好市多 (COST) 2007 Q2 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to Costco's February sales and Q2 earnings conference call.

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

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

I would now like to turn the conference over to Mr. Richard Galanti, Costco's Chief Financial Officer.

Please go ahead, sir.

Thank you, Katora, and good morning to everyone.

As with every conference call, let me start by stating the discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 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 call as well as other risks identified from time to time in the Company's public statements and reports filed with the SEC.

To begin with, our 12-week second quarter fiscal '07 operating results for the quarter.

We came in at a reported $0.54 a share compared to last year's second quarter $0.62 per share.

As outlined in this morning's press release, excluding the three non-recurring items recorded in Q2, what I will term normalized earnings per share would have been $0.66 per share and of course this normalized $0.66 result compares to our December 14th guidance of $0.62 to $0.66 and current First Call of $0.66.

In terms of sales for the quarter, as previously reported our 12-week comparable sales figure showed an increase of 5%.

We are also, of course, reporting this morning our four-week February comp sales results which came in at 4%.

I'll shed some light on those numbers in a minute.

Other topics of interest I'll review with you this morning, our opening activities and plans.

We opened four new locations during the second quarter which ended this past February 18th, three new in the U.S. and one new in the U.K, such that fiscal year-to-date, we have opened 16 net new locations in the first 24 weeks of fiscal 2007.

I will also review with you this morning our ancillary business results, our online results, our membership trends.

I'll talk about our new returns policy for consumer electronics, update you on recent stock purchases, talk a minute about the $2 billion debt offering that we completed a couple of weeks ago, give you some balance sheet numbers and lastly provide you with some updated direction guidance for the third quarter.

As I review with you our quarterly results, I will discuss not only the reported figures but also the Q2 year-over-year comparisons on what I'll call a normalized basis, i.e., without the three non-recurring items.

Stay with me as it gets a little confusing not only as we exclude those three non-recurring items and trying to compare apples-to-apples but also because of the sales adjustment, many of the percentages on a normalized basis, of course, would -- we would add back the $242 million sales figures so you have an apples-to-apples comparison of the last year.

So we'll go through this.

Reported sales again for the quarter, the 12 weeks ended February 18th, were $14.8 billion, up 7% from last year's $13.8 billion.

Excluding the $224 million sales adjustment to the returns reserve, again over what I would call a normalized sales number, excluding that would be $15.03 billion in sales, representing a 9% increase, total sales increase on a quarter-over-quarter basis, excluding that one-time true-up.

On a comp basis, Q2 comps were up 5% for the quarter and that is an apples-to-apples number.

The 5% second quarter comp was comprised of a 9 in December.

Really this 9 in December was a 6, adjusted for the extra day in December year-over-year.

In January, we reported a 2, which again you lost a day so that 2 really is a normalized 5, and a 4 in February as I mentioned.

Again I will speak more to the 4-week, 4% comp figure in a few moments.

For the quarter, our 5% reported comp results were a combination of an average transaction increase of around 3%, and average frequency increase of about 1.5%.

Included in the 3% average transaction increase, about half a point from FX, so a declining level of importance of that is the dollar relative to the countries have not been as weak as it's been last the couple of years.

And gas inflation frankly had a very nominal impact on comps of only about 13 basis points to the positive.

In terms of cannibalization, we pretty much ramped up our expansion, of course, over the last year and a half, two years.

Given that, it impacted our comps by about 150 basis points to the negative in the quarter.

For the four-week month of February, our reported 4% comp results were a combination of an average transaction increase of 3.5%, and again that compares to the whole quarter, which was a 3%.

Also, as I mentioned, the 3% included a benefit from FX of 50 basis points.

The 3.5% for the month of February represented only a 20 basis point improvement due to FX so we can't let the dollar to compare to other currencies is getting pretty close here.

And average frequency increased a little under 1% over, about 0.75% for the month.

Cannibalization, a little higher year-over-year at 160 basis points, again in that mid-150 range.

Also included in the average transaction of 3.5, again very nominal impact from gasoline and gasoline inflation year-over-year was only 10 basis points.

Also, similar to the January's Canadian comp, at the end of the January numbers for that last week or two being impacted, significantly impacted on the negative side by tobacco in Canada.

During the month of February, in Canada, tobacco comps were down nearly 50%.

This, it's an impact of two things.

One, reduced availability of the largest manufacturer over there in terms of selling, using people like us as a wholesaler, as well as a price increase a year ago that we're preparing against.

That impact to the month of February represented, for the whole Company, a little over 100 basis points so that's baked into that 4% number as well.

It would have been higher had we not had that impact of tobacco.

Finally, regarding February comps, the first two weeks were in the low single digits with the second two weeks averaging a little over 6% so it's kind of an improvement, an improving trend throughout the the month and into this week as well.

So the first couple of weeks of the third quarter are looking a little better than February although it's only 2.5 weeks of the 12-week quarter.

In terms of geographic sales, again, on the relative to the 5% comp for the second quarter, northwest was pretty close to that number, as was the northeast, as was the midwest.

California, a little less than that, still positive, as well as the southeast a little less than that.

Recognizing California, we had the biggest impact of cannibalization.

International, Canada, pretty consistent with what we've seen the last couple of quarters.

Probably the strongest area both in local currencies and using U.S. dollars are the other internationals, notably Asia and the U.K.

In terms of merchandise categories, hard lines and fresh foods, of the main four categories, food and sundries, hard lines, soft lines and fresh foods, hard lines and fresh foods still tend to be a little stronger than the average with food and sundries and soft lines being a little under the average.

Ancillary, of course, still in the low double digits, even without gas.

Nothing real surprising here.

Our strongest area of hard lines, of course, continues to be consumer electronics, although that rate of increase has come down somewhat.

I think our comp was in the mid-teens instead of the high teens for the month of February.

In terms of fresh foods, the standout department was produce.

In terms of moving down the line item for the income statement, I'll start with membership fees.

Membership fees were up in dollars 14% and in basis points 12 basis points and $37 million year-over-year.

Again, in the interest of fairness, this is based on reported sales, which of course include that $240 million sales adjustment, $224 million sales adjustment.

If you normalize the sales to show the higher sales figure, if you will, that would still be a very strong 8 basis point increase year-over-year on a normalized sales basis, again reflecting the increase, the increasing benefits associated with the last summer's $5 increase in our basic membership fee in the U.S. and Canada as well as the ongoing conversion of members to the executive -- $100 executive membership.

As I mentioned last quarter, I would expect us to continue to see a nice pop in the membership fee increase as a percent of sales on a quarter-over-quarter basis, on a year-over-year quarterly basis, as we continue to get the first year positive impact of the $5 increase and that's how deferred accounting works.

In terms of the number of members at the end of the quarter, Gold Star members were 18 million, up about 300,000 from the end of the first quarter.

Primary business remains around 5.3 million, business add-ons around 3.4 million, recognizing there's a little skew there because if somebody converts to an executive, they become a Gold Star if they're a business add-on so my guess is the 300,000 increase in Gold Star is a little less and a little bit of that offset is an increase in the add-on.

All told, we ended the quarter with 26.7 million member households, up 1.2 million from the end of the first quarter, I'm sorry, up 200,000 from the end of the first quarter, and with spouse cards 49 million, up a litter under 0.5 million for the quarter.

At Q2 end, we had 5.7 million paid executive members, adding about 177,000 during the quarter, so that continues to be nice increases, recognizing that these roughly 21% of our membership base generate a little over 50% of our U.S. and Canadian sales.

In terms of membership renewal rates, they continue strong and at the all-time high percentage, rounding up to 87%.

Again, as I think I mentioned on last quarter's call, as we continue to go through the first year of the $5 increase, you usually have anywhere from 1 point to1.5 point reduction in your membership fees for that year.

So far, we continue to, as a Company, to average up to the 87% but as we've ticked down 0.10 in the last quarter from an 86.7% to an 86.6% so we may be looking at an 86% renewal rate and we'll see it pop back up right after the anniversary of the $5 increase.

Nonetheless, a strong number.

Now going down to the gross margin line.

Our reported gross margin in the second quarter, again which included two of the three non-recurring items impacting this year's second quarter results, on a reported basis, we were lower year-over-year by 28 basis points coming in at a 10.49 versus a 10.77.

As you will see in a moment, again what I'll refer to as the normalized impact excluding these two items showed year-over-year gross margin in Q2 lower by 17 basis points and I'll give you a little chart in a minute.

Before I ask you to jot down a few numbers, let me give you an explanation of the one-time items that impacted quarter gross margin.

The first is the $10 million refund we're booking in this quarter related to a decision that a previously imposed federal excise tax charged on phone cards should not have been allowed.

This doesn't just impact us, this impacts any company and any individual that was charged these excise taxes.

This refund covered several years and is non-recurring, of course.

Of the $10 million pretax benefit to our income statement, a little under $9 million is a benefit to gross margin, the rest mainly booked to interest income, about, a little over $1 million.

The second item relates to unproved assumptions used to estimate anticipated sales returns and associated reserves.

Let me stop for a minute and walk through that with you.

In connection with our review, as recent changes to our consumer electronics returns policy, we, over the last several months, we performed a much more detailed analysis of our return patterns than we had ever done in the past.

Frankly, for a number of years, for historically, we have used principally a frequency of shop method.

Once this detailed operational data became available over the last several weeks, we determined that it should be, it should also be considered estimating our reserves for sales returns.

Previously our estimate of the reserve for sales returns was largely based on information that reported returns as a percentage of sales.

However, we did not have detailed information that specified the exact lag time between when when the items were sold and when they were returned.

Historically again, we estimated this time frame considering a variety of statistics including the frequency in which the members visit our warehouse.

However, our recent analysis provided us with new information that indicated that lag time for certain returns was longer than previously estimated.

Therefore, our revised estimate contemplates a longer average lag time over which returns are expected to occur notwithstanding the fact that our average frequency of shop is higher than most retailers.

With our new study indicating a need for an increase in the amount of sales comprised in the returns reserve, we also reviewed our assumptions as to the estimated realization rates on the value of the merchandise expected to be returned.

The overall net impact of the sales return reserve, of course, is a function of the proportion of returned merchandise that can be resold, returned to our vendors for credit, sold at markdown prices or scrapped.

In reviewing information on recent experience, we've also revised downward our estimated overall recovery rates on returned merchandise.

This, of course, exacerbated by, exacerbated the issue by significantly increasing returns of electronics over the past -- was exacerbated by significantly increasing returns of electronics over the last few years which have consistently lower realization rates than returned merchandise in other categories.

Ultimately, after revisiting the assumptions used to estimate our reserve for sales returns, we increased the reserve balance and recorded an adjustment to sales of $224.4 million and a pretax charge to gross margin of approximately $48.1 million in the second quarter.

Remember, these reserves adjustments represent a cumulative impact of many years of sales and margin results again using our new methodology, improved methodology.

Now if you jot down the following, I think it will, I'll shed some light on how we get from the reported year-over-year difference of 28 basis points to the 17 basis points on normalized basis and then I'll spend a minute talking about the 17.

If you jot down several line items in three columns of numbers.

The three columns of numbers will be '06, all of fiscal '06, Q1 '07 and Q2 '07.

The seven line items will be merchandising, core merchandising business.

Second line item would be 2% reward.

Third line item would be LIFO.

Fourth, fifth and sixth item represent the three non-recurring items, IRS federal excise tax claim.

The fifth item would be returns reserve gross margin adjustment.

The next item would be returns sales adjustments, recognizing the sales is a denominator that affects it, and the last, of course, would be total.

Now going across merchandising in '06 year-over-year, core merchandising business was lower by 4 basis points in Q1 '07, higher by 8 in Q2 '07, lower by 11.

Our 2% reward in all of '06 had a detriment to reported gross margin of minus 10 basis points.

Similarly in Q1 '07 of minus 10 and a little improvement in that detriment if you will in Q2 '07 of minus 6.

LIFO, plus 3 year-over-year for all of '06 and then zero and zero.

The next three line items have zeroes in the first and second columns so the excise tax refund going across the three columns would be zero, zero, plus 6 basis points.

The returns gross margin adjustment, zero, zero, minus 33 basis points.

The returns reserve sales adjustment, zero, zero, plus 16 basis points.

And if you add up those three columns, year-over-year in all of '06, our reported gross margin was lower by 11 basis points, in Q1 '07 lower by 2, and in Q2 '07 lower by a reported 28.

Now very simply looking at that chart, you can see the two things that are normalized are the minus 11 and minus 6.

I think we've gone through the others.

Let me just spend a minute on the return sales adjustment, the plus 16.

That is simply saying that our reported margin is based on a sales denominator which includes the reduction of sales by the $224 million.

If you looked at it simply by changing the denominator to the normalized sales number before that adjustment, that was a 16 basis point difference in the margin percentage.

That's simply how I'm getting to these numbers.

So, looking beyond the non-recurring items again.

The year-over-year change in gross margin was 17 to the negative, 11 in merchandising and 6 in 2% reward.

Now in terms of our overall merchandising gross margin being lower year-over-year in Q2, our core merchandising business and again that's the 80% of sales of food and sundries, hard lines, soft lines and fresh foods, as a group was down year-over-year by about 20 basis points.

Within these four major departments, food and sundries, which is a little over half of that group, was actually up.

Hard lines and fresh foods were down, and that was the principal reason we saw the whole group there being down 20.

Hard lines, of course, is impacted by our higher cost of dealing with returned items, which is a recurring subject here, and of course with the change in returns policy sometime in the future, we should see some of these numbers hopefully go down.

Our year-over-year gross margin in the retail gas business was actually up slightly in the quarter but given that it's low margin business, not a real big impact either way.

Also in Q2, gross margin was negatively impacted by the 6 basis points that I mentioned, the higher sales penetration of the Executive Membership program, recognizing we're starting to see the -- that negative impact dwindle as the rate of growth in sales penetration from those members, while increasing, is increasing at a slightly lower rate, as you would expect.

Lastly, a component of ancillary businesses which is helping is pharmacy.

Certainly there have been a lot of questions over the last year and a half, first with Medicare Part D and how that impacts margins as well as some of our competitors and what was done with generic pricing which we have dealt with, we feel, pretty effectively.

Our pharmacy gross margin Q2 was actually strong, up a little over 50 basis points and growing nicely, so that was again, I think a view that has not been an issue for us.

And so overall gross margin again, pharmacy was positive.

Let me take a minute now and talk about the returns policy.

Many of you have read or heard about it, but I just want to make sure we're all on the same page.

Basically, starting, it's a program that we're rolling out throughout the the United States over about a six-week period which commenced a week ago Monday on February 26th in California.

On the 12th of March, next Monday, I believe, it's rolled out to all the other western states, Colorado, New Mexico, Arizona, Washington, Alaska, Hawaii, and what have you.

And then over the next few weeks, on the 19th, the 26th and lastly on the 2nd of April, the remainder of the midwest, Texas, northeast, southeast, and Puerto Rico.

We continue to look what the we want to do, if anything, in Canada.

In terms of the policy itself, basically we'll be implementing a 90-day return policy for the following electronics categories -- televisions, computers, and of course those two are the big two.

Computers, of course, for the last five years, have had a six-month return policy.

Again that's going to 90.

The remaining areas -- televisions, computers, cameras, camcorders, IPod and MP3 players, and cellular phones, will all now be in a 90-day return policy.

During those 90 days, it will be like always.

You bring it back.

We'd like to you bring the box.

We'd like to you bring the receipt, but it's not necessary, and we'll gladly give you a full refund for whatever reason.

There are no restocking -- there have never been any restocking charge and there will not be any restocking charge, so we think even so that 90 days is still significantly better than most of the mass retailers out there and electronics retailers as well.

In addition, a couple of things that we're adding to this process are two-fold.

One is a free technical support 1-800 number for all those items I mentioned other than cell phones, the cell phones are through a third party and they provide their own technical support, but this will be basically be a what we're calling a Costco concierge type of support.

This is -- we've been testing it in southern California for the past several months.

Basically it's a way for that customer who has bought this item at Costco to call in, not sit on hold for 20 minutes, but get through relatively quickly and also talk to what we're contracting for is a higher level and higher quality response such that a much higher percentage hopefully of calls can, with questions, technical questions can be answered not only the phone answered more quickly, but the response more likely be handled by that first point of contact.

We also have backdoor numbers to all the major manufacturers where those people can quickly get somebody on if they're unable to answer the questions and provide that support to the customer.

This is something that we're paying for and it's something that has actually solved, we believe solved some of the issue of returns not just for TVs but other products as well.

In addition, as it relates to televisions and computers, again, this is the far largest part of the consumer electronics area, whatever the warranty is on these items, will be extended, will be extended such that the -- manufacturers' warranty will be in place for two years.

Again, this is something we're contracting with the manufacturers to do but it will be subject to their warranty.

If it's broken, you don't bring it back to Costco.

You follow the rules, you call us and we'll help you do it, but you follow the rules of the manufacturer's warranty.

There's a cost associated with that, of course, for us and needless to say, we will reserve for that, reserve for that conservatively I hope.

The one added feature is as it relates to the two-year warranties, these items that any televisions greater than 32 inches, such warranty service will be provided in-home at no additional cost to the customer.

So we think that while we've gone from a policy on most of these items of essentially infinity bring it back anytime, you don't need the receipt, you don't need anything, there's no restocking charges.

Certainly 90 days is not infinity, but it's significantly better than most out there.

In addition, there's no restocking charge.

There's the concierge technical support line as well as the extension in computers and TVs to two years.

While we've had a few nay-say letters, what we tend to find is is many of these letters are being written by people that have been fairly aggressive in their returns personally.

So we really have seen not a big negative from it.

In fact, on many of the blogs out there, there have been a lot of positives from our customers defending us on the policy.

In terms of our, now I will mention by the way, well, let me continue.

In terms of our gross margin outlook going forward, reported gross margins will probably continue to be challenging, particular in hard lines, over the next several months.

Recognizing, even with this policy change, anything but prior to the implementation of it is under the old rules.

We're not changing the rules on something that was bought the day before.

And so we would expect over the next many months to not see a real impact, positive impact in terms of the real significant hits to disposition costs of some of these items that we've seen over the last few years.

The impact, as I mentioned, from increasing Executive Member business should still be a hit to reported gross margin but a little less as we move, continue to move through the quarters.

I think we saw a good sign of that in Q2.

LIFO, not a heck of a lot going on there.

It' ever so slightly deflationary and we're not putting any charges right now and, as we did not either last year, so it's really of of no impact year-over-year so far.

Again our core merchandising groups, notwithstanding electronics, have been pretty good.

I think a little of the fall-off in the quarter, this past quarter, in fresh foods, again was a slightly weaker sales assumption, and irrespective of what you do when you have slightly weaker sales, you have a little extra spoilage which can certainly add to the detriment of the margin on a short-term basis.

In terms of, again in terms of the impact of the return policy change, I think that's still several months out.

We are working on other initiatives.

I'm not trying to be cute or coy, but Jim, with his senior merchants, are working on initiatives of how to show some improvement in the margin as we go forth over the next couple of years.

I think what we've shown is is that notwithstanding a little weakness this past year and if you take out the weakness related to the Executive Membership improvement, we've actually had some decent margins and we continue to grow that going forward.

Ancillary businesses, we added three pharmacies to be at 416 at the end of the quarter.

At the end of quarter, we had three.

We added four food courts, four minilabs, four optical labs, 10 hearing aid centers to be at 220 hearing aid centers, and seven gas stations to be at 268 gas stations.

In total for Q2, our ancillary business sales comps were 10% and again there was not really not a big delta in gasoline inflation so with and without gasoline, there was a 10% comp in ancillary.

In the four-week cover month, it was actually a little better than that.

Moving forward to SG&A, again I'll start with our reported SG&A percentages in Q2 over Q2, were significantly impacted by the stock options, stock options related charge of $46.4 million taken in the quarter.

Including this charge on a reported basis, SG&A year-over-year was higher or worse by 49 basis points coming in at a 10.05 reported versus last year's number of a 9.56.

Again, as you will see, this year's Q2 SG&A figure of 10.05 is negatively impacted by that options-related charge as well as the sales adjustment of $224 million so the sales return reserve.

So again jot down a few simple numbers and I think we can look at this pictorially and you'll see what I'm talking about.

Three columns again, all of '06, Q1 '07 and Q2 '07.

The seven line items would be operations, central, stock options and this stock options is the normal ongoing charge of stock options year-over-year.

As you know, we started voluntarily expensing options in fiscal 2003, fiscal year 2003, and this will be the culmination of getting all the vesting in and a few other things and we shouldn't see any big change in this number going forward.

The fourth line item would be the stock options related charge of the $44, the $46.4 million.

The fifth line item is sales return.

The sales, the adjustment to the sales based on return assumptions, and actually those are the line items, then the total.

Going across, operations and plus means good or lower SG&A percent year other year.

Operations is plus 5 basis points in all of '06, plus 4 in Q1 '07, and plus 3 in Q2 '07.

Central, plus 4 in '06, minus 2 in '07 and minus 1 in Q2 '07.

Stock options, and this is just the regular ongoing stock options, minus 5 in '06, minus 8 in '07, and minus 5 basis points in Q2 '07.

The one-time charge we're taking here, the non-recurring charge, zero, zero and minus 31 basis points.

Sales return reserve zero, zero and minus 15 basis points.

Not unlikely plus 16 basis points we had in the margin because of the sales.

And then, I will mention quarterly adjustments so add a line item, please.

That will be zero in '06, plus 6 in Q1 '07 and zero in Q2 '07.

So all told, for all of those six SG&A, year-over-year was lower or plus 4 basis points, better by 4 basis points.

Q1 '07 was flat year-over-year and Q2 '07 was again reported 49 basis points higher or negative 49.

Now, let me -- get the little ones out of the way.

The quarterly adjustment of plus 6 is simply the hit to SG&A in Q1 '06, a year earlier, related to hurricanes, and so that plus 6 is just the fact that we didn't have that one-time charge this time versus last year.

In terms of a little editorial on these SG&A figures, again let me point out operations showed an improvement of 3 basis points year-over-year.

Our payroll percentages were up slightly, very slightly, but various expense accruals continue to be lower, better year-over-year.

Our stock option expense again was higher, minus 5 basis points in Q2, but in line with what we expected.

Again, I think as we get beyond '07, that number will vary plus or minus a basis point around, probably around a zero delta year-over-year.

The stock option related charge of $46.2 million, as you guys will recall, in our 8-K filing on December 14th, we described the Company's intention to protect the more than 1,000 employees whose face possible adverse income tax consequences in connection with a review of stock options announced by the Company last October 12th.

As noted in that release, we estimated that Q2, we will take a charge growing out of the previously disclosed investigation and this charge related to protecting our employees against these adverse tax consequences for events beyond their control.

There were a few of us that were not protected for that, as you might expect.

The protection largely entails repricing upward the options while compensating, with compensating payments to the employees for the difference.

At that time, last quarter, we estimated that we were record a charge of up to $70 million pretax.

The actual charge we are recording, the $46.2 million, is lower mainly because certain components of the $70 million estimates did not flow through the income statement.

Rather they're recorded as a reduction to equity.

I think we mentioned, even when we felt the charge might be up to $70 million, that the actual cash impact was significantly less than that.

That really hasn't changed.

In all, this is the 31 basis point hit to SG&A.

Next, reported sales are lower by $224 million due to the increase in the estimated sales return reserve.

This quarter's SG&A as a percent of sales, therefore, is higher by 15 basis points more than it would be using the normalized sales figures as a denominator instead of the actual reported sales figures.

Lastly, in terms of SG&A impact from the revision to our method of allocating certain payroll and related expenses, again, I'll let you put your pencil down for a minute.

I'm really re-explaining this next comment not that it does much of an impact to Q2, but it did benefit greatly Q1 SG&A.

As we mentioned back then, it will hurt by up to $0.02 a share, we estimate, Q2's -- Q3's number.

As I mentioned in the first quarter of '07, we revised our method of allocating certain payroll-related expenses in order to more accurately reflect the costs for a given quarter.

This basically has to do with FICA taxes and other payroll-related taxes, and again, because our fiscal year is on an August year-end, and during that first quarter, we had typically done it, accrued on a regularly over the course of the fiscal year.

What you have happen is as people max out on certain of these payroll taxes midway through the calendar year, we typically had recorded something in the first quarter when in fact the cash impact was negated because many people had maxed out or some people had maxed out already individually.

And so what that did is it benefited or reduced SG&A in Q2.

It has an offsetting detriment, a more than offsetting detriment in Q3, and a slight positive, plus or minus a little, in Qs 2 and 4, such that for the year, there's no impact at all.

But again, it was a more, it was what we believe the correct way to account for it.

I only bring it up again to simply remind everyone that in Q3, we estimate that it will have a negative impact on apples-to-apples comparison with the prior year of a little over $0.02 a share.

In terms of SG&A outlook for the remainder of '07, payroll probably will be a little bit of a challenge.

Effective this month, we, every three years, we review our pay scales or our whole employee agreement and as you would expect, we always look at top of scale on an annual basis, increase that ever so slightly.

But in addition, this time we are also changing the, we're upping the bottom of the scale.

For the last, I believe, six years we have been at $10 and $10.50 an hour as entry-level wages, and some locations like L.A. or some aspects in New York, sometimes a warehouse manager may have some discretion to start at a little higher rate if it's required to get good people.

That being said, effective this month, we're going from starting wages of $10 and $10.50 to $11 and $11.50.

We estimate this will cost us, just $1 increase is probably about $3 million a month pretax.

Again, probably not the full impact of that but a lot of it related to the fact that some locations sometimes in some markets have to start people a little higher already.

We should get some offset with the continued, with this with the continued improvements in benefits and workers' comp but again the big question is going to be sales trends.

Every extra percentage point in comps helps that.

And as I mentioned, we've gotten off to a decent start at least in the first 2.5 weeks of this quarter.

Next on the income statement is pre-opening expense.

Pre-opening expense this year was about $3 million higher coming in at $7.5 million versus $4.6 million in the quarter.

Not any big surprises there and we're working on a few more things this year than last year.

In the quarter itself, we opened four this year versus two last year.

In terms of provision for impaired assets of closing costs, again no big surprises.

They were higher this year.

Last year in the quarter, $1.4 million.

This year, $3.5 million.

So all told, reported operating income was down year-over-year, of course, with the one-time items from $431.3 million last year to $361.3.

However, on what I would term a normalized basis, i.e., excluding these non-recurring charge items, operating income year-over-year in Q2 would have been $446.8, higher by $15 million and 3.5%.

I think given the little weaker sales and the tremendous impact that we've seen in majors with margins, not a bad showing there.

Below the operating income line, reported interest expense was higher year-over-year by about $700,000.

The biggest delta there is simply capitalized interest, which is an offset to interest expense being a shade lower.

Interest income, $36.5 million in Q2 this year versus, about $1.3 million higher than $35.2 million a year ago, and then no big surprises.

Let me now spend a minute talking about the $2 billion debt offering that we completed a couple weeks ago.

Basically the $2 billion debt offering has two traunches, a five-year debt, the $900 million of five-year debt with an all-fixed rate of 5.36% and $1.1 billion of ten-year debt with an all-fixed rate of 5.57%.

The debt will be reflected on our balance sheet in Q3 as the transaction was funded just after the end of the second quarter.

A few of you have called and asked why so much?

You have 2.5, looking back in the second quarter, at the first quarter balance sheet on November 26th, you guys have $2.5 plus billion of cash and equivalents on your balance sheet already, what do you need to do this for?

Let me very simply share with you our thought process and I think it's pretty straightforward.

If you think about the basic cash in items, net income and use whatever estimate you have, $1 point blank million for the year.

We have depreciation of about $600 million, and we also have on a regular basis right now, the last couple of years, anticipated the next couple of years, we have $200 to $300 million a year in exercise, proceeds from exercise of existing stock options.

Now, a year ago, we went to RSUs, restricted stock units, but we still have close to 40 million options outstanding, 37 million options outstanding that are all on the money and we would expect to see that nearly $1.5 billion aggregation of all the exercise prices to flow into the Company over the next several years.

So, yes, again you start with a net income of $1 point blank million, depreciation of $600, exercises of of $200 to $300.

Rounded to the nearest billion dollars, you've got $2 billion coming in.

You've got CapEx of a shade under $1.5 billion this year, dividends of around $260, and a debt payment of $300 million, which will be next week on our old five-year note.

So again, in very rounded terms, you've got 2 in, $2 billion in and $2 billion out.

Now the only thing I've excluded from this little simple analysis is stock buybacks.

In the first half of this fiscal year, we've spent a little over $900 million on buybacks, which, if you annualize it over those 24 weeks, if you annualize those 24 weeks to the whole year, you're talking about a kind of a current trend of about $2 billion.

So, adding that to the equation, you've got $2 billion in and $4 billion out.

Again, many of you ask well, what about the balance sheet cash?

You've got $2.5 billion out there.

When you look at our $2.5 billion between cash, cash equivalents and short term investments at Q1 end, about a little over half of that is what I'll call not readily usable.

It's monetizable but it's not readily usable.

Examples would be weekend debit and credit card receivables to the tune of $600 million, international cash of a few hundred million which we typically repatriate on a regular basis to the U.S. from particularly Canada, but that's on a formula basis so there's a little lag there if you will so we don't see that coming back.

As it comes back, more is then generated there.

There's a little in foreign accounts as well, other foreign accounts, and as well as just over the weekend cash in transit.

So, when you look at all that cash, while we're earning interest on a lot of it, it's not -- it's not all necessarily usable to go out and buy stock.

So, with that, the other question would be, why so much right now?

Why not a little later?

We basically looked at the yield curve and as many of you know, it's inverted and the feeling was is that with us not being out there in the debt markets in a long time and being a relatively good name and having a lot of appetite out there and having an inverted yield curve, we basically do this and take advantage of the fact that we can invest very short term and have a very, very small negative carry versus what we're earning on this money while we're holding it and what we're going to pay long-term for it.

So we thought it was a good timing and we're pleased to have gotten it done quickly and we think cost effectively.

Overall, so that's that debt part.

Overall, reported pretax earnings was down year-over-year to $394 million.

Again, on a normalized basis, pretax income was up 3.5%, up from $463 to $478 million.

Our tax rate was a shade higher, still better than average for the year, but a shade higher this year in the second quarter versus last year coming in at a 36.72% versus a 36.11% a year ago.

No big surprises there.

The balance sheet will be part of the Q&A that we'll have posted shortly on our website.

I think that it may be a day or two before we have a finalized cash flow statement.

But and that will be put up accordingly as well.

But in terms of preliminary balance sheet numbers here, and there's always subject to a couple of minor reclasses, but I don't see any big changes here.

Cash and equivalents at the end of Q2, which was February 18th, of $2.233 billion.

Inventories of $4.931 billion Other current assets of $1.112 billion.

Total current assets of $8.276.

Net PP&E is 8.917.

Other assets of $732, for a total assets of $17.925.

Short-term debt of $461, and that includes the current portion of the $300 million of long-term debt.

Debt will be paid off next week.

Accounts payable of $4.962 billion.

Other current liabilities of $3.242 billion for total current liabilities of $8.665 billion.

Long-term debt of $168.

Deferred and other of $238.

Total liabilities of $9.071.

Minority interest of 66.

Stockholders' equity of 8788, and total of $17.925.

Let me point a couple of things out on the balance sheet.

Basically, again a very strong balance sheet, and even adjusting for the $2 billion, nothing -- no issues or concerns there, plenty of financial strength.

Accounts payable as a percent of inventories at Q2 end, down slightly from a year ago.

Again, that's indicative I think again of a little lower sales and a little higher inventory.

The inventories, I might add, while they're higher, I'll mention that in a minute, they're clean.

We had our best ever physical inventories at mid-year, just this past few months.

And as Jim said at the last budget meeting, he wants to plan to reduce the inventories by anywhere from $0.5 million to $800,000 a warehouse.

Basically, if you look at inventories, and I think again this is more a reflection of sales than anything being a point or two weaker in the last few months, there's no one department.

There's a little here and a little there.

The average inventory per warehouse last year at Q2 end was $9 billion, I'm sorry, $9.656 million.

At the end of this quarter, year later, it was $10.403 million, so an 8% increase, and again we think that over the next several months, we can bring that down a little bit.

Again, it's all over the board.

Hard lines were down $70 or $80,000 a warehouse, hardware rather.

Majors, about 70, which is electronics, jewelry, $40,000, even though jewelry has been a positive comp.

Pharmacy, again, I think that has to do with being a little more aggressive on what we're offering, not only the pricing, but on generics, but adding a little there.

It was up about $100,000 a warehouse.

Again, I want to reiterate no inventory concerns at all.

It was our best year ever and we still think we can improve our inventory levels.

In terms of CapEx, in fiscal '06 we spent $1.2 billion.

Year-to-date we spent a shade under $700 million, pretty much in line with our budget.

Again I'd estimate the CapEx for the whole year would be in the $1.4 to 1.5 billion range.

Our dividend is currently annualized at $0.52 a share, which again on an annualized basis would be the $260 million I mentioned.

In terms of Costco Online, it's continuing to do well.

Its -- while its level of increase has come down a little in Q2 versus Q1, it's still very strong in Q2.

Sales were up 34% and putting our year-to-date number at 43% up.

And that of course is on top of a 61% increase in all of '06.

In terms of expansion, as I mentioned, for the first half of the year, we opened 16 total new units.

We opened another one a couple of weeks ago in Colorado and we're opening one, I think this morning, in Pittsburgh and a total, in addition to those two, we expect a total in Q3 of six.

Net new units in Q4, we expect to open 10 or 11 including one relo so 9 or 10.

So that will put us at 31 to 32 for the year.

Again, following I think one or two from what we estimated three months ago and it's simply timing.

When I look at our fiscal '08 list and what we affectionately call around here what has been "green inked," since Jim uses green ink to okay things, and I think we have currently on that list of green ink items for next year, 38 units with only five or six of them being in month 12 of next year, so we're again a little delay in a few this year but ahead of the curve next year at this point at least, and I would expect in '08 to easily do in the 35 to 40 range.

If you just look, I said 31 to 32.

If you just use the 31 number on last year's ending base consolidated of 458, that excludes the Mexico units, unit growth would be 6.7% this year and square footage growth about 7.2%.

I know Jeff Elliott here gets lots of calls right afterwards about what is your quarter-ending square footage.

At the end of the quarter, we ended up with 66.6 million square feet.

Lastly, let me talk about stock repurchases.

Since June of '05, we have repurchased approximately 55.5 million shares at an aggregate purchase price of a little bit $2.8 billion or about $50.81 a share.

So we still have repurchase authorization under our current programs of approximately $1.7 billion, which authorization expires in a couple of traunches in calendar 2009.

I would expect that to be done before then, and we'll worry about what else we need going forward.

In Q1 '07, as you know, we purchased $425 million of stock representing an annualized run rate of about $1.8 billion.

In Q2, we purchased $481 million of stock representing an annualized run rate of 2.1.

While any number going forward is subject to change, as we've shown I think since June or July of '05 when we commenced buying back stock, we've generally done so on a regular basis, perhaps increasing the run rate this year from the $1.4 billion run rate in all of '06.

And finally, before I turn it back to Katora for Q&A, a little direction for '07 -- for Q3.

First Call is currently at $0.57.

My guess is that some of you include that assumption of a $0.02 hit related to the payroll related thing and some of you don't.

So we'll assume the $0.57 probably includes at least $0.01 for that so a normalized basis would be $0.56.

My guess is I would look at a range that has that at the high end and the lower end probably in the $0.52 or $0.53 range.

And the fact of the matter is is we're going to have to wait and see.

Sales have picked up a little bit, that's good.

I don't anticipate any changes in returns over the next few months as again, anything prior to the return change is grandfathered in and we'll see.

But given where we are now, I think it's better to be a little conservative and hopefully we can continue to come in at the high end of your ranges out there.

Q4 is currently at $0.84.

That's certainly within the range that we think.

And for the year, First Call is at $2.58 which again I would say is at the higher end of the range of of what we would like to conservatively assume at this time, but even I think at the end of Q2 end we said $2.50 to $2.60, which would represent a 9% to 13% increase in a year which has one less week than last week's 53-week year.

Again these are normalized numbers excluding the non-recurring items in this quarter.

With that, let me turn it back to Katora for Q and A. Thank you.

Thank you. [OPERATOR INSTRUCTIONS] We'll pause for just a moment to compile the Q&A roster.

Your first question comes from the line of Deborah Weinswig.

Good morning, Richard.

You touched on the change in your generic pricing in the gross margin this quarter.

Can you also please provide some additional color on the program launch during the quarter and how it compares to the $4 generic program that you had previously?

Sure.

Well, we matched what our competitor did out of the box on the $4 for 30 days.

Historically on generics, our sense is it costs us at least more than $4 to fill any prescription.

So we might have a -- three traunches on a generic.

There might be, I'm making this up, but $7.99 for 30 days, $9.99 for 60 days and $10.99 for 90 days, recognizing the cost of the pills is very little on the generics, but you're still having only one cost of filling a prescription, whether it's 30, 60 or 90 days out.

So -- but that being said, we wanted to match the competition while we came up with our own plan.

We have since have our own list of generics which again I think numbers in the 200 to 300 range in terms of how many generics and ours is pretty flat, just 100 pills for $10.

So as compared to 30 pills for $4, 100 pills under that program would cost you, I think, $13.33 and we're at $10 bucks and in some cases, it's 100 pills for less than $10 because we were less than $10 to begin with.

And so we are not interested in selling 30 pills for $4.

We lose money on it and so we think we're giving our customer the best value and protecting ourselves as well.

Okay.

And then with regards to the inventory reduction that you talked about, is there a new technology that Costco has put in place or you're just instilling greater discipline?

Jim just raised the decibel level a little.

Yes, the fact of the matter is is when you're talking about doing $1.2 or $1.3 billion a week in sales here, $1.2 billion a week in sales, and it's every percentage point is $12 million of sales, and while we turn our inventory fast, again, when I looked at it, usually the concern is you look at it and say oh, my god, there's $700,000 more of inventory and you expect $300,000 or $400,000 just because sales are growing at twice that level, but where's the other $400,000, and where your concern is is in one category that's not doing well.

The $100, the $50 or the $70 that's in electronics, no big deal.

That's still comping in the mid-teens.

But when you looked at it, it was throughout.

It was $20,000 in this department and $15,000 in that department, $42,000 in that department, including departments like paper goods and stuff.

That's again simply a fact that sales in February, at least certainly through the first part of February and the last part of January, have softened a little bit.

They've come back a little bit.

I think that will take care of some of it.

Again, I think a gentle reminder from the boss reminding them if they would not like to do it, he'd be happy to do it in about 30 minutes.

And it's really that simple.

I'm not trying to be cute about it.

We are, this is not complete science.

This is also the art of merchandising and mapping out merchandise.

Okay.

And then last question, can you talk about what you're seeing with regards to Executive Membership trends for traffic and ticket and I think most recently you had talked about them representing about 50% of sales.

Are we still in that ballpark?

Yes, I think I mentioned that the 21% of the members represent in the U.S. and Canada 53% of sales.

Now, about 10 percentage points less, about 43% I believe, is rewardable sales because we don't reward, we don't provide Executive Member reward on tobacco, gas and alcohol.

And so it's still increasing, but it's increasing at a really low rate so if you look like the hit to gross margin of 6 basis points, if you reverse engineer that, that would imply at a 2% reward about a 3 percentage point increase year-over-year in sales penetration of Executive Members getting the reward.

And that's again, it's still growing but growing at a lesser rate as we now have so many of those higher-volume people wanting to do it.

But once they're there, they end up buying more because affinity programs do work.

And they are our most important customers.

Their renewal rates, which is part of the 87% renewal rate, is in the low 90s.

Great.

Thanks so much, Richard.

Your next question comes from the line of Mark [Rowen.]

Thanks.

Rich, the reserves on the -- that you're taking, I understand it's a one-time charge.

But given the fact that your returns are costing you more than you thought it was, what's it going to be costing on an ongoing basis?

And does the change in the policy on the electronics, does that more than offset that?

Well, we won't know, certainly we're not -- it took Jim easily two years to get to the point where he was even willing to approve this change that we're doing.

Certainly we're doing it, recognizing that we had to do something and we think that it will be, it will offset a big chunk of what we're being impacted by.

But again, that's several months from now.

Because as things, everything that was bought prior to the day of the change is grandfathered into the old policy.

But yes, certainly during '08, fiscal '08, you should start to see some of that improvement.

And I'm sorry, the first part of that question?

Are you starting to reserve at a higher rate now going forward as well?

Yes, we are.

So how much -- ?

Look at that $48 million, recognizing it in a way it's from inception to date in the Company because it's a change in the methodology of what we're using and it's a cumulative impact.

Certainly, these are not auditable numbers but when we've done some back-of-the-envelope estimates of how much would it, if had you this methodology three or four years from now, during which time the sales of these electronics items has gone through the roof and the return issues have been exacerbated, how much of that $48 million relates to the last several years?

A true ballpark number might be $0.01 a share for the last couple of years.

You wouldn't spread $48 million evenly over 20 years.

But you wouldn't also say that it went from 14 to 60 or 12 to 60 or whatever in just the last year or two.

So, what, like if you look at all of your TV returns or I guess TV is probably the best product to look at since it's such a big-ticket item, if you look at all the TV returns, are a big percentage of them returned after 90 days?

No.

A majority are returned within 90 days.

But when you're doing $2.5 billion a year in TVs and even a small percentage, which has a low, low realization when you dispose of the item, is still going to impact you greater than you thought it would.

Okay, all right.

One other question --

How is that going to impact it once the change in return policy goes into effect?

We got our fingers crossed.

We think we've done it a good way both for our members and ourselves.

Okay.

One other question, on the new clubs that you're opening, as far as new club members, not the ones that are being cannibalized from current clubs, but new club members, are the trends that you're seeing similar to what you've experienced in the past or are there any differences there?

I don't think we've seen any major differences at all.

Okay, great.

Thank you.

Your next question comes from the line of Charles Grom.

Thanks.

Richard, on your prepared marks, you mentioned that Jim was working with the merchants to drive better margins.

I'm sure he's been doing this for the past, call it 15, 20 years.

Could you elaborate on the potential opportunities that he's looking at on this front?

I can't elaborate specifically on them but I can tell you that as I sort out examples over the last few years, like when we took the allowable maximum markup on goods for private label from, whereas they used to be at 14 and now it's 15.

When we looked at certain -- when we looked at our depot operations and demanded a higher return on those assets, which in effect raised the cost of goods a little bit and arguably, without cheating, allowed us to improve the low margins.

There are different kinds of things and I can't go into them and I don't want to be cute or coy and suggest it's overnight where you can get X dollars per week.

But there are real things that we can do to allow us and our buyers to still maintain, in our view, the integrity of being, of limiting our markups but still allowing us to earn a little bit more where we're very competitive.

Okay.

And then just kind of similar follow-up question.

In your annual report, you outlined a private label mix of about 25%, which was higher than your former guidance.

What -- when you look at the store, what product areas do you see the most opportunity going forward?

Well, it really is everywhere.

Certainly there's more in general consumer products, whether it's supermarket products and domestics.

We've seen our name on, we just put our name on these very high end 520-count Egyptian cotton bedding.

So there are really a lot of different items.

Certainly the big ones, typically, like when we do a private label diaper and it's 100 million a week -- 100 million a year in sales out of the box.

But there aren't many of those left.

Okay.

And then just one last question on international, how much longer do you expect Canada to be weak because of the tobacco issues up there?

Looking at Bob here.

I think it happened in the summer.

Bob thinks it happened in August so we'll assume July or August.

Okay, so we would expect to see international comps kind of in this mid single digit range until then?

We're getting a double whammy because there was $0.01 price increase up there.

So the detriment should improve a little but then be at that lower level of detriment from now until summer.

Okay, good luck.

Thank you.

Your next question is from Adrianne Shapira.

Thank you.

Richard, I just wanted to go back to the guidance for the third quarter.

We were just -- the last conference call, I guess the $0.57, it sounded like that was not at the high end and it sounds like the early trends on sales are pretty encouraging.

So I'm just wondering where does the, understanding the payroll impact, but where does the further conservatism come in?

Yes, while keep in mind that the payroll impact is maybe up to $0.01, a little less because it starts in mid-March and that's a month into the quarter already so it's a little less than a full $0.01.

And again there's a a little offset to that already because some markets already.

But normalize the lower end is up close to 10%.

I -- I think that -- I don't think there's a big change here.

Arguably I'm allowing myself or this economy to be a little more conservative.

I remember when we gave guidance for Q2 of $0.62 to $0.66, which was honest guidance.

We also recognized that the impacts from returns are still going to impact us for the next few quarters even if we change the policy, as we're changing the policy now.

So there's a little conservative, certainly there's a little conservatism built into the number.

Again as I mentioned, I would hope that like we gave with our range of $0.62 to $0.66 and we came in at a normalized $0.66, we can do the same here.

Okay.

That's helpful.

I'm just wondering, as you say, in this economy, is it the economy the macro or is there something else on the competitive landscape that you see that has -- ?

Absolutely nothing else on the competitive landscape.

I mean competition is not easy, but it's not any tougher than it was a month ago or a quarter ago.

Again, arguably I think we've taken the viewpoint, we want to be a little conservative in our outlook because you never know what's going to happen tomorrow.

I even was, wasn't sure if I wanted to share with you the last couple of weeks of sales were a little better than planned.

They're a little better than plan, but who knows what tomorrow brings?

Okay.

You had mentioned pharmacy as a standout.

Are you seeing any sort of lift as BJ's gets out of that business in overlapping markets?

At the last budget meeting from the east coast regions, I guess by definition you'll see there's a small amount of lift but I doubt if it's that meaningful to the whole Company.

Okay.

And then just lastly, I mean given, you had mentioned traffic seemed to have softened a little bit in February, down 1%.

Anything to read across in terms of the success of the wallets for, anything there to call out?

First of all, it was 0.75% versus 1.5% so still up.

Traffic was still up in the quarter.

No, I think that the fact that those things worked, certainly the strength last week I think is important, the last couple weeks is in part due to some of the mailers we've done, and that, my guess is at least for the first partial week of this year, of this month, I don't have a daily traffic number, but our traffic is probably up a little bit from the 0.75.

Thank you.

Bob is mentioning to me and again, we've been pretty good at not mentioning weather, but certainly the craziness from snow from the midwest to the east coast has not helped.

Your next question comes from the line of David Strasser.

Thank you.

The question, back on, when Wal-Mart announced their fourth quarter, they talked about gross margins of Sam's being up.

And I guess the question is A) do you notice that and B) do you kind of take that into your consideration from a pricing standpoint, from a strategy standpoint, when you see their gross margins going up there?

No.

Really every location with nearby competition, Sam's or BJ's, and in some cases, others, but principally those two, we're out there weekly and sometimes more than weekly comp shopping them and react to whatever the competition is doing, and try to stay ahead of them.

I think part of their argument for improving margins is some of the greater level of global sourcing and collaborative buying with their parent that they've done over the last couple of years.

We also, one of the things that we have seen, when we do, we do also comp shops of like Sam's units where we're not competing with them, in markets where they're by themselves.

And we've seen the spread of themselves, of Sam's versus Sam's competitive and- noncompetitive, expand a little bit over the last couple of years.

Now perhaps that because we've hit them in a lot of markets where we weren't before.

We really don't use their comment that their margins are improving a little as giving as confidence that we can improve margins at all.

We're very paranoid out there and we're out there every day and week comp shopping them.

And I guess one other question.

You talked about the entry-level wages and you talked how you're always trying to raise the high end of the wage.

What about sort of in the middle of the scale?

As you raise your low end, do you ultimately bring up the whole wage structure, the hourly wage structure?

Usually it takes about a year for -- in the old structure, it took an hourly full-time employee I think about a year, maybe a shade under a year, to get from $10 to $11 or $10.50 to $11.50, so there are a handful of new hires that will automatically go to the $11 and $11.50.

They've been here six months and they went from $10 to $10.25 to $10.50.

They might get that free six-month ride to $11, and so there's a little bit of that built into it as well.

The top of the scale, somebody who's been at the top of the scale, we basically every year have increased that somewhere in the low 2s as a percentage of their hourly rate.

All right.

Thanks a lot.

Essentially every three years we re-up it for three more years with that kind of 2-ish percent increase each year for the next three years so we've always been able to do that.

All right.

Your next question comes from the line of Christine Augustine.

Hi, Richard.

Thank you.

What are you hearing, if anything, about supermarket negotiations in southern California?

The only thing I've heard is what I've read, which says that there are some stumbling blocks, but I cannot imagine that the unions or the companies would allow to happen what happened last time.

Because it was not only short-term detrimental, it was a couple of years detrimental.

But that's, logic sometimes is not a word used in those negotiations.

My guess is that even though you've heard some rumblings that there are some issues that aren't surmountable, I got to believe they'll figure it out.

And what about workers' compensation in California?

Is there still the talk about some people really got penalized and maybe it went too far and it needs to get reversed?

I, there's always an example of a person that can come in front of a regulatory presentation and talk about their particular case that was impacted negatively and unfairly by it.

But again I would assume, we're not out there lobbying but I would assume there's lots of lobbying activities going on on both sides.

Again, we haven't seen, like anything in California, they're going to be proactive as a state in providing additional benefits to their citizens and being more fair, whether it's paid FMLA or you name it.

And so my guess is over time, it slips a little bit but we don't go back in that abyss.

Okay.

But you are anticipating that benefits and workers' comp, I guess in terms of how you're accruing for it, that that actually should continue to help you on the SG&A this year?

Yes, but the workers' comp is a much smaller piece in fairness.

Okay.

And then how about on utilities or just overall energy costs this year versus last year?

Are you seeing, still seeing increases?

Have you been able to offset anything?

Well, if I look at total warehouses for our year-to-date, which would be 24 weeks, this is just our internal warehouse P&Ls, utilities as a percent of sales are essentially flat year-over-year.

Okay

So we must be doing something because the costs per hour are certainly a little higher.

Okay.

And how about, I guess just international expansion?

What's happening with Australia?

Is there something going on there?

Well, like a couple of other countries that we're not in yet also, there's been something going on for many years off and on.

We haven't made any announcements.

We've, over the last several years, like six, seven years, we've had somebody there for a while and then they come back.

So there's really nothing to say yet.

And that again is one of probably two or three countries that you could have used as an example.

But we constantly are looking at a few other countries.

There's nothing on the horizon over the next 12 months, but it doesn't mean that tomorrow that can change.

I can assure you things have changed before, like when it's a done deal and we go into a given country and then three months later, we're not going.

So who knows?

I would, that would certainly be one of three countries that is a possibility over the next few years.

The last question I had was on Smart and Final.

Did you guys look at that at all?

Do you compete against them or do you not consider them competition?

And if so, do you think anything is going to change under different ownership?

We -- did Apollo Group buy them?

Yes, Apollo.

Well, as you know, retailers have only one way to be arrogant.

It's when Harvard-educated buy-out people buy stuff.

My guess is we're not terribly concerned about any changes there in their new capacity.

They've always been a competitor.

Certainly they are a competitor for all the food service people that we serve, the food service customers that we serve.

I don't think it's a real big deal.

We're zero for whatever when it comes to acquisitions other than the merger of Price and Costco back in 1993.

The only time we've ever looked at it is on the half a dozen times a year when it's an unsolicited, it's a tab in an unsolicited presentation from an investment banker

Thanks, Richard.

Your next question comes from the line of Robert Drbul.

Robert, your line is open.

Thanks, Richard.

The question I have is can you just elaborate a little bit more on the trends in the fresh business?

Well, they were generally positive.

They were positive comps.

But produce was the standout app.

Maybe a little of that is pricing.

There's nothing terribly unusual.

I think again, if you look at some of the weather factors, if you look at commodity pricing was a little up in some of those areas, I'm sure that hurts you a little bit.

We don't really see anything that alarms us at this point.

Okay.

And then I guess just sort of bigger picture, Richard.

Do you have any insights you'd care to share with us around the consumer or the economy as you're seeing it from a business standpoint?

Not a whole lot that would I do other than make some stuff up here.

I mean, one of the things I think is continually gratifying when I look at our numbers, is whether our comps were 4 or 12, the frequency has never, in the last I bet you 60 months, the last five years, the last 10 years probably, the frequency other than the change of a number of days or something but the daily frequency has never been below 1%, hasn't been below 1% or above 2%.

And probably three-quarters of those data points are within the zero to plus 1%.

So whether sales are a little stronger or a little weaker, we generally are still getting a slight, ever so slight positive frequency, and that's good.

That means we're doing our jobs as merchants.

Whether it's through couponing or mailers or diverting merchandise that people want or having great pizzas or whatever out there.

And so I think from that standpoint, when I go to the budget meetings every month, I'm still comforted by the fact that the merchants have a lot of things up their sleeves as it relates to new stuff that's coming ing.

Whether it's new manufacturers, brands that historically outsell us, new fresh food items.

I think merchandising-wise,we're still at the top of our game in a lot of that stuff.

And that didn't really answer your question, but at least made me feel better.

The other question I have, Richard, I guess when you look near term or the next couple of quarters, do you think gross margins can continue to improve or will start to improve, be a little bit higher?

Can you just talk about your thoughts around gross margin a little bit more?

Well, what I can say is that as tough as competition out there and it's ever so tough, it's not any tougher or less tougher, but it's ongoing and all the time and arguably when people say who's your toughest competitor, I sincerely say Jim.

So we already have that issue.

I can't tell you with confidence it's going to improve over the next year.

I can tell you with some cautious optimism that the hit from Executive Membership will be less and start to be closer to zero than 10.

I can tell you that Jim and the merchants are working on some initiatives that are real and it's not just willy-nilly raising the price of a few items.

It's looking at some of the thing that we do that -- how do you improve margins -- and sometimes it includes effectively raising the cost and therefore getting a little more on something.

But it's doing it without cheating while maintaining that philosophy.

And Jim is still committed to having pretax earnings, notwithstanding this year and last year, committed to trying to get pretax earnings to grow faster than top line sales.

And so I, again all things being equal, I know that we're also going to, the rate of annual expansion won't be skyrocketing like it has from 15 to 25 to 31 or 32.

It will be more in line with top-line growth.

So even though those are existing market units, which are better than new market units out of the box, they're still much lower than average units, the average of all our units.

So it's a higher level of tempering that will slow down.

That's a positive.

Yes, so when you ask me, how comfortable I am in Q3?

Give me more quarters and I'll be more comfortable, more fiscal quarters.

Clearly, if I look just at electronics, which is what, 5% of sales, 5%, 6% of sales?

Year-over-year, you're talking 100-plus basis points detriment in that department.

That alone should help you a little bit.

So I think a combination of things out there.

Unless competitors get crazy out there, but we're all crazy already.

I don't, and we're all logical, though, level-headed.

There's fierce competition out there.

I think we've been able to show we can do it.

And I mentioned to many of you before, let's not lose sight of the fact that on a cumulative basis since we started the 2% reward back five years ago, that has hit margin for 84 or 85 basis points.

So even though reported margin the last year or two have been flat or down a little bit, our margins over the last five years have been up slightly, even with higher competition, stronger competition, and an 84 basis point hit from that.

So I'm encouraged that we have the ability to do it.

It sometimes doesn't come as smoothly and as quickly as we all like.

Thank you, Richard.

Your next question comes from the line of Mark Miller.

Hi.

Just trying to understand a little bit better the gross margin trend, and specifically talking about the merchandise margins down 11 basis points where they were up 8 basis points last quarter.

Were you saying that the change in that trend has been exacerbated by more returns in the second quarter?

Because presumably that was hurting you last quarter as well.

Or is it more there's been more deceleration in fresh food or is it something else?

I think it's both.

First of all, we have our new methodology which again, while most of it's cumulative, some of it's the quarter.

In addition, we have even a percentage point or two of comps lower than you had planned originally, hurts you a little bit, and a little deceleration in fresh foods hurts you a little bit.

None of those are insurmountable, though.

I mean that's what we do for a living.

When you look at the comp trend over the last few months, any observations when you look at the business customer versus the individual customer?

Interestingly, the two customers have been pretty darn close in terms of pretty darn consistent so we haven't seen any dramatic change in trend between the two.

Last question would be on the traffic.

How much do you think the in-store traffic has been impacted by the stabilization of gas prices year-on-year?

My understanding is that half the people that go to get gas also come into the store.

As we lap higher oil and gas prices in the summer, should we think of that as a tougher comparison or is that not material?

I don't know that we've ever looked at in it that way.

I think something that helps our comp a little bit, interestingly, is the infills.

If we're now a 15-minute drive instead of a 30-minute drive from you, you're more likely to come a little more often.

I think as gas prices went from the high ones to the high twos, probably we saw some benefit from that.

I'm not so sure that it's discernible with all the other factors as it goes up or down $0.30.

Okay.

Thanks.

Your next question comes from the line of Peter Benedict.

Thanks, Richard.

On the membership fee income, can you talk a little bit about what we should be expecting in terms of the growth rate in the back half of the year?

It looks like things grew about 14% in the first half.

I would think that, again, without giving away the hat here, I would think that you basically, once the $5 increase was initiated, while it was initiated May 1st for new sign-ups, the bulk of people are existing members and that commenced July 1st.

So kind of from July 1st to June 30th, it should be a slightly ever-increasing benefit.

So that rate of growth should continue, if not improve a shade, over the next quarter and a half, two quarters.

Great.

And then just, can you talk a little bit about maybe what you've seen consumers do with respect to spring product in markets where you have had a break in weather?

Have you seen a meaningful pickup there?

Honestly, I haven't looked at it.

It's almost too early.

I mean, the Floridas and the Arizonas and the southern Californias, they're used to it.

I have not looked at it, I'm sorry.

Thanks so much.

Your next question comes from the line of Dan Geiman.

Good morning.

Regarding the wage increase, what was kind of the methodology behind it?

Is there anything you can add there, recognizing that obviously you're pretty generous with your employees?

Also, when was the last increase that you took and would you expect a similar interval going forward?

The methodology is not clearly not as scientific as you might think or hope.

Basically the ongoing discussion that we have every month with our operations people, with the challenges, one of the observations that in some markets, notably California or parts of New York, in some locations, there's been something over the last couple of years, last year and a half, we've had to raise the starting wage in given locations just based on the ability to hire the right people.

And so, and the fact that others have raised theirs so the spread has come down some.

I think it's been six years since we changed the bottom of the scale.

And you mitigate it a little bit by changing the hurdles.

If your traunch is to get from bottom to top, six years ago was a full-timer, 3 1/2 years and then it was four and now it's maybe a little more, so we've mitigated a little bit that way, too.

But it's, I can't tell you when we're going to do it next.

We like to have a good spread.

We're more based on the observations that we see in some of our markets.

And we're not prepared to have different wage structures in different markets in the U.S.

Okay.

Thanks.

Your final question comes from the line of Daniel Binder.

Hi, it's Dan Binder.

Just on your last comment about not having different wage structures across the country, I guess just out of curiosity, what is the logic behind that?

It would seem like in some of the lower cost of living markets, that would maybe be an opportunity to optimize it a bit.

Well, one would think.

You'll to have ask Jim that.

It's always been that way from our inception.

It's simple.

It's easy to understand.

We do have people transferring among locations.

And a lot of people, particularly when we've gone into new markets, some of which are smaller markets.

And the view of the operators and Jim has always been is is that it's easy to, maybe it's expensive, but it's easy to do.

And it eliminates any risks that are sometimes caused when somebody is being transferred.

And on the tobacco issue in Canada, in the past when we've seen price increases, whether it was in the U.S. or in Canada, typically it's been like this one month hit and then you kind of go back to normal but this time around it sounds like January and February were hurt.

Was that just because the price increase somehow straddled the month or was there two price increases?

Jeff is here.

It was the last week of January and the first week of February so it did straddle it.

That's the biggest reason.

So then next month it goes back to a more normal?

I would think so.

Except for the imperial piece, where we, the largest manufacturer of the most popular brands.

That was like a 25% hit before in prior months.

Is that kind of roughly what would you expect going forward?

Maybe there's a also piece that you catch up because people bought more for the price increase from a year ago.

Okay, and was the -- I know the Chinese New Year shift hurt you last month.

Did that, how did that benefit the international and overall comps this month?

I think -- wasn't it the last week of January that it helped us, Bob, or was it this year?

It was in February, hold on.

I got it here.

If I look at Korea and Taiwan, good example, in local currencies, Taiwan for the first two weeks of February or the calendar February, were comping over 100%.

And I think they were comping negative teens the two weeks prior to that.

Or negative 30.

Korea, same thing.

Not over 100, but between 50 and 80 in the first two weeks of the month.

So, if I look at, interestingly, Canada, remember, Taiwan, Korea are nine locations.

Canada is 70.

Canada in local currency was ever so slightly negative as it has been for a number, it's actually much less negative than it had been in local currency.

And then actually the U.S. dollar at least in the month of February, strengthened relative to it, so Canada in Canadian dollars in February was at minus 1 and U.S. dollars was a minus 3.

That more than offsets that plus 100 for those two weeks in Taiwan in four locations.

And Canada, of course, is and tobacco in Canada is hurting you, too.

So if you isolate the Chinese New Year shift itself.

I guess I'm just trying to get an understanding on what the run rate is for international if you sort of take out some of these --

Year-to-date in local currencies, ex-Canada, international is at 11.

Okay.

In local currency.

And in U.S. currency, it's 17, because the dollar has been weaker.

Okay.

And then last question was, with related to the TV return policy.

I think the conventional wisdom has been that there was about a $0.07 to $0.09 hit on earnings last year as a result of the excessive portion of the returns, I guess what you consider beyond normal.

As that policy starts to kick in and gives you benefit, when we take into consideration that there are some costs associated with extending the warranty to two years and the concierge service, how much of that would you ultimately expect you could recoup over time?

Let me start by saying I think the $0.07 and $0.09 has been a few of the analysts out there that have put out some numbers.

We haven't blessed any numbers although we haven't said they're out of sight or major wrong, either.

Our view when we went into it was that the cost associated with making some of the changes like the extra warranty and the concierge 1-800 number and maybe you still get 70%, 80% of the benefit back.

Okay.

But that again is not going to even start for several months.

Right.

Should we start to see some sort of benefit by Q4?

My guess it would be no earlier than Q1.

If you think about the fact that if a good chunk of your stuff is returned in the quarter but then the other chunk is returned over the next six months, it's really, if I had to say give me your best single-point guess, and this is just a guess, it's easily six months after, six to nine months after you put the policy in place, which would imply the beginning or the end of Q1 of our fiscal year next year.

Okay, great.

Thanks.

Well, thank you, everyone.

And we'll be here.

Good-bye.

This concludes today's Costco's February sales and Quarter 2 earnings conference call.

You may now disconnect.