there's probably less than two or three that are in a brand new market.

Probably another half a dozen that are in kind of new markets whereas we're opening a second unit in a midwest city where we already have one.

Not a lot there.

In terms of international, my hope would be that two years from now we'll be in -- we're looking at a couple countries right now and my hope would be that we might can have something open, but it's probably two or three years away given how things take over there.

Thank you very much.

Your next question comes from the line of Adrianne Shapira.

Thank you.

Richard, can you just touch on cannibalization?

It seems like it's inching higher and given the ramped-up expansion plans, where would you expect it to maybe level off and what level would you be comfortable with?

You know, we're comfortable, as you know, we're comfortable with wherever it is.

My best guess a year ago when it was in the mid-50 basis point range, that we thought it might get up towards 100, maybe a little over 100.

We're certainly doing more of it.

It could get to -- I'm pulling a number out of the air but if you get to 150, 200, and that would be just fine with us. 250 would be fine if it means that we're expanding the market.

The net benefit of doing it in terms of return on, incremental return on investment is still quite positive for us even though it impacts that number.

We asked ourselves that same question yesterday, and we kind of look at it as yet it as yes, it's up significantly from a year ago, but even net of that comps are up and net of cannibalization and net of FX and everything else our comps are showing improvement.

We're completely comfortable wherever it lands.

When we look at every new opening, even net of the impact to nearby locations, it's a net positive.

We view it as a net positive.

Okay.

You're clearly growing through so it makes sense.

Just maybe talk about the mailers.

We've noticed kind of ramped-up mailings in between the wallet programs.

Talk about how important they are and are you noticing they're getting a little bit more important in the current environment?

You know, it's been an ongoing effort probably since we did our first Summer passport, gosh, eight, ten years ago, seven, eight, nine years ago, whenever it was.

I think more of it is a reflection of the vendors like it as well, and sometimes mailers, you may see different mailers in different regions.

Some of it's based on regional items, some of it is based on the pool of money that's available for a given program.

I think probably we've gotten better and smarter over the years as well a understanding, while ideally we would want everything to be, every day low price at net [dead] landed cost, take everything out, co-op dollars, slotting allowances, volume and term discounts, you name it, there are different pools of monies that different vendors have, and sometimes you don't get it unless you use it in the way that they want as well.

But it's all over the board both ways and so I think it is a gradual -- it has improved -- it has helped us gradually.

I don't think it's that big of a deal on a year-over-year incremental basis.

In the quarter, certainly, I think it helped a little as I mentioned in weeks two, three and four versus one, but so did Mother's Day.

Thank you.

Your next question comes from the line of Mark Husson.

Just wanted to follow-up on that cannibalization question.

You said that you get an incremental return on capital.

Are you talking about incremental dollars in the market or incremental percentages?

We look at it two ways.

One is, of course, what that unit's going to do in terms of a cash-on-cash ROI but also, what is the impact of it net of cannibalization.

So as an example, in an existing market if we do a new unit and it does 110 million in its first 52 weeks, that's great and wonderful and it's an existing market, and we probably have a little higher than average gross margin versus the Company.

It opens up pretty healthy.

Take that 110 million and subtract 20 to 30, you know, of cannibalization out of it so maybe it's net of 80.

That net of 80 is still quite a good return compared to a new market unit that might do a net of 55 or 60 in the first 52 weeks arguably with a little lower than average margin on average.

And is it the lower return on capital which means that the new markets are such a small part of your opening program?

I think it's more the fact that, first of all, some of what we used to call new markets or existing markets, you know, if you just put out a dart board out there with a map of North America on it if you will, we're in a lot of the markets that we're in, and over the last, starting in late '96 to probably '04, we went from I think 23 or 4 states in the U.S. to 37 states.

Chicago for a few years was a new market.

Now Chicago, probably the oldest unit in Chicago is four plus years old and we have, I think, 12 or 13 units.

It's no longer a new market.

I think it's more the fact of there is that as well as the fact that we see, we continue to see more -- we continue to appreciate the ability that in-fill's work and that there's more opportunity.

Many of you have known us for awhile, you know, a slide that I used to have a PowerPoint for a few years up to a couple years ago was the example of the greater Los Angeles market where Costco and Price Company merged in late '93, combined we had 31 units in that larger, greater L.A. area.

At the time of the merger we felt there was probably two or three locations we were going to close because there was a Price Club and a Costco within a mile or two of each other.

That wasn't first order of business the day after the merger, a year later they're all growing.

They all have a couple hundred plus employees, and keep them open.

Today we have 42 or 3 locations there, and we think there's another 10 or 15 to go over the next five plus years.

I'm hoping five plus years from now we've done 10 or 12 and we think there's another 10 then.

So I think just the market penetration of our concept, not just for us but for our industry, is still positive.

Okay.

Just one quick sort of follow-up then.

If you look at the next 50 stores in your pipeline, do you think you can open them all without hurting overall group return on invested capital?

Given that we're probably hurting it a little this year because of the ramp-up from 16 net units to 26.

It's going to hurt a bit.

That 26 to next year 33 or whatever, maybe it hurts a little bit, but I think we got a lot of good things going on now.

I don't know yet.

We haven't done -- we're just starting a few weeks ago we just started the detailed bottoms up six or seven iteration process.

Okay.

Thank you.

At the end of the day I'd be cautious and say it's going to hurt a little bit.

Okay.

That was useful.

Thanks very much.

Your next question comes from the line of Daniel Binder.

Good morning.

Just had a couple of questions.

First, I guess just on the gas business historically one other retailers have seen softer traffic trends because of rising gas prices.

I suspect you have benefited because you're offering a compelling offer.

I'm just wondering, are you still seeing sort of that customer reaction at the gas pump in terms of the traffic as the prices shoots up or are you primarily just getting the benefit in gas from the inflation?

That's the first question.

Second question was related to consumer electronics.

Just wondering, I think in prior calls you've talked about how that business has impacted the gross margin negatively because of a lot of open box returns that you get and the no hassle return policy.

Just curious if you're doing anything on that front by holidays to mitigate that impact?

And then the last question was maybe if you could just give us an update on some of your other formats, what you're doing with them, Home Store I think you have the Pro Store, too, as well.

Just kind of directionally where you see those businesses going.

The gas business, first of all, anecdotally absolutely we continue to see a positive there.

It comes in different levels.

If you go back to September with the hurricanes last year when prices spiked nationwide dramatically, we were in the news every day and every market it seemed like.

That certainly helped.

Over the last several weeks and, again, anecdotally, I've heard the same thing from the operators, not to that extreme but to the fact that Costco's the place to buy gas when in virtually every news account about it.

I know anecdotally I hear that all the time from people telling me the lines are so big but they're still standing in them.

That helps, but it helps not just there as you're standing in line and you call home and you go in and pick up dinner and you buy a few other things on the way out the door.

In terms of electronics, you're right.

I did mention both in Q1 and Q2 recognizing Q1 ends in late November, so you've got the first four, six weeks of the Christmas season, selling season, and then Q2, of course, is late November through mid February so you've got the first four or five weeks of Q2 is the last four or five weeks prior to Christmas and during that Christmas selling season.

We did see an impact because of our favorable return policy, and again that has been mitigated somewhat.

The things we have done, first in our business we put signage out saying warning this picture may not look as good as home if you don't have the right hook-up and the right availability with HD.

So our success in TV is both availability from suppliers as well as a much better quality picture being fed into our locations through HD satellite feeds created our own problem in that way, if you will, recognizing that it's not just bringing home the TV and screwing in the little cable thing.

It's making sure have you the right box in the basement and making sure you know how to use it.

The second thing we did, which I believe is now rolled out, we have a, on all the screens in our locations a, basically a 60-minute feed which is really 20 three-minute feeds and every three minutes, about one minute of each of those three minutes, the TV screen splits in half and it shows you, again, compares this will what it will look like if you're HD ready and this is HD compatible TV will look like if you're not.

It shows the customer the difference, and again, to remind them that they need to have proper installation and call their service provider to make sure they have the right box, if you will, in the basement.

The third thing we're doing, and I'm not sure where and when, I know it's in the next few months, it may be tested already in one market on a small basis.

We're testing with some outside service providers on installation ability as well which we part of one of the offerings that we have that at Costco.

We already have that at costco.com where it's essentially a white glove installed service.

We think, again, we've seen improvement in the markdowns related to returns from just what we've done so far, and we'll keep working it.

It's a great business for us mitigated by returns, not nearly as extreme as the impact that we saw like on computers a few years ago when we had a change of return policy.

At this juncture we have no plans to change our return policy.

That could be different a year or two from now, but at this point the answer is a clear and concise no.

The other formats, I think we have five Costco business centers and four Costco business centers and two Costco homes.

We plan to open a third home this calendar year, and it may be a couple months later, but in the next twelve months for sure, and we, I think have plans to open, Bob, do we have one more home, one more business center next year?

I'll call it zero to one at this point.

I think they're working on one.

Again, they're good concepts.

We take things slow, as you know.

Our primary focus is figuring out even with these two concepts they are profitable with regard to Costco Home even though we've been open as long as about two years in the first one a little over a year in the second one, we want to make sure it has legs a couple three years out.

Secondly, again, the primary focus on both of them is see what we can learn from it to bring into our 477 Costco's worldwide.

Great.

Thanks.

We did open, by the way, our first car wash last month here in Seattle.

But no plans yet.

We'll see how it goes. [OPERATOR INSTRUCTIONS]

Your next question comes from the line of Dan Geiman.

Good morning.

Can you talk a little bit more about our Hillsborough, Oregon store, some of the things you're doing there and also some of the things you might be applying to the rest of the stores in your chain?

The Hillsborough, Oregon is a 205 or 6,000-foot unit so it's a 55,000 feet bigger than the current prototype.

We did that purposely.

A, it's near home, here in Seattle, about 20,000 feet is devoted to increased presence of furniture and home furnishings.

Another 10 plus thousand is devoted to expanded fresh foods, expanded floral, both consumer and commercial floral, so as an example a caterer, or a hotel or a wedding planner can come in and buy a box of, I don't know how they come, three dozen uncut roses in a waxed refrigerator box, if you will, ready to process themselves.

And so we're just testing new stuff.

Certainly, the thing that has been exciting from the late 80s has been fresh foods.

We've got a lot of, we've got expanded whole meal replacement items, expanded pastries, expanded cooked items so it's, if you will, kind of the R&D kitchen for us as well for some expansion there.

It's going fine.

Again, it's one unit.

We'll see how it goes.

Don't expect us to start opening 205,000-foot units any time soon.

Great.

Thank you.

Just doing what we thought.

Your next question comes from the line of Mark Husson.

Just a quick follow-up.

Insofar as you can tell in the U.S., is there any difference between the velocity of sales growth for people who are buying primarily for themselves and their families relative to your people buying primarily for businesses?

Is one healthier than the other right now?

Just looking at the daily sales sheet of mix, not a big delta there lately.

Clearly, Executive membership tends to be more business occupied, if you will, and when people do convert to Executive member, they see -- we see a spike in their sales growth, their purchasing growth.

My guess is that benefit is over, though, because we're now into year five of the Executive membership program so probably more of the Executive sign-ups today, I mean I'm guessing here, are Gold Star versus Business a little bit.

So the answer probably would be no.

Okay.

Great.

Thank you.

Your next question comes from the line of Robert Toomey.

Good morning.

A question, Richard, regarding industry retail square footage trends, one large retailer I think has recently indicated it may be slowing its retail square footage growth.

Yours, you've been running 6 to 7% a year, seems pretty stable and moderate.

I just wondered if you could talk about your view right now on retail square footage growth and how that might impact your business?

You know, not to sound sharps here or have blinders on, but we feel kind of very strong about our business and the ramp up that we're doing in it.

It took a couple years here to get off the ground with changes arguably out there in terms of availability of large sites, zoning, traffic mitigation issues and building up our own pipeline and expansion of our real estate efforts.

If you think about from 16 net new in '05 to 26 this year to clearly something in the low to mid 30s next year, if Jim were sitting here, I'm sure he would say 40 in '08.

So clearly, and I would then temper it a little bit.

But clearly, that trend would be that percentage might grow a little, but certainly in that six to seven range, and I don't know if it averages up to seven and eight.

Certainly we feel good about our growth over the next few years.

And we've got a lot more in the pipeline to do so.

What about the industry trends, though, Richard?

Is there anything going on there that when you look out at your competition, you know, some of the large big box retailers, is there anything going on there that is worrisome or positive for you?

You know, with respect to Sam's, I think, as you know, Wal-Mart of all probably a year ago publicly indicated that they're ramping up all their expansion, again, for concerns of what's going on in communities around the country as it relates to traffic mitigation and zoning.

We see some of that, too.

My guess is we see a little less of it than they do for other reasons, but again, I hate to sound like I have blinders on.

We're more focused on looking at our own growth and feeling that we've got a lot of market potential still.

To the extent that doesn't bode well for other retailers outside of the warehouse club business or even our competitors, so be it.

And again, I'm not trying to be cute, we are singularly focused on ramping up our own growth and we do have a lot in the pipeline.

Okay.

One other question I have relates to, I think you mentioned earlier in the call that there was a question pertaining to gross margin, and you felt that ex the impact of gasoline that there could be some increase in gross margin in '07.

Do you think most of that would come from an anniversarying of the gasoline or would there be other factors that might have an impact on that?

Well, clearly, again, I can answer this a few weeks ago to someone.

Over the last year starting with the hurricanes back in the Fall and more recently the last couple months, we've seen these unprecedented increases in gas prices.

Who knows.

A year from now we might be talking about hopefully gas will come back below $4.

You really don't know what's going to happen.

Over the next several years we may have two or three more unprecedented moves in gas.

Certainly each time that happens it causes a little consternation with our gas P&L numbers.

I'm hopeful that if there's at least a little slow down in it, recognizing that it has impacted us negatively now for three quarters because of this continuing rise in gas prices, that a little slowdown of that will help us.

And certainly the increased sales penetration of private label, the global sourcing that we talked about a minute ago, just our buying power out there and the constant aggressiveness on innovative new items where you get a little higher margin because it's a more unique item, are all things that are net positive.

So that's a very vague way of saying I'm cautiously optimistic.

Great.

Thank you.

Your next question comes from the line of Neil Currie.

Sorry to beat on the drum about gas prices but within your comments about fourth quarter and your comfort with First Call number out there or that being the high-end of your range, does that include an assumption on rising gas continued rising in gas prices or what assumptions have you made about gas prices over the summer?

Basically, it assumes that they weren't going to fall, and again, I don't want to be cute here, but doing a very bottom up approach, and recognizing every four weeks we do a rolling update for the next three, four-week periods, this is where the numbers fall out.

My guess is it includes an assumption that they're going to remain high, but relatively speaking not go up another 20 or $0.30 a gallon.

They've actually gone up a little in the last couple of weeks until yesterday I think a little bit, but, so again, we'll just have to see.

I would say that there's a little caution in the numbers but not a lot.

Thanks.

At this time, there are no further questions.

Thank you, everyone, and, Jeff, Bob and I are here to answer any questions.

By the way, the Q&A will be out later today which will include the cash flow as well, about 11:00 our time.

Thank you.

This concludes today's Costco Wholesale Corporation's conference call to discussion third quarter earnings and May sales results.

You may now disconnect.