好市多 (COST) 2007 Q3 法說會逐字稿

Good morning.

My name is Laurie, and I'll be your conference operator.

At this time, I'd like to welcome everyone to the Costco third quarter earnings conference call.

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

After the speakers' remarks, there will be a question and answer session.

(OPERATOR INSTRUCTIONS) Thank you.

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

Please go ahead, sir.

Thank you, Laurie, and good morning.

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 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 third quarter '07 operating results for the 12 weeks ended May 13th.

For the quarter, as you know, we came in with a reported $0.49 a share compared to last year's third quarter $0.49 a share.

As outlined in this morning's press release, excluding the additional sales return reserve adjustment and the associated reduction in gross margin on this sales adjustment taken in Q3, earnings per share would have been $0.56 representing a 14% increase above last year's $0.49 figure and this compares to our March 8th guidance of $0.52 to $0.56 and current First Call of $0.56.

Please recall also that our March 8th guidance included an estimated $0.02 per share hit in Q3 related to the change we made at the beginning of the fiscal year to our method of allocating during the fiscal year certain payroll-related expenses such as FICA taxes.

As you recall, this change, while a zero effect to the entire fiscal year, helped Q1 by $0.01, actually hurt Q2 by a very small amount and also hurt or hit Q3, not by $0.02 but a little under $0.01 and not the $0.02 per share hit that we had originally budgeted or estimated.

Again, it's a zero sum game for the year.

It's a -- it will be no effect on the Company but in terms of comparing to last year.

In terms of sales for the quarter, our 12 week comparable sales figure showed an increase of 7%.

We will report, of course, our four week month of May next Thursday, June 7th.

Other topics of interest or review, our opening activities.

We opened a total of six new locations during the third quarter of the year which ended two and a half weeks ago, five new in the U.S.

and one in Canada.

Such that fiscal year to date, we've opened 23 total units including one in Mexico so 22 net new units in terms of what we consolidated into our numbers during the first 36 weeks of the year.

We have eight additional openings planned in Q4, all net new units before our September 2nd fiscal year-end, so for the year, it looks like we'll be at 30 net new locations in '07 or 31 including the Mexico site.

In the last several weeks, a couple of units had actually slipped out of August into the first quarter of '08 so we have a fairly expansive upcoming fiscal year '08 which I'll talk about later.

I'll also review today the normal things -- ancillary business results, online results, membership trends, certainly speak about the returns policy that was put into place in the U.S between February, mid-February and early April, update you on recent stock purchases, go through your balance sheet, and provide you a little updated direction guidance for the upcoming quarter.

Now as I review with you our third quarter results, similar to what I reviewed during Q2 a month ago -- three months ago, I will discuss not only the reported figures but also the Q3 year-over-year comparison on an adjusted basis.

That is, without the sales return reserve and the related charge to gross margin.

We believe these adjusted results are important as they provide a meaningful comparison of prior period earnings to current period earnings exclusive of these unusual non-recurring items.

In terms of discussion of our quarterly earnings, sales, as I mentioned, were -- total sales were reported at $14.34 billion, up 10% from last year's $13.01 billion.

Excluding the sales return reserve adjustment, sales would have been up 12% year-over-year.

On a comp basis, comps were 7% for the quarter, as I mentioned.

Now, the 7% third quarter comp, excuse me, the 7% third quarter comp was comprised of 6% in the last couple of weeks of February which is the beginning of our third quarter, 6% in March, 7% in April, and just under 7% for the first couple of weeks of May.

For the quarter, our 7% comp report results were a combination of an average transaction increase of just under 5% and an average frequency of a little over 2%, both fairly strong numbers for us.

Included in the average transaction increase of 5%, FX represented about 35 basis points of benefit because of the weak U.S.

dollar.

Gas inflation has come back up a little bit.

That was about 50 basis points so those two together about 85 basis points.

I'll say that of course over the last few years has been our increase in in inflows and in terms of cannibalization, given our ramp-up and expansion, with most of it in existing and inflow markets.

That impacted us by an estimated 150 basis points in the third quarter.

In terms of sales comparisons by geographic region, qualitatively, Northwest was strong, in line with our Company as a whole.

California also showed a nice improvement over the second quarter comp as did Northeast.

Southeast, a little better than Q2 but more to lower end of our numbers, and probably the biggest area that has picked up is our Canada operations, which was slightly negative in the second quarter and pretty healthy positive during the current quarter.

That is both in U.S.

and in local Canadian dollars.

International continues to beat the rest of the Company as well.

In terms of merchandise categories, food and sundries was, as expected, up a little bit, in the middle of the road.

Hard lines continue to be the strongest -- one of the stronger areas of our core businesses, almost double digit.

Soft lines slightly positive but better than the slightly negative in Q2, and fresh foods continuing to do well.

Ancillary still low to mid double digits, and without gas, high single digits.

A little color on the comp.

Within food and sundry, tobacco, which is nearly 11% of our food and sundry sales, as it has been the last couple quarters, was the big impact negatively, the minus 7%.

That has to do principally with in Canada about eight or nine months ago an elimination of a supply relationship with the largest manufacturer up there, not only us but other in effect major retailer/wholesalers of tobacco as they go more direct to small retailers, and so that continues to impact us a little bit up there.

Within the hard lines comp, majors of course, which is electronics, sporting goods and lawn and garden, were the strongest subcategories, all up in the low to mid-teens, respectively.

Within the soft lines comp, small electrics, women's apparel and jewelry were stronger offset by weaker comps in media, photo camera, which includes film, and housewares.

Frankly, very similar to Q2 in the soft lines area.

Fresh foods again up well and produce again the standout among the four subdepartments within fresh foods.

And again, ancillary is -- all the businesses were up and comped nicely during the quarter.

Moving on to the line items in the income statement, membership fees were up 15% in dollars, $317.7 million compared to $276.2 million a year ago in the third quarter, or up $41.5 million.

That's a 10 basis point increase year-over-year but again, in the interest of fairness, looking at it on a normalized sales basis, it would have been up 6% using the adjusted sales figure, 6 basis points rather.

Good showing is continuing to have strong comps, continuing under the deferred accounting method still gets a little benefit from the $5 increase we did a year ago in May, really a year ago in July as it relates to renewals, and as well as the conversions, successful conversions of some of our members to the Executive Membership program.

I would expect to see that continuing over the next couple of quarters, again, benefiting from the deferred accounting nature of the $5 increase as well.

At quarter end, Gold Star member household 18.3 million, up from 18 million at the end of the second quarter.

Primary business 5.4, up from 5.3 million, business add-on flat at 3.4 for a total of 27.1 million households versus 26.7 at the end of the second quarter.

Including adding our spouse cards, 49.6 million at the end of the third quarter, up from 49 million even at the end of the second quarter.

At quarter end, our paid Executive Members continue to grow.

In fact, grew significantly up from what it's been growing the last few quarters prior thereto.

We ended just over 6 million Executive Members, an increase of over 300,000 or 6% just in the third quarter as compared to second quarter end.

That represented about a 27,000 new member, new Executive Members per week increase in the quarter, up from about 15,000 per week in the first half of the year.

Part of that has to do with our own activities where we on an ongoing basis rotate the focus in warehouse of what we call our marketing people do, whether it's tabling activities or other types of Executive Membership activities, or going out and canvassing on small businesses and so part of that is a reflection I think of additional activities that we had during the quarter.

I should point out that roughly 22% of our membership base generated about 54% of our sales, and we would expect that to continue to increase as we see additional conversions.

In terms of renewal rates, it remains at 87%, just a shade, rounding up to 87% but nonetheless 87%, very consistent with what we've seen in the last few quarters.

We've really seen very little resistance to the $5 increase implemented last year.

Going down to the gross margin line, our reported gross margin in the third quarter, which of course included the impact of the sales return reserve and the associated margin impact.

On a reported basis, it was year-over-year, it was lower by 34 basis points from a 10-55 last year to a 10-21.

As you'll see in a moment, the adjusted impact, excluding the unusual item, showed the year-over-year margin lower by 19 basis points, fairly similar to the year-over-year delta in Q2.

Before I ask you to jot down a few numbers let me give you an explanation of the sales return adjustment and how it impacted Q3.

As you know, we also had an impact in Q2 as we this year, we had taken on a fairly substantial task of going back and looking at a lot of historical data.

Much -- some of that analysis has been completed at Q2 end, and we booked to those numbers as we should appropriately.

During the course of the last quarter, we completed much of that analysis and booked at a remaining based on that new data.

So, basically, let's go back to Q2 and what we did and it's pretty much similar.

This relates to the previously announced review of historical data of trends in sales returns, used to estimate future returns recorded in our reserve balance which is further and hopefully final analysis that we began earlier this year, and again, of course, we booked something in Q2.

Please recall that earlier in the year in connection with reviewing the recent changes for our returns policy, we performed a much more detailed analysis of our return patterns than we had ever done in the past.

Once this operational data became available, we determined that it should be also considered in estimating our reserve for sales returns.

Prior to Q2, if you recall, our estimate of the reserves for sales returns was largely based on information that reported returns as a percentage of sales.

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

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

Our analysis earlier this year provided us with new information that indicated that the lag time returns was longer than previously estimated.

And therefore, our revised estimate contemplated a longer average lag time in which returns are expected to occur.

With our new study indicating the need for an increase in these reserves, we also reviewed our assumptions as to the estimated realization rate on the value of merchandise expected to be returned.

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

In reviewing the information, we had also revised downward our estimated overall recovery rates on returned merchandise.

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

Ultimately, at the end of Q2, while recognizing that additional information was still being gathered and analyzed , we used the preliminary data available at that time to increase the reserve balance to reflect our best estimate of future returns.

This resulted in an adjustment to sales in Q2 of $224.4 million and a pre-tax charge to gross margin of approximately $48.1 million.

Over the past ten or so weeks, we gathered the remaining historical data and now have a more complete and very up-to-date in the sense that it's through the actual third quarter end of all returns, picture of historical returns patterns.

These historical return trends were worse frankly than those indicated by the data that we had included just a quarter earlier that related back to '05 and '06 data.

And therefore, we determined in our sales returns reserve, estimates should be increased further and that's what we did in Q3.

In that regard, in Q3 we booked an additional $228 million in sales returns reserve and an additional $47 million in associated gross margin reserve.

I was asked internally and just to be clear that the current balance of our reserves at Q3 end has only a very nominal impact of any anticipated impact of the new returns policy, recognizing that as of Q3 end, very little merchandise sales have occurred that are even subject to the 90-day return policy.

So that's something that we would expect to see an impact of over the next several quarters, really into fiscal 08.

Now, in terms of reported gross margin, as I always ask you to do, to jot down the following numbers, we'll start with the third, let's do the third quarter column but in terms of merchandising is line one, year-over-year, the merchandising impact was minus 11 basis points in the quarter.

The 2% reward, line two, was minus seven.

LIFO was zero.

The returns gross margin adjustment, that would be the $47 million I talked about, was minus 32 basis points.

The sales return adjustment, again because we have a different denominator depending on if you include or exclude the impact from the sales return, was a plus 16 basis points.

And if you add up all of those, that's how you get the reported comparison of a 30 basis -- 34 basis points year-over-year comparison.

So looking beyond the non-recurring item, adjusted -- what I'll call adjusted year-over-year change in Q3 was the sum of the 11 and the 7 basis points that actually rounds to 19, but the sum of the 11 and 7 basis points, 11 in merchandising and 7 in 2% reward.

Now the 7 is pretty straightforward.

It's simply a function of the increasing penetration and success of our Executive Membership program.

As I mentioned in the past, while it is still a negative impact to the reported gross margin, it is continuing to come down as we see a slightly declining level of new increases in those numbers but nonetheless should dwindle down over time but still be a slight negative impact over the next couple years.

In terms of our overall merchandising gross margin, which again on this comparison was 11 basis points year-over-year, our core merchandise business, which is about 80% of our sales, food and sundries, hard line, soft lines and fresh foods, as a group was down year-over-year by about 10 basis points.

I might add, I think in Q2 that same group was down about 20, so year-over-year, so we did see a relative improvement in that.

Within these four major departments, food and sundries and soft lines were both higher year-over-year by a fairly good amount.

Hard lines and fresh foods were down.

Now hard lines, of course, significantly impacted our higher cost of dealing with returns.

Keep in mind, in the third quarter, we're talking about nothing that was impacted by a change in returns policy because this is all returns that were done prior to -- that were grandfathered into the old policy.

In fact, just the electronics department, within hard lines, which is about 9% or 10% of our total sales now electronics, that was more than all of the 11 basis points of impact to the Company's merchandising gross margin impact.

That's how much of an impact and that has nothing to do with the quarterly adjustment.

That has to do with just the ongoing number.

Now, despite fresh foods margins being down year-over-year in Q3, again the delta was much less than in Q2, and as I mentioned last quarter, I felt that was more of a little bit of an anomaly with what was going on in fresh foods with some of the prices and availability of goods.

Also, Q3 gross margins were, I've already mentioned, the Executive Membership.

The question I've asked often is profitability of our pharmacy.

It continues to be strong, up year-over-year in terms of margin as a percent of sales.

To just review very quickly our returns policy change, this is something that we rolled out in the U.S.

between February 26th and April 2nd, so over about a five-week period.

This impacts about 75% to 80% of our what we call Department 24, our majors department, so and it includes the following categories: televisions, computers, cameras, camcorders, iPod and MP3 players, and cellular phones.

There's a couple of things.

First of all, it's a straight across 90-day return policy, bring it back open or unopened, we give you a full refund.

There's no restocking charge.

In addition, on televisions and computers, we've increased the warranty.

Whatever the warranty is normal, we've increased it to a total of two years so if it's a year warranty, it's now a two year warranty, but you can't bring it back to Costco.

You go through the warranty process and we pay for it.

On larger TVs, TVs greater than 32 inches, the warranty service will be provided in home as required.

In addition, we've set up a Costco concierge technical support calling service, which we're getting a lot of calls on and we think that that has a bigger impact of getting even some of the shorter term returns where customers are frustrated by simple tasks such as even simply downloading music on to an iPod or how do I set up or how do I plug my TV into the wall, and so we're hopeful that that should help us a little bit as well.

But all those, while that will certainly increase the cost relative to perhaps industry standards out there of a much lesser return policy, we still think it could be a significant impact on our experience over the last few years in this category.

In terms of our outlook for going forward, reported gross margin in Q4, again we'll continue to be challenging, again particularly in hard lines before the real impact of the return policy kicks in next year.

Keep in mind, while purchases made in Q4 in the U.S.

are subject to the 90-day rule, many of the returns may still be related to stuff that was grandfathered in prior to the enactment of it so we would expect any benefit to start to slow in but on an increasing base over the next year.

Really LIFO has been an impact for the last almost two years on average.

Any small inflation in some categories is more than offset by deflation principally in the electronics area.

Overall, I think again what we found is our core merchandise group should be okay and hopefully we'll see that okay directed towards the electronics area over the next year as well.

On the second quarter conference call, and I'll mention it again now, but it's more qualitative and I can't give you lots of specifics, is we are mindful of our margins and we are implementing initiatives under Jim's direction to improve margins over the next couple of years, subject of course to competition.

We're not going to do anything to compromise our competitive levels.

But we think we're smart enough to be able to do both, be competitive and improve our margins a little bit, and I can't be anymore specific than that, but we are focused on that as we put our budget together for the upcoming fiscal year under Jim's direction.

In terms of our ancillary businesses, we've added a few to everything.

The print and copy centers we went from nine to eight so we closed one of them, very small business frankly.

All of the other ones, pharmacies, we added six to be at 422; food service, we added six to be at 474; one-hour photo labs, six to be at 472; optical, six to be at 464; and we continue to grow our hearing aid business from 220, up seven more to 227; and we added four gas stations during the quarter to be at 272.

Now, moving on to SG&A, our reported SG&A percentages year-over-year were of course also impacted by the sales returns adjustment.

Including this on a reported basis, SG&A year-over-year was higher or worse by 13 basis points coming in at a 999 versus a 986 reported a year ago.

Again, ask you to jot down a few numbers and I'll give you the last couple of quarters just so you can see the comparison.

And the line items would be operations, central, stock options or RSUs,, 409A which was the second quarter adjustment to protect our employees on adverse tax consequences, sales returns reserve, and total.

Looking across, which again two columns, Q2 '07 and Q3 '07, operations was plus three basis points year-over-year in Q2 and plus eight basis points in Q3 meaning lower or better by that many basis points.

Central was higher or minus one in Q2 and flat year-over-year in Q3.

The impact of stock options, and this has to go -- this goes back all the way to fiscal '03 when we voluntarily began expensing options.

That has a rolling impact over several years as more of the number went in, became vested and hit the P&L, so cumulatively we probably had a 30 basis point hit to SG&A over the last five years.

We would expect in the future that to really grow normally and not really be a big plus or minus basis point number but nonetheless in Q2, it was a five basis point hit or minus five, and in Q3, higher by four or minus four.

The 409A in Q2, of course, was the $46.2 million options expense, again to protect our employees from adverse tax consequences from the issues with stock options.

That was a 31 basis point impact in Q2.

It was a minus one, higher by one basis point or minus one in Q3.

That's simply a trueing up of less than $1 million pre-tax in the quarter.

We'll see small little true-ups like that relative principally to some of our overseas employees as some of those governments haven't completed, haven't gotten back to us or we're still in the process of talking with them.

Sales returns, and again this has to do with the $228 million adjustment affecting the denominator in this calculation.

In Q2, that was minus 15 basis points and in Q3 minus 16.

So total for the year, of course, in Q2 is 49 basis points year-over-year higher and as I mentioned in Q3, 13 basis points higher.

When you take out the 409A and the 16 from sales return, as you can see, as is the core business was better by eight -- up by eight.

Stock options, of course, which should start to go away after this year was a minus four or higher by four.

So let me give you a little editorial.

In terms of the improvement of eight basis points year-over-year in Q3, that's actually the best number on that line in several quarters.

Our payroll percentage print percentage is using the adjusted sales figure, were actually up a couple of basis points year-over-year but various expense accrual, including various components of our benefits and insurance and healthcare, were lower or better year-over-year.

Payroll actually would have been down very slightly, a basis point or two instead of up, excluding the March increase in our bottom of the scale wages.

Now that's part of our Company and it was the right thing to do and we should see that impact our number by a few basis points on an ongoing basis through next March.

Next, our SG&A percentage was impacted, as I mentioned, by the $228 million.

Again, that was a big impact that hopefully is an anomaly and we wanted to take it out in our comparison purposes.

The last thing that is not in the matrix and I'll just spend a moment on was again this change in how we accounted from the beginning of the year of certain payroll expenses, payroll related expenses like FICA, Social Security.

If you recall, we are of course a September, we begin our year in September, and historically, we always basically charge that throughout the course of the year almost on an amortizing basis when in fact the actual numbers and a more correct way to do it is to do it when it's paid.

Given that peoples max out on things like FICA, certain people max out on it as they get near the end of their calendar year, there's actually less of a FICA cash expense to the Company in the first fiscal quarter which is the last calendar quarter of the year and more of course as we start January.

Recall from the beginning of this fiscal year that had an impact of benefiting Q1 by about $0.01 a share, having the minor effects in Q -- anticipated effects in Q2 and Q4 and having a bigger impact -- negative offsetting that in Q3.

While that impact again was about three basis points hit to SG&A, as it was in fact in Q2, but I wanted to point that out so our numbers in Q2, while we showed operationally we were better by eight, taking that anomaly out, we were actually better by a little more and again that's an absolute zero sum game for the year so we don't expect any big number in Q4 at all in that which pretty much close so zeroed out through the three quarters.

In terms of the SG&A outlook for the remainder of of fiscal '07, payroll will be a challenge particularly with the dollar increase.

That's costing us, as I mentioned, in the second quarter a little under $3 million a month, and of course, we hopeful we're starting off decent, with decent sales and hopefully that will help us a little bit.

Next on the income statement, in terms of outlook, what I didn't put in my little notes here, was outlook looking forward into next year.

Again, a lot of it is going to be based on comps assumptions.

We should continue to cannibalize our locations as we continue to ramp up expansion a little bit but I guess -- I think the level of ramp-up will be a little bit more normalized in the future.

As I mentioned, the expense on an annual basis for ongoing equity related grants which are now RSUs instead of stock options but kind of the same book kit economically.

Now that we've kind of anniversaried the voluntarily expensing of those starting in '03, I don't expect any big change plus or minus a basis point or two going forward so something that's been hitting us for five or six basis points and in fact four basis points in the current quarter, once we get past Q4, shouldn't be a big impact at all.

And then of course we'll anniversary the dollar an hour increase starting in the third quarter next year.

Next on the income statement is pre-opening expense.

About a $1.4 million lower than a year ago and coming in at $9 million versus $10.4 million a year ago so improvement of 10.2 basis points.

No surprises in both quarters.

Q3 last year and this year we opened six new openings.

In terms of provision for impaired assets and closing costs, last year we had a $1.2 million charge.

This year, just under $1 million charge for the quarter, no big change there.

So all told, reported operating income in Q3 was down year-over-year from $355 to $339 million this year.

However, excluding the sales return item and the associated gross margin impact, Q3 would have been higher by 8.5%, $385.3 million versus -- would have been higher by $31 million to $385.3 million and excluding that change in accounting that I just mentioned on the payroll-related taxes, operating income would have been up right around 10%.

Below the operating income line, reported interest expense of course was higher year-over-year in Q3 coming in at $26 million this year versus only $2.7 million last year.

This of course reflects the $2 billion debt offering that was effective the first day of this fiscal quarter.

As I mentioned on the last call, our $2 billion debt offering, we completed it in February, $900 million, five-year debt at a 5.36 all-in and $1.1 billion of ten-year debt at 5.57 all-in, on average about 5.47.

The debt was booked on our balance sheet in Q3 as the transaction was funded just at the beginning of the third quarter.

Interest income and other correspondingly since some of that money hasn't been used yet and was up and of course we have spent cash over the last year though as we've bought back stock, but interest income and other was up $9.1 million in the quarter, $42.8 million this year in Q3 versus $33.8 a year ago.

So overall reported pre-tax income was down year-over-year to $355.9 million, but on an adjusted basis, pre-tax income was up about 4.5% versus last year from $385.8 million to an adjusted $404 million this year.

And again, up about 6% without the $4.5 million -- that 4 plus million dollar hit from the payroll taxes.

Now in terms of our tax rate, looking back over the last several quarters, there was a little anomaly upward last year to 38.93% in the quarter.

This year it's been a little more consistent each year and coming in at the third quarter at 37.06%.

In terms of our balance sheet, at the end of the quarter, cash and equivalents $3.821 billion, inventories 4.955, other current 914, total current 9690, net PP&E $9.098 billion, other 750, for total assets of $19.538 billion.

On the right hand side, short-term debt 62, accounts payable $5.189 billion, other current $3.336 billion, for total current of $8.587 billion.

Long term debt, again and this includes the $2 billion we just raised, $2.159 billion, deferred and other 244, for total liabilities of $10.990 billion.

Minority interest 67, and stockholders equity at $8.481 billion.

That number of course going up with earnings and down with stock repurchases.

Total $19.538 billion on that side as well.

Balance sheet even with the data is quite strong of course.

In terms of accounts payable, at third quarter end, you'll note that we had 5.

-- almost $5.2 million of accounts payable compared to just under $5 billion in inventory so a reported basis 105%.

That compares to a year ago of 101% so a little improvement there and that of course includes payables from construction as well.

If you look at just merchandise payables, a year ago, merchandise payables as a percent of inventories was 85% and this year, it's up a percentage point to 86%.

In terms of average inventory per warehouse, at Quarter 3 end a year ago, it totaled $10.322 million.

I'm sorry, last year, I'm sorry, a year ago was $9.835 million.

It was up to $10.322 million at the end of the third quarter so that represents on average a 5% increase in inventories or $487,000 per warehouse.

Now that's down in Q2 year-over-year comparison was up 8% or $750,000 and as I mentioned, there really were no problems.

Inventories were clean.

It was pretty much across-the-board.

Some of it has to do with increasing electronics.

Some of it has to do with some of the couponing we've done and building up inventories with some of those items but our goal is still to get our inventories actually down over the next couple of years on a year-over-year basis.

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

Year-to-date, we spent just under under $900 million, a little under our under our budget, as some of the locations have slipped into next year.

I would estimate that our CapEx this year will be more likely in the $1.3 to $1.4 billion range instead of the $1.4 to $1.5 billion range that I anticipated a quarter ago.

In terms of our dividend, last month we announced an increase in our quarterly dividend from $0.13 a share to $0.145.

This $0.58 per share annualized dividend represents the cost of the Company of just about $250 million annually.

In terms of Costco Online, during the quarter, a 38% sales increase and a 41% increase for the 36 weeks year-to-date, and this is of course on top of last year's increase of 61% for the entire year.

Sales, as I mentioned, in each quarter, will exceed $1 billion for this fiscal year.

In terms of expansion, I mentioned we are going to open 30 -- it looks like we will open 30 units this year, plus one in Mexico.

Our '08 is going to be a fairly decent ramp-up, recognizing a few have slipped into next year.

We're also, whereas we've had no relocations this year, we anticipate having upwards of 8 to 10 relocations next year.

In total, including the relocations, we expect somewhere between 42 and 47 openings.

If you net out the relos, net openings would be somewhere in the 33 to 38 level, up from the 30 this year.

Now, if you look at the 30 units on last year's consolidated base, I think consolidated I'm excluding the 30 units in Mexico, but if you look at the 30 we added this year, for the year that represents a 6.6% unit growth and right around a 7%, maybe a shade under 7% square footage growth.

We ended the quarter with about 67.5 million square feet of retail space.

Lastly, let me talk about stock purchases.

Since June of '05, we have purchased through the end of the third quarter approximately 66.1 million shares at an aggregate price of $3.39 billion or $51.36 a share.

So we still have repurchase authorization under our program of approximately $1.1 billion which authorization expires in 2009.

In Q1, we purchased 420 -- and these are all three of these quarters, Q1, Q2, and Q3 are 12 week quarters.

In Q1 we repurchased $425 million of common stock; in Q2, $481 million; and in Q3, $614 million.

Looking at the 36 weeks today and simply annualizing it over 52 weeks, that would represent an annualized rate of about $2.2 billion year-to-date.

And I would expect us to do what we've done in the past on an ongoing regular basis at least for the time being.

Before I turn it back to Laurie for Q&A, just a little direction for '04.

First Call I believe is at $0.83.

As usual, that will be at the top end of my range.

I would expect a range probably in the $0.81 to $0.83.

Now, compared to last year's $0.75, that range would be in the 8% to 11% range.

Recall, however, that last year's $0.75 was a 17-week quarter with a 53-week year versus a 16-week quarter so if you simply normalize the quarter to 16 weeks and round upward to maybe $0.71 last year, simple math, that would imply an $0.81 to $0.83 being more like a 14% to 17% increase.

Again we hope we can get there.

It's subject to sales expectations and we'll see how we do.

So far so good, but we're only a couple weeks into a 16-week quarter.

For the year, that would put the year compared to First Call at $2.56 at $2.54 to $2.56 compared to last year's $2.30.

That would be a 10% to 11% increase.

Again, adjusting for the extra week, that 10% to 11% will be a 12% to 13%.

Looking ahead, membership continues to be fine.

There's no indication that we should see any change there.

Margins, again, expect a little bit of a negative hit to margin because the increasing penetration of Executive.

We should see a positive impact from the returns policy.

How quickly it comes we'll wait to be seen but certainly into '08 we should see some of that and as I mentioned, some concerted initiatives on our part and I'm sorry I can't be more specific about it, but we are doing things to try to improve margins a little.

SG&A, the negative, if you will, from year-over-year from stock options over the last five years should be done.

Again I'm sure it will fluctuate plus or minus a basis point but not in terms of on an going 4 or 5 or 6 basis points on an ongoing basis.

The slight negative from the bottom of the scale increase, again we're a little under half a year into that or by year-end we'll be a half a year into it so that will anniversary after Q2 and next year.

With that, I'll turn it over to Laurie for Q & A.

Thank

(OPERATOR INSTRUCTIONS) Your first question comes from the line of [Mark Nowakowski.] Mr.

Nowakowski, your line is open.

Your next question comes from the line of Deborah Weinswig.

Good morning, Richard.

Some of the office products superstores have said that they are seeing a slowdown in small business customers.

Can you elaborate on any issues you might be seeing in your business or if you think it might be just specific to those retailers?

Well so far, I'm hopeful it's just specific to other retailers.

We haven't seen any dramatic change in our mix between wholesale and business customer.

So and again, our comps in the last quarter have actually been a little better than they had been in the first half of the year, so at this point, the answer is no.

We haven't seen any impact.

Okay, and then can you also discuss and maybe provide some color on the Martha Stewart exclusive and the gross margin policy around exclusives as well as should we maybe expect to see more exclusives in addition to private label continuing to grow?

Well first of all, I think it got a little more press than one would expect relative from our side to start with simply because they indicated the announcement of inking a deal.

The deal was I think one or two days old when that was announced but it was in line with their quarterly numbers.

We're excited about it.

We've done other what I'll call co-branded opportunities with Newman Zone and Quaker and Starbucks and others.

We're thrilled to be able to do this and together we'll develop some products on the food side and there's really not a lot to say other than that at this point, we're in the process of doing that.

In terms of margin policy, our margin policy for all products is 14 on branded and 15 --- no more than 14 on branded and 15 on private label.

This would be in the private label category as a co-branded item, but it doesn't mean that everything will be 15.

Some of that of course is based on competition.

Some of it is based on certain pricing points.

My guess is having a co-branded item does lend it to have at least a fair margin which some other retailers would argue that 15 is unfairly low.

We look at that as on the high end of fair, so again, there's nothing specific to that item that will be any different other than the fact that sometimes we can get a little closer to our own fairness, if you will, by having a co-branded item.

Okay, and then when you're giving us a percentage of items that are private label, would you include your exclusives in there as well?

Well, I would include our co-brandeds, yes.

Okay.

And then last question, obviously you discussed on the last quarter call and alluded to it here as well in the fresh foods side, can you maybe just talk about what you think is happening with that business and is there any change in terms of competition, etc?

Well, it's still good business.

I mean I think for several years, we were enjoying mid-teen comps in that business as just dependent every quarter was like clock work.

It's still every quarter -- generally every quarter stronger than the Company's comp.

I think this quarter it was in the high singles and so it's still an important part of our business and expanding.

More important -- as important, not only is it a profitable business into itself at a good margin, it is also a business that we think distinguishes us from others in terms of the quality and we continue to roll out new items in that area, so I would expect to see its comp, if you will, at least that's our plan, for it to grow at a rate faster than the rest of the Company in part because we continue to find new things to expand into in that wide category.

Now, in terms of competition, probably the toughest component of it which is half of fresh foods is meat because we're competing not only with the other two warehouse clubs, but every supermarket and specialty supermarket out there and as you well know, every week, there are ads in the paper.

Not that all meat is the same quality, it's all healthy and good but there's of course Good, Select, and Choice, and when you see our presentation, I think it tends to be at the upper end, but nonetheless even at the upper end, our direct competitors, most importantly Sam's, as well as large supermarket chains tend to be very competitive whether it's ground beef or steaks.

Okay, great.

Thanks so much.

Your next question comes from the line of Charles Grom.

Thanks.

Good morning, Richard.

Can you speak to the cadence of TV returns during the quarter and if you saw a spike during the February 26th to April 1st period, and then also what you guys learned when you went back and studied the historical data a little bit more on the kind of the pattern of returns or the aging of returns?

Well, first of all, in terms of, we actually expected a little spike simply because sometimes even though we didn't make any formal announcement of the change in policy, it was out there pretty quick and looking at some local newspapers around the country, one headline that I remember that I liked the most was, you better bring everything back now because things are changing, when in fact that's not the case.

Anything purchased prior is grandfathered in.

We saw, according to Jim, he said he saw a little spike in the first couple of weeks, less than expected, and we've actually just in terms of actually looking at actual returns in a given week versus sales that week, as kind of ongoing percentage, we've seen a very slight dip in that number in the last month, but that arguably shouldn't relate to the return policy change because very little, if you think about it, if today is May 31st, the earliest change we made in mid-February, so mid-February, mid-April, mid- May, we're only 75 days.

The most impacted item purchased is 75 or 80 days old.

It can't be brought -- it's still, anything out there that's bring backable is still bring backable, if you will, returnable I guess is a better word.

And so in that regard, I can't explain why this month is a little different other than maybe people think hey, they got this new return policy, I can't bring it back.

So really that's going to be more impactful over the next 12 to 18 months, I think.

In terms of what we saw differently, keep in mind again, historically, it was a fairly, a more simplistic approach that didn't delve down to the item.

When we were doing our analysis initially earlier in this year with making decisions on what we would do in terms of changing return policy, we had IT drill down to the item.

Now think about it even though they are computers and they are fast, it literally was a time cruncher and a massive eater of computer time because literally, we took every returned item and I tried to identify when it was returned.

I'm sorry, when it was originally bought.

Now, when we first started that because of the time crunch, we literally had to look at the item and then look at all the previous sales of that from that member -- identified member in virtually all cases.

Many, most cases you had the identification number, and then lag that.

We originally started with data that was mid '05 to mid '06 data because we could look back further there and we originally, but given the time crunch, we looked back over the course of the year and then extrapolated the last 10% or 12% of the returned dollars because most of it is in that first year.

With that indicated, needless to say, at Q2 end was a big change in what we had historically booked.

That's what we booked and we booked to those numbers.

Unfortunately in accounting, you have to book to data, make it -- and these are estimates, but we booked what we felt was the correct estimate.

Now what changed during the next 10 to 12 weeks?

During the next 10 to 12 weeks, we completed that study, not only completing it in terms of going back beyond a year, but completing it in terms of looking at all data from the middle of '06 to the end of Q3 '07.

Well, two things happened.

The tail on that last 15% or so which we extrapolated over the course of a year and beyond looking backwards, had a longer tail on it than we anticipated, than we estimated, and secondly, lag data, even for the current 12 months looking backwards, so what was returned today, looking just back to the last 12 months, people in the last five quarters compared to the previous five quarters, so Q2 '05 and '06 versus Q3 '06 to Q3 '07, are taking longer to return things.

Now, why I can't tell you, but those things together added up to a big chunk.

Now, why didn't we know that?

When you have a big chunk in front of you and you're looking at it and it's based on literally millions of items returned that are only a year and a half old, and it's so bigger than the previous estimate, you figure that's got to be correct but more importantly, that original data that we kind of the first churn of that major study which we completed literally after Q2 end and a few days before Q2 reporting, under accounting rules, we had no choice correctly so to book according to our best estimate was.

We did so during the next 10 to 12 weeks, we completed that.

That's what it is, and now one of the questions I was asked is does this take any impact into the return policy change.

It has a very miniscule impact on that simply because of the fact that as of Q3 end, there are some purchases that have been made over the last 60 days that in the future won't be returned because they will finally anniversary beyond their 90 day from when they were purchased, but that is a very small amount and really any impact from that you'll start to see on an increasing basis going forward.

Okay, but just to clarify, you don't expect any more reserves to hit the P&L in the fourth quarter?

You guys are done with the study?

Yes.

We're done with the study.

We feel it's robust.

It's granular, and I don't want to have to go back to anyone.

Okay.

In all seriousness, it was a study that we took on close to a year ago.

We began it -- our first real data, earlier this year rather, earlier this fiscal year, and our real first data came out just a few days before reporting Q2 and we booked to it because that was our best data.

Okay, just switching gears, second question.

Could you provide some details on your decision to mail the multi-vendor coupon book, I guess over the past couple of months, and what the approach is going to be with the Summer Passport book?

I know last year you kept it in store.

Are you going to mail it this year?

We're going to mail it.

Last year, we handed it out at the warehouse and the savings, of course, is -- I think it was like $5 million to $7 million in mailing costs.

The cost is is does it get in everybody's hands?

How many will end up on the floor or the parking lot, and at the end of the day, the sales data in terms of the multiplier effect of how many more you sell of those items, was about the same.

I mean, ever so slightly less but about the same.

A rounding error, but we felt that -- the operators felt that they probably spent more time, what you do is -- the thought was in the warehouse, they would be sitting there and customers would take them.

Well, every time you walk through the warehouse, you had two employees standing there handing them out, and we probably spent not $5 million to $7 million, but a chunk of that just on standing around handing them out and the other chunk on picking them up in the parking lot.

And then just on the multi-vendor coupon book as well?

Yes.

I don't know if all of those are mailed.

I think we do that both ways still, Chuck, and some of those multi-vendor mailers are done regionally.

Some are done nationally.

I got you.

All right, thanks.

Good luck.

Your next question comes from the line of Adrianne Shapira.

Thanks.

Richard, we didn't hear you call out anything, any impact related to margins due to gasoline.

Should we take away that there was none and if not, how have you been better managing that situation?

The entire management is luck in the sense that we're subject to the competitive vagaries of the nearby gas stations.

We have dipped our toe in the water ever so slightly in some hedges like less than a few hundred thousand dollars worth of risk and impact for one month a couple months ago and on a low margin business, actually even the thought of hedging has gotten a little wild because of the giant gyrations in gas so we're not doing any of that.

Getting to your first question, there really was not a major impact quarter-over-quarter.

So we've got our fingers crossed.

I mean, looking back now versus a few years ago, the negative weeks are a little less negative and the positive weeks are a little more positive, but there's still variations.

I think this quarter everybody's worried about continuing rising gas prices which in theory hurts us a little bit.

We haven't seen it yet in terms of the hurt but I'm not suggesting it's a big, great profit yet either so.

Okay, and then just talking about geographical disparities.

You talked about the Southeast being a little bit better but still at the lower end.

Do you think that has anything related to the housing market and what's going on in the Southeast?

Probably a little, but it also probably has something to do with we've cannibalized there as well.

We've opened some more units in Florida and Atlanta, and even in a couple of the lower cities, the lesser cities like the Carolinas where we have lower volume units but opening a second unit.

Okay, and then just lastly on the guidance.

I just want to revisit that.

If we look back on the last Q2 conference call, you had mentioned at that point Q4, $0.84 was certainly within the range and the year had been $2.50 to $2.60.

It sounds as if sales are still holding up well.

I'm just wondering why the change to the $0.81 to $0.83 for the quarter?

Well, in fairness, I look at our numbers and I look at where First Call is and going through an environment where I still want to be a little conservative.

Recognizing that again, we're still going to feel the impact of electronics in Q4.

We're still going, I can't assume that we're going to have a 7% comp.

I'm hopeful we can but I can't assume that and again, I think there's not a lot of change other than every month we do an upcoming rolling three months, hold on one second.

I'm just kind of leaving it where it is.

If you wanted to add and subtract $0.01 to both sides, you're welcome to, but I think that the $0.83 First Call number is probably a decent number.

I gave it a range from there down a little bit.

I could certainly make the range $0.80 to $0.84 instead of $0.81 to $0.83, but it's again, it's still, we're two weeks into a 16-week quarter.

We don't know year-end, the year-end accruals which we try to be conservative on like benefits and what have you.

We could easily miss any of the two or three different accruals by $0.01 a share, while still managing things well so we'll have to wait and see until we get there.

Thanks.

Just trying to be a little conservative.

Your next question comes from the line of Gregory Melich.

Hi.

Thanks, Richard.

Two questions.

One, could you just make sure I'm thinking about this right on the merchandise margins?

You said that of the 11 BP, basis point decline that effectively electronics, which is close to 9% of sales, drove all of that decline.

Did I hear that right?

Yes.

If I took that department out, 80%, roughly 80% of our sales are the sum of food, sundries, hard lines, soft lines and fresh foods.

About 9% of the 100%, so nine within the 80%, is what I call majors.

If I took majors out of the 80%, the rest of the 80% would have been up a little.

Okay, so really, ex-majors, which is electronics and other appliances --

Yes, I would up a couple basis points.

Okay, so you can say that by an inference then, majors and other appliances had margins down close to 100 basis points?

Over.

Over, okay.

And then the second is --

All of that is what I call D&D.

The impact of returns and salvage and disposition of those items.

But that's not because of the charge.

That's just --

No.

The charge is kind of an inception to date balance as of Q3 end.

Right.

Just looking in the quarter, of what happened in the quarter, our year-over-year margin of electronics or majors is down over 100 and yes, I don't have that detail in front of me.

I think the -- what we -- a gross margin for a given item is the sum of about eight line items.

It's the initial markup, it's freight, it's rebates, it's incentive allowances, it's payment terms, 2%, net 30, it's D&D, which we called damaged and destroyed when you salvage something, so we add all of that up, year-over-year, our gross margin for Department 24 which is about 9% or 10% of sales, majors, was down year-over-year.

Hold on, where is it?

It was down year-over-year by over 1.5 percentage points.

Okay.

And then the bulk of that was due to the returns and salvage?

What I call D&D was a like amount, down over 150 basis points.

The actual initial mark-up of a good, we buy it for X and we sell it for Y.

That was slightly up, very slightly, so it's not a competitive issue.

It's our return issue.

And of course, that has been driving members for three years now on an increasing basis as we're seeing 50% to 60% increases in sales in these -- in this category.

And then my second question is in terms of CapEx, if it's a little bit lower this year but you're going to be doing more openings next year, do you want to give us the numbers or should we assume it's more than $1.5 billion or is there something else we should put into that?

If you want to throw out a number, I'd probably use a $1.6 billion, $1.650 billion.

Okay, thanks.

Your next question comes from the line of Christine Augustine.

Thank you.

Richard, could you discuss what sort of sales trends you're seeing in your seasonal items that have been set in the clubs this spring?

Well, they've been good.

If I look at the three stand-out categories within electronics were lawn and -- two of them were lawn and garden and sporting goods so seasonally, patio furniture and plants and all those things.

And then are there areas within I guess either food and sundries or maybe in the fresh piece of the merchandise categories where you're seeing inflation and if so, what sort of categories are those?

Meat and, hold on a second.

I'll look that up.

Our last month inflation categories, gasoline, of course, was up.

That's not food.

Blueberries were up 20%, shredded mozzarella up over 20% mozzarella, chicken up 12% to 15%, coffee up 12% to 13%, both Yuban and Folger's, and I'm sure other ones too.

This is just the top of the list in terms --

Any dairy?

Any dairy?

Butter up single -- high single digits, cheese I mentioned the mozzarella up 25%, and again I'm sure there's other cheeses but what I'm looking at is a list of about the top 25 based on LIFO dollars.

Okay.

So it could be -- I'm sure there's other cheeses but they don't reflect on this summary sheet.

Do you think at some point you'll be more willing to discuss specifics with regard to gross margin initiative?

After we get it.

I say that, the reality is I'm not trying to be cute.

I'm trying to, as many of you know, Jim's the boss.

Jim has talked with the buyers about what needs to be done to improve margins while remaining competitive and there's some initiatives under way.

Now I'm not trying to be cute or coy, but we're really not prepared to talk about them.

Okay.

Thank you.

Your next question comes from the line of Bob Drbul.

Hi, Richard.

Just one question for me.

Can you elaborate a little bit more in terms of what you think is happening in Canada with the pick-up that you saw?

I'll ask and find out and let you know.

I didn't have a good explanation I know last time and I'm sorry when it was down a little in the quarter on a local currency , but it really sprang back to life this quarter and it was a nice number so I don't have any specifics on

Okay, and then how about California?

Can you maybe just give us some insight in terms of any trends that you're seeing in California with the improvement there?

Well, again, California is one of those markets where we keep cannibalizing.

We have the highest volume units and the most mature units and if anything, if I look back over the last few years, California comps have always lagged a little, if you will.

If we were X, they were X minus a little.

And that X minus a little, that gap got a little wider generally speaking over the last few years.

In this quarter, it sprang back a little, and I can't explain it economically, from an economy standpoint other than it's happening.

Can you just elaborate on how you think we should think about D&A for this year and next year as well?

Just seems to be a little lighter than I would have thought.

Depreciation?

Yes, and amortization.

I think, I don't know exactly what we expect for the year now but if it's $40 million versus $50 million increase.

It's really a function of where we open locations.

If anything, per given location, it should go up a little.

We haven't changed our depreciable lines of items.

The cost of a building and the cost of equipment has continued to go up a little every year, particularly in the last couple years, so again for cash flow purposes, I -- we simply use a rounded $50 million number because it's usually in the $40 million to $50 million range.

Okay.

Thank you.

Your next question comes from the line of Dan Binder.

Hi, it's Dan Binder.

Couple questions regarding the reserve.

I was curious, was there any part of the reserve that was taking as there's a one-time that would have normally been taken in the quarter in the operations numbers?

Well, my guess is there is some.

The question is over how many years do you go back.

Right.

Clearly with the impact that we see on, if you look back to, as an example, I think it was I looked at some numbers back in -- if you look at the current nine months, the dollars returned every day represent -- a little over 50% of the dollars are electronics representing, so it's only 9% or 10% of sales dollars and 50 plus percent of returned dollars.

If you look over a few, like '04 I believe I looked at, it wasn't, it was like 7% of sales and a third of the return dollars, and my guess is is the return dollars related to electronics have had ever higher disposition costs related to salvage because you're talking about big ticket items that depreciate.

I can't, it's hard to go back and estimate what piece of it, if you assume that the sales returns reserve at quarter end, total Company, conception to date, is is around $600 million in sales and a little over $100 million in margin and disposition costs, I can't estimate how much of that relates to this year, last year and the year before.

My guess is is certainly half of it or more relates to the last three years, so is it $0.01 or $0.02 a year?

Could be, but there's no way to know that.

Recognizing if it were, it was something that was also in the prior year some amount.

My guess is the delta year-over-year on a correct basis would have been a nominal increase but again, Dan, I'm not trying to skirt the issue.

What we know it is now, we haven't done the study as of each quarter end.

Okay.

I realize you don't want to discuss a lot of the details behind the gross margin initiatives that you mentioned but I mean in terms of magnitude, is this a 20 basis point opportunity, 50 , 100?

I realize that would be very aggressive but

100, it's less than 100, but again we have to realize it first.

And my guess is it comes over a couple of years but there are things that buyers have changed and other components of our business have changed, starting in the next few weeks that we're implementing.

Okay.

Now when I say next few weeks, that doesn't mean you get the full impact for ten weeks this quarter because it's a starting process.

Hopefully you're starting to get a full impact of something or a better portion of an impact starting in next year.

And is it starting point would 20 basis points over a couple of years seem reasonable?

I would go out on that limb.

What's that?

I'd go out on that limb.

Okay.

And then with regard to the extended warranties that you've put on electronics and the concierge service, how much would you say that's costing you?

Obviously you're going to gain something on the return side but you're spending a little bit more to get -- I'm assuming you're spending a little bit more to get the extended warranties and obviously the concierge service.

What would you say -- what would you estimate that's costing you?

We're not disclosing it but we're booking something now for that, well, the cost of concierge service we're booking now.

Yes.

The cost of the second year warranty, we're booking based on estimates from outside people in this business but that included the cost of sales for that department going forward.

Okay and then final question relating to coupons.

Seems to be a little bit more use of coupons as you get greater share of vendor support, in the last several months.

I'm curious as you think about this quarter versus this quarter last year, is there, would you anticipate a significant benefit?

I'd say significant meaning a point or more of benefit from the way you're couponing versus last year?

I think it's a point or more, is it more than a quarter of a point?

It could be in a given quarter.

But I'd say it's been a evolutionary change, not a revolutionary change, over the last number of years but looking at a -- in a given week, you could see a difference just based on something starter and a week early, but in a given quarter, not 100 basis points, no way.

Okay, great.

Thanks.

Your next question comes from the line of Todd Slater.

Thanks very much.

Just I have an additional technical question on the reserve.

Maybe I didn't understand entirely how the $100 million will get taken.

Is it on electronics bought before the second quarter or third quarter going back all the way and then looking forward, on forward purchases, how are you going to, how do you count the extended warranties and the salvage costs, and so what do the gross margins look like in electronics going forward compared to let's say the club average?

How is that changing?

Well keep in mind the total gross margin now in the electronics department is in the low single digits, because of what's happened, the low to mid single digits trending downward from a normal number, something in the 8 to 10 range perhaps, three or four or five years ago to whatever it is today.

In terms of how we account for the concierge service, that's expensed monthly, whatever the costs are.

There's some nominal -- so that number is expensed.

There's the warranty.

Every time we sell an item, a TV or a computer, we're booking a small amount on every computer based on expected warranty.

Keep in mind, even the electronics, stuff usually breaks quickly or a long time later, so the second year, and this is again, it's warranty work, not return work and people can't just bring it back to us.

They have to go through the warranty process and we'll compensate the vendor or the vendor's third party for that process so we're reserving for that.

Now how does the reserve get impacted?

In theory, as if you think about it as of Q3 end, we looked at all prior quarter sales going back a couple of years and that very small amount less beyond the two years, but most of it is done over the first two years, and we looked at actual lag data going back over the last couple of years of actual returns and saw when those are coming back.

To estimate that as of Q3 end, if we were to close our doors today, what would come back using those same lag experience?

Now, as we go forth each quarter, we'll have new lag data for the upcoming three quarters -- upcoming three months.

If you think about it, let's take a year from now, in the third quarter of '08.

In that quarter, recognizing that a majority of your returns are done in one year, a greater majority are done in two years, a vast majority, that as we get further and further down the road, four years from now, will you still have a TV return that was purchased six years ago?

Sure.

There's going to be one or two of those, but what you'll see is that lag data should change and I'll give you the extreme example that I've used.

A year or so ago when the iPod with the movie screen came out, that first week, we sold many thousands of units.

That same week, we had returned about half as many of those thousands of units.

Maybe 100 of them were broken and the rest of them were just upgrading the one that you bought a year ago that was $10 more and didn't have a movie screen.

That is almost entirely eliminated because anything bought more than 90 days ago can't be returned.

So that's I think an extreme example but a good example of where you are going to see the lag data beyond 90 days or something goes to zero rather than has a tail out for a couple of years.

Okay, so looking at the low single digit, mid single digit margin range in the business now, that would be after the cost of let's say the monthly concierge expense and the extended warranty?

The last three months we've had kind of a double whammy.

You have the concierge service starting up.

It's not a big number, but nonetheless a number that's an expense.

You've got the returns from historical stuff, so you've got everything hitting you right now.

Right but the returns of the historical stuff are now covered -- going to be covered by the reserve.

Only those things purchased after the policy went into effect.

Got it, so it's not going to be, none of the reserves on anything going forward?

Correct.

Okay.

Great.

Thanks a lot.

I got it.

Hold on.

Yes, let me just clarify the reserves.

There's a what I'll call a balance sheet reserve balance which is this number that we have now, the $600 million of sales returns reserves and the roughly $100 million of margin related reserves and disposition related to that $600 million.

That number is related to expected future returns on purchases that occurred between the last day of Q3 and prior.

As we go forward, that number should change and improve to the extent that that number has been abused by electronics.

Unrelated to that, we are expensing every month, the costs associated with the technical support call-in number.

We are also reserving on every new TV and computer where we've extended the warranty from whatever the normal one was, call it a year to now two years, that what is the anticipated cost of fulfilling that warranty obligation through the manufacturer or the manufacturer's third party that does that work for them.

And we've talked to each of those manufacturers and again this is when it's broken.

When it's under warranty and that's -- it's a normal manufacturer's warranty.

If your kid throws a baseball through it, it's not covered.

Historically, if your kid threw a baseball through it, my guess is we take it back, if somebody actually had the gall to do that.

Okay, thank you.

Your next question comes from the line of Peter Benedict.

Hi, Richard.

Could you comment a little bit more about the outlook for your membership fee income growth?

It did accelerate, as you said, in the third quarter at about 15%.

Should we expect another modest acceleration in the fourth quarter and then does it start tapering off into -- in '08?

What can you tell us about that?

Yes.

I think you'll still see an increase year-over-year and it should start to taper off where -- keep in mind, while the increase was effective in May, the real bulk of the increase was effective July 1st.

We started in store with new members charging the higher $5 May 1st.

The July 1st is when the first renewal notices went out and needless to say, 87% of our members signing up roughly are renewing members, so it's really a July to July, so I think we're still on a little bit of an uptick through month 12, and then still showing an increase year-over-year but not as perhaps as much for months 13 to 23.

Okay, and then just a couple of modeling questions.

Can you give us what the option expensed number was in the third quarter and then I might have missed this, the number of shares that you actually bought back in the third quarter?

I don't think we give that number out, the detailed option expense number.

Okay.

Well then the shares --

Well actually, it may be on the cash flow.

So let me take a look.

I don't have it in front of me.

We haven't finalized the cash flow yet.

Okay and then the number of shares you bought back in the third quarter?

The number of shares I can tell you.

Hold on a second.

I have that sheet somewhere.

In the third quarter, we bought back 11,315,000 shares.

Great.

Thanks so much.

Your next question comes from the line of Dan Geiman.

Good morning.

Can you talk about the competitive environment?

Would you say that it eased during the quarter or was it as strong as it has been what you've seen over the past few quarters?

I think it's been as tough as it's been.

There's always a region where it gets a little easier and as soon as somebody mentions it, it seems it goes the other way, and I mean that.

If anything, probably in the last year, fresh foods like meats have been a little more competitive than I mentioned.

Again, our ability to get a little more margin has to do also not just with initiatives but the private label impact, the co-branded impact, where we can set ourselves apart on certain quality items and whether it's high end almonds and olive oil or some unique items in non-foods.

Okay, great.

Your next question comes from the line of Mitch Kaiser.

Good morning, Richard.

I was wondering -- I know you're not going to give a lot of detail on the gross margin but could you just talk about would one of the ways to expand margin maybe to look at changing your philosophy in 14% branded and 15% private label and then if you could help us refresh us on how that policy was set?

I was just struck down by lightning.

I think that would be something that I would still call sacrosanct.

The policy, if you go back to the beginning of time, when Jim and Jeff wrote an original business plan, and started out with here is kind of the footprint and here are the different areas and how that's evolved, my guess is is 15% was put into place as a cap on all items at least 15 years ago, maybe closer to 20 years ago.

It's been a long time.

Probably about four years ago, maybe five, is when the suggestion was made internally that on private label, recognizing we developed these items and whatever other reasoning we could come up with, the suggestion was made is perhaps on private label, recognizing that it's a greater saving, in every instance, it's a much greater savings to the customer than the competing national brand, dollar savings, that we could cap it at 15% instead of 14%, and Jim agreed, and so it didn't mean you got automatically 100 basis points extra on everything because not all of that was at 14% and not all of it went to 15%.

You're still subject to competition and probably more importantly you're subject to price points.

I'm making this up but let's say an item was out there at $14.99 and it happened to be at 14%.

Now that you went to 15%, you're not going to go to $15.14.

You're going to stay at $14.99 so when you raise the cap on the what is now 16% or 17% of sales, 17% of sales, when you raise the cap from 14% to 15%, my guess is over the course of the next year or two, you saw margins for that basket of private label go up half that amount.

Okay, okay.

That's helpful.

I mean, so it's not conceivable as you continue to push along with vendors and become a bigger portion of their mix that maybe that could go up above 15%?

Well that won't go up.

I mean, to the extent we buy better, again, if you go back 20 years ago, the unwritten theory was if you bought a dollar better, you give $0.90 or $1 back to the customer.

Now it's give more back to the -- give most it it back to the customer.

I'm not trying to be cute to say it's 51% but I think the buyers have a little more flexibility and recognizing even with our 14% and 15% cap, our margin is just under 11, so there's still room in there.

I think what we're recognizing is that none of us, whether it's other clubs or other category dominant retailers win this game, play the penny game on commodity items, and while we're all, we all play it and we all make lower margins on lots of commodity items, where you make it is on items where you can distinguish yourself, where items where in our view that we can sell more of because we're a higher end -- we have a higher end customer, on specialty items, on the food area where we've been pretty creative of late and continue to be so, on product label where you get a little extra margin so those are the types of things that are going to separate us.

Okay.

Fair enough and then just one last one if you don't mind.

You mentioned the 7% kind of the first couple weeks of May.

Would that be inclusive of FX and gas and cannibalization on all those sorts of things?

I think I said a little under seven.

Okay.

Inclusive of those things?

Inclusive.

Okay, thank you.

Your next question comes from the line of Stacy Pak.

Hi.

Just not to go too far out on the limb here but just wanted to see, can you comment would the magnitude, how do you feel about 50 basis points over a couple of years, and just following up on that gross margin conversation you just had, is there anything on the efficiency side as well or is it really all about sort of getting a better margin on these areas where you can differentiate yourself?

Well, I think the last question for us, we're always working on the efficiency things.

I don't think there's a lot built into here based on we're going to do something better tomorrow.

We're always trying to do that.

Arguably it's not like there's a lot of silver bullets out there.

We're not running a shabby show so you always get some little improvements there but they tend to be little.

I really hesitate to go any further out on a limb than the earlier comment, because we got to wait and see where we come out.

I'm hopeful that as we get into the middle of '08 and we start to see some -- hopefully see some improving trends we could talk more about things.

Okay.

Thanks.

You have a follow-up question from the line of Charles Grom.

Hi, Richard.

Just to clarify your recent comment there, do you have a sense for how many of the 4,000 SKUs in your store are actually at a 14% to 15% margin?

Are there say 60% at 11% to 12% and that could be a way you could get there?

I have no idea off the top of my head.

I bet a smaller percentage than that are at the top of that.

Recognizing though, you've got some items, you've got tobacco which is still even though it's been declining, it's still 5% or 6% of sales at a sub-5.

You've got I'm sure items like Coke and Pepsi that range from the 4% to 7% or 8% range depending on whose footballing the item that week in what region.

You've got copy paper and things that are single digits, so it's not like there's a bunch, there are probably some items that are closing on the 14% but there's ways to improve things.

Got you.

Thanks.

There's plenty of items out there.

At this time, there are no further questions.

Mr.

Galanti, do you have any closing remarks?

No, thank you.

And as Bob and I said earlier today, we look forward to a quarter when it's about a half a page press release and nothing unusual.

Thank you very much, guys.

Thank you.

That does conclude today's Costco third quarter earnings conference call.

You may now disconnect.