好市多 (COST) 2011 Q1 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the Costco first quarter results.

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

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

(Operator Instructions).

Thank you.

Mr.

Richard Galanti, Chief Financial Officer, please go ahead.

Thank you, Debbie.

Good morning to everyone.

This morning's press release reviews our first quarter fiscal 2011 operating results for the 12-weeks that ended November 21.

As with every conference call, I'll start by stating that the discussions we're 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 certainties 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 first quarter operating results, for the quarter our earnings per share came in at $0.71, an 18% increase over last year's first quarter earnings per share of $0.60.

Three items I will quickly note here.

First, last year in first quarter we enjoyed very strong gasoline profits.

As many of you know, when gasoline prices are flat or falling, Costco's gasoline operations can be quite profitable.

And when prices are rising, they can be less profitable.

This year's first quarter gasoline operations were profitable, but less profitable than a year ago to the tune of a little over $0.03 a share.

Second, you'll note that our income tax rate is almost two percentage points lower year-over-year, 36.1% last year in the first quarter, compared with 34.2% tax rate this year.

In the first quarter of this year, one of our foreign operations received a tax refund in connection with a tax loss in 2007.

At that time, no tax benefit had been recorded due to the uncertainty of the refund claim.

During the first quarter of 2011 here, the issue was resolved and the refund issued.

It reduced our first quarter 2011 provision for income taxes by approximately $9.6 million.

The impact to our first quarter EPS, however, was a benefit of about $0.01, not $0.02.

That's because half of it, or $4.8 million, half of that benefit of -- half of the $9.6 million is backed out on the noncontrolling interest line down below.

So again, the two things I mentioned here, a little over $0.03 benefit from gas, and a detriment of gas year-over-year, and a benefit of about $0.01 here due to this unusual tax item.

And the third item, as I mentioned in our fiscal year-end conference call, effective the start of fiscal 2011, our current fiscal year, we have begun consolidating the results of the operations of our Mexico joint venture.

Historically, these operations were treated as an equity method investment.

Thus, we only reported our 50% share of the joint venture's net income, within the nonoperating interest income and other line item on our income statement.

As of the beginning of this fiscal year, back in September, we are acquired to adopt a new accounting method, which makes it appropriate to fully consolidate the Costco-Mexico joint venture into our statements.

In effect, it adds approximately 2% to 3% to top line sales, assets and liabilities.

100% of the venture's financial statements are now included in our P&L and balance sheet and cash flow.

And then the 50% portion held by our joint venture partner is backed out at the bottom of our income statement to offset it.

That's a line item called net income attributable to non-controlling interest.

Such that there's no effective cost to the bottom line or earnings per share.

It does impact our discussion of gross margin, SG&A and earnings basis points.

I'll discuss that as we go along here in the conference.

In terms of sales for the quarter, 12-weeks reported comparable sales figures for first quarter showed a 7% increase, 5% in the US and 14% internationally.

Excluding gas price changes, and the impact of FX, the 5% reported US comp would actually be 4%, for the fiscal first quarter, and the 14% international comp reported would be at 10% in local currencies.

And overall, the 7% that we reported for total Company comp would be at 5%.

The comp figures, by the way, do include Mexico in both years for the calculation, so that it is an apples-to-apples comparison as it relates to that.

Other topics of interest I'll review, our opening activities and plans.

We opened a total of eight new locations during Q1, which ended November 21.

Seven of these eight openings were in the US, including one new business center.

And the eighth new location was in Alberta, Canada.

For all of fiscal 2011, our current plan is 27 units, net new locations, but two of those are relocations, 15 of which would be in the US.

And as I mentioned, two relocations.

Since Q1 end, on November 21, we've opened two new locations, one in Minnesota and one in the state of Washington.

So, we now operate 582 locations around the world.

Also this morning, I'll touch on our online results, our membership trends, some discussion about margins and SG&A of course, stock repurchase activities, and as you know from the last quarter or so, we include in our press release our balance sheet, so we won't go through that.

Okay, the discussion of our results.

Very briefly, sales for the quarter were $18.8 billion, up 11% from last year's $16.9 billion.

If you exclude Mexico, this is not apples-to-apples, it's included in this year, not in last year.

Without these sales, the 11% increase would have been 8% on a total basis.

On a reported comp basis, Q1 comps as I mentioned were 7% excluding gas price changes and FX they were up 5%.

Again, on a comparable basis, those numbers include Mexico both years.

For the quarter, our 7% reported comp sales number was a combination of an average transaction increase of a little over 2% for the quarter, and an average frequency increase of 5% for the quarter.

So, continuing very strong frequency now going on almost a complete second year at relatively strong frequency, shopper frequency numbers.

I might mention that the average transaction increase of 2%, that figure would be slightly positive if you excluded gas inflation and the FX issues.

In terms of cannibalization, it continues not to be a big issue, about 35 basis points in the fiscal quarter, not that different from past months and quarters.

In terms of sales comparisons by geographic region, keep in mind both for the quarter and the month that we reported -- the month of November, which we reported last week, the combination of FX and gas is right around 200 -- about two percentage points, FX being 110 to 130 basis points, and gas being 65 to 80 basis points.

Geographically, northwest has really been consistent for the past several fiscal quarters, continuing in the mid single positive range, positive percentage range.

California has trended upward overall over the last several quarters and months, particularly in November, it showed its strongest recent month.

The rest of the United States, northeast in the low-to-mid positive singles, southeast in the mid-to-high singles positive, and midwest in the high-singles.

In every US region except the northwest, where we had very -- we had freezing snow and ice for two or three days leading up, the Monday through Wednesday of -- before Thanksgiving, November was the best comp sales month during the three months of September and October and November.

And even in northwest, even though November was impacted by that last week in November, November overall for the midwest was in the mid-singles.

Internationally, local currencies, we're doing quite well.

In terms of -- in local currencies, UK is the weakest foreign region, slightly positive.

All other countries are fine in local currencies, in the plus 10% to plus 35% range in local currencies.

In terms of merchandise categories for the quarter -- for the quarter, and again, that's mostly September, October, first three weeks of November.

Within food and sundries, comps were in the mid-single digit positive, with candy, deli, and refrigerated being relative standouts.

We're starting to see the beginning of some inflationary pressures in some of the food related areas, but not a lot of impact in our Q1 figures.

More important to November, I think in going forward, we'll see some inflationary pressures.

Our hard line sales showed slightly positive comps overall, with mid-to-high single digit negative comps in electronics, offset by sales strength in tires, and automotive, and sporting goods, office supplies, and hardware.

Within the positive soft lines comps, which are actually in the low positive double digits, housewares, jewelry, and special events were particular standouts.

Many of the other departments, small appliances, domestics, home furnishings, up nicely as well.

Media continues to be the struggling department.

No surprise, starting with relative industry weakness in CDs, a few years back in DVDs and books with the pressure of other forms of distributing those items.

Fresh foods in the very high singles overall.

Standouts in fresh foods continue to be both meat, beef, and produce.

But also categories including bakery and deli were up as well.

Again, we are seeing some inflationary pressures impacting fresh food prices.

Our buyers in that area estimated that in Q1, that represented perhaps up to 3% of inflationary pressures.

Anecdotally, state prices are up year-over-year 15% per pound.

The entire, what they call the beef complex, which is everything, both imported, exported and all parts of beef, was up about 4% on average.

So steaks, which is what our strength is, has had the most inflationary pressure.

Poultry not up yet a lot, but coming.

Overall, beef, chicken, pork, the estimates are that you would expect over the next six months to see perhaps inflation in the 5% to 10% range.

On the bakery side, soybeans and soy oil are up 50% to 60% year-over-year, sugar up 20%, butter up 5%.

And wheat, up 30% year-over-year.

So, the raw materials in bakery are good.

In bakery, we've been trying to hold the prices as long as we can.

So, we've actually incurred lower margins in Q1 in the bakery, notwithstanding that, the strength in margins in meat and produce more than offset that.

So, overall fresh foods margins in Q1 were up year-over-year.

Moving on to the line items of the income statement, membership, $415.8 million or 2.21% in the first quarter.

That's up 10.2% in dollars, and down 2 basis points, up about $38 million overall.

We consider that a good showing.

Strong renewal rates, we've actually cracked the 88% number, and continue to see increasing penetration of the executive membership.

Our new memberships sign-ups in Q1, Company-wide were up 1% year-over-year.

Actually, stronger in the US, because if you recall in the fall of 2009, Q4 of 2009, we had incredible sign-ups in some of these new Asia and Australia markets that we opened in, and very strong sign-ups going into Q1 of 2010.

So, we're comparing against that this year.

But nonetheless, Company-wide up about 1%.

In terms of numbers of members at Q1 end, I'll give you two columns, at year-end and at Q1 end.

Gold star members, 22.5 million at the year-end back in August, and 23.5 million now.

Primary business, 5.8 million and 6.2 million at first quarter end, 6.2 million.

Business add-on, 3.3 million and 3.6 million.

So, all told, 31.6 million member households as of Q4 end, and 33.3 million as of Q1 end.

Including spouse cards, 58 million card holders at year-end, and 61.2 million at Q1 end.

I will make a note that the 58.0 million at year-end, would have been 60.8 million with Mexico included.

So still an increase overall.

At November 21, first quarter end, paid executive members, 10.76 million, an increase of just under 300,000 or 3% since 12 weeks earlier, at fiscal year-end.

So we're still either converting or signing up as new, 24,000 per week, members per week as executive members.

Executive members represent about a third of our member base, and a little over two-thirds of our sales, certainly an important member for Costco.

In terms of renewal rates, as I mentioned, they've strengthened for the quarter.

They ended up at 88.2% versus 87.7% at fiscal year end.

Remember, these renewal rates consist of US and Canada, which total just under 90% of our total Company.

The newer regions where we've opened newer locations we start off with a lower renewal rate.

But overall those two have trended upward.

Going down the gross margin line, year-over-year we were up 9 basis points, 10.97% versus a 10.88%.

And again, just jot down three columns here.

Core merchandising would be line item one.

Ancillary businesses, line item two.

2% Reward, line item three.

LIFO, line item four.

Total, line item five.

And I'll add two new line items.

Six and seven, that would be Mexico, would be the impact of Mexico, and then the Company without Mexico.

I'm just doing that to share with you how much of the 9 basis points related to Mexico.

Mexico works on a little higher margin, and works on a little lower SG&A.

So, that impacts both of those figures for our Company.

All told, again, with three columns, fiscal 2010 overall, Q4 2010 and Q1 2011.

Going across, our core merchandising was up 6 basis points year-over-year for all of fiscal 2010, up 5 basis points for the fourth quarter, and up 19 basis points for Q1.

Ancillary, plus 3 basis points, plus 8 basis points, and minus 9 basis points.

2% Reward, this just simply reflects the increasing penetration of the executive sales, and the associated reward with that.

Minus 2 basis points in all of 2010, minus 1 basis point in Q4, and minus 1 basis point in Q1 of 2011.

LIFO was minus 5 basis points in all of fiscal 2010, a minus 8 basis points in Q4, and not an issue in Q1, zero.

And totaling plus 2 basis points.

So, in all of fiscal 2010, we had reported gross margin 2 basis points higher year-over-year.

Q4 plus 4 basis points, and Q1 plus 9 basis points.

The only thing in the last two line items would be in the right-most column of Q1.

Mexico represented plus 3 basis points.

So, without Mexico, it would be plus 6 basis points for the Company.

As you can see, our overall reported margin was higher by 9 basis points, or 6 basis points excluding Mexico.

Our core was up 19 basis points.

Our lower margin gas business represented 8% of sales in Q1 2010, and a little under 9% in Q1 2011.

As well, our gross margin in gas was lower this year in Q1 than a year ago.

So, a combination of a little higher sales penetration, and a little lower margin on a business that already is quite a bit lower margin than the core business.

This resulted in all of the ancillary businesses being hit by 9 basis points, to the whole Company.

Within that number, gas was actually 15 basis points, and all the other ancillary businesses was 6 basis points positive.

So, that was the impact from the ancillary business and most particularly gas.

So, our gross margins in our core merchandising business, food and sundries, hard lines, soft lines, fresh foods, were higher year-over-year in Q1 by 22 basis points.

Its slightly lower aggregate sales penetration year-over-year, caused it to be up 19 basis points in this matrix.

As I mentioned, all four major departments, food and sundries, hard lines, soft lines and fresh foods were up year-over-year, ranging from up as little as up 12 basis points, to as much as up 44 basis points.

In sum, margins in the first quarter were fine.

And again, Mexico represented 3 of the 9 basis points to the Company overall.

Moving on to SG&A, our SG&A percentage in the first quarter was better by 19 basis points, coming in at a 10.31% this year versus a 10.50% last year.

Again, we'll do three columns and seven line items.

The line items are operations, second one is central, third one is equity, RSUs or stock options, fourth is quarterly adjustments, fifth is total, and then six and seven is simply Mexico and without Mexico.

So what is the impact of Mexico on these numbers.

So again, going across Q4 2010 -- switch these around.

So let's do fiscal year 2010 is the first column, Q4 2010 and then to Q1 2011.

Going across, operations plus 2 basis points for the fiscal year.

Plus 9 basis points for the quarter, and plus 17 basis points for the first quarter.

Plus means better or lower.

Central, plus 1 basis point, minus 1 basis point, and plus 1 basis point.

Equity, zero, zero, and plus 1 basis point.

Again, pluses are better or lower.

Quarterly adjustments, plus 7 basis points, plus 4 basis points, and zero.

So total reported SG&A year-over-year for all of fiscal 2010 was plus 10 basis points.

For Q4, it was plus 12 basis points, and for Q1 was plus 19 basis points.

Now, down below in the right-most column, Mexico's impact on these numbers were plus 7 basis points, meaning that it had a higher impact on SG&A than -- because it's lower SG&A than margins on the upside.

And without Mexico, therefore, we were 12 basis points.

Now, in terms of a little editorial on SG&A.

Again, SG&A was lower by 19 basis points, 7 basis points of that was Mexico.

Mexico operates on a lower SG&A percentage, mostly lower payroll and benefits.

Frankly, most controllable expenses, as well as lower occupancy costs, in those cases where we have a rent factor.

In terms of our core operations, I might add our payroll percentage was better or lower year-over-year by 16 basis points, somewhat offset by higher benefits expenses.

I might add that the rate of dollar increases in our healthcare costs, while still increasing at a rate higher than top line sales, is subsiding a bit.

Our central expense was better year-over-year by 1 basis point.

Central payroll again was actually better or lower by 1 basis point, again, not the case with healthcare costs.

Overall SG&A performance we think was quite good.

We're benefiting we believe from both a little stronger sales levels, and I feel an increased focus on expense control, which I've talked about in each of the last couple of fiscal quarters.

Next on the income statement, pre-opening expense.

Pre-opening expense last year was $10.8 million.

And this year, $11.9 million.

So both years, 6 basis points, about $1 million higher, no big surprise.

Last year, we opened six openings in Q1, this year eight openings.

In terms of provision for impaired assets and closing costs, in Q1 2010 last year, we had a charge of $2 million there.

This year we had a charge of $4 million.

Again, small little things that go both ways and fluctuate, no big surprise there.

All told, operating income in Q1 was up 23% year-over-year, from $427 million to $525 million last year, or an increase of $97 million.

Now, on these items, we are benefiting -- these percentage increase, when I talk about up 23%, we are benefiting from where Mexico -- we now have all of Mexico in the 2011 number, and half of it in the -- down below in the other number.

So without that, the operating income increase would still have been in the high teens.

Below the operating income line, reported interest expense was about the same in both quarters, $25.9 million in Q1 2011, up a little from $24.1 million in last year.

I think the difference there has less to do with interest expense, but the reduction of interest expense associated with capitalized interest, which is an offset.

These amounts mainly reflect the interest on our $2 billion debt offering, which we did in February 2007.

By the way, $900 million of that comes due in March of 2012.

And at this point, we would simply pay that off, which would be a nice interest rate arbitrage since it's fixed in the low 5% range.

Interest income and other was lower year-over-year by almost $13 million, coming in at $5.5 million this year versus $18.2 million last year.

The big variable there is other revenue and interest income.

Actual interest income was up $300,000.

Last year, sounds like a broken record here, but last year half of our Mexico earnings were included in the income statement line item, interest income and other.

In the current year, the results are fully consolidated, and the joint venture partner's 50% share is reported down below as net income attributable to non-controlling interests.

Overall, pretax income was up 19.5%, mid-to-high teens if you exclude the -- where Mexico appears on the balance sheet.

On to our tax rate.

Our Company tax rate this quarter came in at 34.2%.

About 2 percentage points lower than 36.1% a year earlier.

Again, our tax rate benefited or was lower due to a handful of discrete items, most notably, as I discussed earlier, a tax refund in one of our foreign operations.

Now for a quick run down of other topics.

The balance sheet is included in today's press release, so we won't talk about that.

I will point out a couple things.

Depreciation and amortization for the first quarter was $189 million.

We have a strong balance sheet, I don't have to tell you that.

Plenty of financial strength.

Accounts payable ratios continue to improve, in other words, payables funding more than all of our inventory levels.

That always is at its peak as we approach Christmas, where we have higher sales and extra dating on seasonal items that don't get paid until the early part of next year.

But year-over-year, we reported a year ago accounts payable as a percent of inventory at 102%, a year later, 105%.

If you take out non-merchandise payables like construction payables, all similar type of improvement, 88% a year ago, 91% at the end of the first quarter this year.

Average inventory per warehouse was up only 1%, $11,815,000 this year, average inventory versus $11,676,000 a year ago.

So, up $139,000.

Again, our inventories tend to peak around now, too, with all the seasonal stuff, particularly bigger ticket electronic items coming in for Christmas.

Of that $139,000, $105,000 of it is the FX difference because of the strong foreign currencies relative to the US dollar.

So, inventories are darn near flat on pretty good sales this past quarter.

So, we're seeing the benefits of that in improved payables and improved turns.

In terms of capital expenditures, in Q1 we spent $306 million.

Our fiscal 2011 CapEx is budgeted at just under $1.6 billion.

This compares to capital expenditures in fiscal 2010 of roughly $1.050 billion.

Not a surprise, we mentioned that, I think, in the year-end conference call.

In terms of dividend, our current quarterly dividend is $0.205 per share, or $0.82 per share annualized.

Total cost to the Company is right around $360 million.

Costco online in fiscal 2010, Costco.com sales were up 6%, in first quarter they were up 9%.

So a little bit of improvement there.

In terms of expansion, as you know in fiscal 2010 we opened 14 locations, which included one relo, so net of 13.

This year, we expect to open -- we opened eight net in Q1.

We've opened two so far in Q2, which is it for Q2.

In Q3 we plan two openings, which includes a relocation, so a net of one.

In Q4 we have plans for 17, including one relo, so a net of 16.

All told for the year, our own budget assumes 29 new -- or 27 net new excluding the two relos.

Now, as you know, these are all actively being worked on, and different phases of construction are getting ready to start.

The reality is, is that inevitably a few of those in Q4 may fall into Q1.

My best guess is that the 27 net could easily be 23 to 25, but we're shooting for certainly 25.

But we'll see where we go.

So in fiscal 2010, we added a net of 13.

So, about 2.5% square footage growth.

In fiscal 2011, assuming we added all 27, we would be about 4.5% square footage growth.

Probably if I were betting on this, it would probably be 0.5% lower than that.

Assuming we open 27 net, it would include 15 in the US, three in Canada, possibly one in the UK, it's a matter of timing, two each in Korea and Taiwan, three in Japan, and one and possibly two in Australia.

So again, percentage-wise you're certainly seeing plenty of openings in the US, but also a higher percentage of openings overseas, notably in the three Asia countries, a total of seven planned versus typically two or three on average planned in the last few years.

As of Q1 end, some of you keep square footage figures.

Total square footage for our Company, this by the way includes Mexico now, was 82,000,098 square feet, and that would be on the base of 572 warehouses, I'm sorry, 500 -- at quarter end, I'll get you that number in a second, 582, sorry.

In terms of stock repurchases, we currently have -- remaining repurchase authorization of our previous Board approvals of just under $1 billion.

In fiscal 2010 overall, as you know, we started back up repurchasing just before Q2 began last year.

We purchased 9.9 million shares for a total of $568 million.

In the first quarter, we purchased an additional 2.4 million shares for just over $150 million.

Again, our supplemental information pack, which includes some useful stats and our cash flow statement as well -- or I'm sorry, does not include the cash flow, will be posted on the Costco investor relations site later this morning, and the 10-Q should be out in a few weeks.

With that, I'll open it up for questions, and turn it back over to Debbie.

(Operator Instructions)

Your first question comes from the line of Deborah Weinswig with Citi.

Hi, good morning.

This is actually Tina Wang on for Deb.

Thanks so much for taking my question.

I was just wondering based on what you've seen so far in November, can you just provide us an update on your holiday outlook?

And also address specifically how you are positioned from an inventory perspective for holiday.

Thank you.

Sure.

Well, I can't talk necessarily about how the last week or so was.

But what I know I have mentioned and I know what Jim has mentioned when asked in the last -- going back a couple months ago, we approached the Christmas season as far back as September somewhat aggressively.

Recognizing structurally we feel that, A, we've had great shopping -- shopper frequency.

We have on average a little bit more upscale member that perhaps can weather the economic storm on average a little better.

Coming in, hopefully pick up some of those discretionary items as well.

And structurally we can afford to be a little more aggressive because of the types of merchandise we sell and the turns that we have.

We're in and out of seasons early.

We have continued to approach it with a plus sign in front of it, if you will, versus caution and that continues.

Is there anything from Black Friday that you observed that you could call out?

Not really.

For us, Black Friday -- Black Friday, while we do -- in the last several years we've done a handout with a few items in it, it's really more of an advertising traditional retail holiday.

Certainly Black Friday is better for us than an average Friday.

But it doesn't really portend in our view for us.

And it was reflected in our November comps by the way.

Great.

Okay.

Thank you.

Your next question comes from the line of Charles Grom with JPMorgan.

Thanks.

Good morning, Richard.

I know you don't want to give forward guidance but just provided the Mexico consolidation, would you anticipate that minority interest line to be about $20 million per quarter this year?

Or was there something in this quarter that made it pretty high?

Just trying to get a sense for how we should model that line.

Well, I can't give you guidance on it other than you note in that line there is that tax benefit I mentioned.

So, it won't be that high.

I think a little under $5 million of that line is a tax benefit.

Okay.

Because of Mexico.

Okay.

So closer to that $15 million, maybe?

I'll let you do that.

Okay.

Fair enough.

And then in your 10-K that you filed last month, you reported I think about 100 basis point increase in Canada.

What was behind that increase?

And do you feel like that 4.5% is sustainable?

You're talking about year-over-year?

Yes, year-over-year.

Well, I think first and foremost, Canada's economy overall not just at Costco has been strong.

We've enjoyed local currency comps for two years now in the mid-to-high single digits now in Canada.

My guess is that a smaller benefit of that is related to the fact that Sam's exited the market, gosh, a year and-a-half ago where they had seven or eight locations in the Toronto, Montreal markets.

Certainly that helps a little.

But, as you expect the day that was announced Jim was the first to remind the buyers, he doesn't want to see big improvement in margins there.

So, I guess that's a little of it.

But a bigger thing is continuing strong comps up there.

Okay.

Fair enough.

My last question is within SG&A, you talked about the core being 17 basis points better, 16 from payroll.

Is that just leverage or is there something else that helped out this quarter?

Because that was particularly strong.

Well, part of it -- I think it's both.

I mean, as I mentioned a minute ago, clearly some of it's leverage but I think also -- again, I don't know what the leverage comp number is completely.

I just believe and we all agree here that it is lower than it used to be.

We have focused on it over the last year and-a-half.

Everybody's focused on it.

But a bad economy -- as so many of you know for years I've always said there aren't a lot of silver bullets in our SG&A because we're pretty efficient to start with.

Well guess what?

In tough times the last two years, everybody's been focused on it a little more.

Little things are being taken out of operations and payroll.

And so keep in mind, as Bob was just mentioning to me, benefits are higher in that number, higher than sales growth.

So actually, overall there was a little bit more improvement that offset that.

So again, there are lots of little things, plus pretty good comps.

Great.

Alright.

Thanks.

Your next question comes from the line of Adrianne Shapira with Goldman Sachs.

Thank you.

Richard, another impressive point of the quarter was the core merchandise margins, up 19 basis.

Can you just kind of walk us through and help us think about how sustainable that is?

Clearly a nice inflection point but as we head into the second quarter we're up against a pretty tough compare, where you had a nice increase a year ago as well.

So just kind of help us think about how sustainable that improvement is going forward.

Keep in mind, the big improvement last year in Q2 really related to the year before that.

When we took about $30 to $35 million of commodity price markdowns.

So the delta a year ago was because of the real under-performance a year earlier.

So, I don't see that as being a concern this year.

Look, one of the things I pointed out a minute ago was that even our overall fresh foods gross margin was up in Q1, not-with-standing a much weaker for us bakery margin because we've tried to hold prices, despite the raw material prices going up.

You can't do that forever, but we recognize that these -- a lot of those muffins are sold to restaurants and delis and the longer we can hold that price, the better.

It won't be forever.

So, we were able to do that and still have pretty strong margins here.

As Jim has said before, and years ago, I'm not sure I always agreed, but I agree more and more.

Margins aren't the issue.

We feel pretty good that we have the ability to do a little of that.

But we're not going to go crazy.

Okay.

And so, we're seeing this margin improvement despite the fact we're not necessarily flowing through some of the inflationary pressures that have yet to -- that have started to materialize?

Is that fair?

Again, where the inflationary pressures have started first would be fresh foods.

Bakery, sugar, the raw material ingredients for baked goods or the food court.

And again, both of those margins in the first quarter were down year-over-year because we're holding on.

But we're able to do -- by the way, we probably wouldn't have done that even if there was margin pressure in the whole Company.

The good news is we're able to do that and still even within fresh foods have a good margin.

So, I think overall -- I think, we're running on all cylinders as it relates to our merchandising, most cylinders as Jim would say, not all, in terms of our merchandising and our ability to achieve our margins.

Okay.

What are you seeing competitors do as it relates to inflation?

How aggressive is it out there and maybe sort of on the heels of Black Friday, how the holiday season has started off compared to -- how would you characterize the holiday season relative to your expectations?

Well, I mean, again, I get back to the comment I made a minute ago in the latter point of the question is that we entered the season positively and we still feel that way.

The first part of your question, Adrianne?

I was saying as it relates to inflation what you're seeing competitors do with prices, given some of the inflationary pressures.

It tends to be all over the board.

If you think about fresh foods, I think the supermarkets have their own set of pressures.

Again, we're stronger in bigger ticket, higher-end beef items like prime rib and steaks and what have you.

And that's where there's a little less pricing pressure.

We're still the best value out there.

The ad items you see like for ground beef and things like that aren't as big of a competitive issue for us.

We're able to compete effectively and not be impacted a lot.

Different regions are doing different things on that side with loss leaders.

I mean, you get driven crazy in a region or two, whether it's milk or soda pop or things like that.

But as it relates to pricing pressures, I think we would all agree here that we're going to be the last to take prices up.

And so far I think that's happened.

And that's good for us.

And we're able to do that and still show decent margins.

On the -- on the non-food side, there's -- you hear about cotton going up a lot.

It does.

It impacts those items.

But it impacts a little higher ticket items less than $8 items at the discount stores.

Makes sense.

So Richard, let me be the one to ask the question.

Since we last spoke the board in California raised the threshold.

Bj's talked about raising their membership fee in January.

Sales seem to be improving.

Understand that you're focused on the holiday season.

But maybe just update us on your thoughts as we think about 2011, since it will be five years since we last saw a membership-fee hike.

Thanks.

Well, there's not a whole lot of new news yet other than what you just mentioned.

As we raised it from the base membership fee from $45 to $50 in I think it was May, roughly May of '06.

So five years would be May of '11 but we really haven't talked about it yet.

I don't think what our competitors do impacts us a lot.

Certainly our renewal rates, our frequency, and the like give us confidence that if and when we wanted to, it would not be an issue as it never has been.

But we honestly haven't sat down to talk about it yet.

And at some point I'm sure it will happen, but whether it's sometime in the first half of '11, or the second half of '11, or the first half of '12, who knows.

I'm not trying to be coy here.

We just really haven't talked about it yet.

It's not because of a lack of confidence in our loyalty and our ability.

Okay.

Best of luck.

Next question comes from the line of Mark Wiltamuth with Morgan Stanley.

Hi, good morning.

Richard, we've seen a bigger push towards the Asian stores in this year's new store introductions.

Is this something we could count on for the next several years?

And do you have a longer term target that you're shooting for there in terms of store count?

If you go back a few years ago when we had the slide that said this is how many we have by country today, and this is what we think the potential is ten years from now.

I think in both Korea and Taiwan we had at the time four or five in each of those countries.

We felt long-term it could be 15.

While I haven't seen the slide lately.

I think in the past year I saw it and the 15s were 25s.

In Japan where we had three or four units the potential, for some reason, was 49.

I don't know why it wasn't 50.

I don't think that's really changed, other than we have committed to a lot more.

We have, what, nine I believe in Japan and seven in Korea and six in Taiwan.

As I mentioned between those three countries we've got several opening this fiscal year.

And yes you'll see a higher rate of openings this year and the next few years than you have in the past.

So, it moves the needle for the Company a little bit.

We've had great success in those countries.

We've had great success in the one unit we have in Australia.

We're anxious to get our second one open this coming Spring and hopefully a third.

My guess is that third slips into Q1 of '12.

But we're working on trying to get it open.

So we'll see.

But I think it's like a lot of things around here, it's a big positive for those operations, given that they are successful.

It's a slight positive for the Company overall, but trending in that direction.

How do the operating margins look on those stores versus like a US core store?

Margins, higher.

End of story.

Keep in mind, in places like Korea and Taiwan, I mean I think eight of our 10 highest volume units are in the three Asia countries.

And I wouldn't be surprised if all 10 were if they were a little older.

It helps when you have four or five locations in a 15-plus million population city like Seoul or Taipei or Tokyo.

So we have met with good success and member sign-ups and sales over there.

But we have to just keep opening some units.

See us higher, payroll -- because sales per location are quite high, payroll as a percent of sales is lower.

But the net of everything, membership fees as a percent of sales tend to be higher.

Some of those units have twice the average number of members as our Company overall.

But again, that has to do with the fact that there's so many -- so densely populated.

And they like American stuff.

What we feel that we've brought is not only the unique membership format, is American sourced goods, bigger, and great value.

And getting back to the inflation question, you said steak prices up 15%.

What kind of price elasticity response do you get there?

Do you see volumes down a little bit in some of those areas where you're seeing double-digit increases?

I honestly don't know.

My guess is -- there's got to be some elasticity.

It probably was -- I know there was huge he'll as the is elasticity to the positive.

When the economy first got hit in late '08 throughout the first half of '09 as what I'll call the high-end steak restaurants, which were hammered and 2% of all prime -- 2% of all beef raised in the United States is prime.

Virtually all of it went to high-end restaurants.

There were weeks and months in the middle of '09 where we represented something like 35% of all the prime steaks being sold in America including restaurants.

So as they slowed down, and the price points on these items -- again, this is anecdotal but I remember a prime steak that we might have had -- were selling at $18 or $19 a pound for a strip steak.

But we didn't sell them because the disparity was so different, was down to $10.99 and $11.99 and we could sell a dramatic amount of them even as the $10.99 or $11.99 choice steak went to $8.99.

I'm guessing on those numbers.

But, directionally, that was the issue.

So, my guess is there is some elasticity but -- they're great.

It's been a good business for us.

Did you say your fresh food margin was down a little bit because of inflation?

Our overall fresh food margin, which is the sum of bakery, produce, meat, and what we call deli, packaged items like cheeses and what have you, our overall gross margin was up in the quarter.

Not-with-standing the fact that our produce -- that our bakery margin was down because of holding prices on many of those items.

We can't hold them forever, but so far we have.

Okay.

And how about on the meats, were you holding there or are you passing it through?

Mostly able to pass most of it through.

Again, on ground beef, you might not be able to but we're selling -- even though we sell a lot of ground beef, we're selling a lot of steaks and roasts and things like that as well, higher end cuts.

It's kind of like in the white goods business, with refrigerators, the one you see on sale is the base model.

But when you go in to buy one you want to buy the model with everything on it like with the ice maker and water dispenser.

That's not the one that's on sale, so there's less price competition on the higher end item.

And just a little more color on California doing better.

Is it back to reasonable levels or is it still just really benefiting from the weak year-agos?

I'd say -- well, in November it was.

Over the quarter, closing in on it.

So yes, it's getting better.

I don't want to suggest that life's great out there.

We all know what the underlying unemployment statistics and the economy concerns are.

But certainly seems -- I think probably the thing that has continued to surprise me is the improvement in shopper frequency.

For 20 years, shopper frequency, month, year-over-year, each month, was on average up 1%-1.5%.

All of a sudden, starting really before the economy got bad in late '08.

We started seeing frequency improve and throughout '09 when the economy was really in the doll drums we continued.

And I was the first to remind people that hey, if we typically run ones and twos and we're running threes and fours, a year from now if we're flat that's not so bad because we got all that frequency in one year.

Well guess what, we're running threes and fours and fives for two years running now.

To some extent people change some of their habits with restaurant usage in '09.

I think that competitively, we are still taking market share from traditional supermarkets.

And that's what drives frequency in our business, and that helps.

I would think with the threes and fours and deflation shifting back to inflation you should start to see more substantial comp above four.

Is that fair?

Hopefully.

Yes, I mean, yes, if that happens, and we'll hope it will continue.

Okay.

Thank you very much.

Your next question comes from the line of Mark Miller with William Blair.

Hi, good morning.

Richard, on the average ticket, November strengthened ex-currency, ex-gas, and a lot of our discussion I think has been around price changes on like-items.

Could we spend just a minute on mix?

And what I'm specifically interested in is, are we beginning to see a shift from what had been trading down over the last couple of years to more trading up?

So, within categories and also on moving towards better, best items.

I know with the Kirkland signature that actually depress that's change, but ex that factor, what are your buyers seeing there?

First of all, I think we did a good job per Jim's instructions.

The buyers, that when the economy got -- originally got hammered, we tried very hard not to bring price points down.

Did we try some lower price points on some patio furniture to get below $1,000 instead of a little above $1,000 on a price point?

Yes.

Did it sell a little better?

Yes.

Did we do that again this year leading into February through April of '10, second bad February through April of the economy.

No, and we were actually scrambling.

I think part of it was pent-up demand from the year before.

So -- I think the ticket's come down a little bit because people are coming in more.

It's gone up a little bit because there is finally a little more strength in penetration of what I'll call medium-to-higher priced non-food items, discretionary items.

Our jewelry business has been up in the teens the last couple of quarters, last several months.

A lot of those categories I mentioned earlier, housewares and sporting goods and lawn and garden are all up in the 10% to 25% range.

Actually, on a high-water mark basis over two years, net positive.

So again, the frequency brings it down a little bit.

We're finally seeing some strength, brings it up a little bit.

But we still are, as Jim would say, operating a healthy state of paranoia because the economy's still a little scary.

But clearly, we're getting more than our share.

Is it fair to make a connection between that second derivative or rate of change on average ticket and payroll leverage?

Were this to strengthen further that would presumably help you get better payroll leverage, all else being equal.

Yes, that helps.

Okay.

My other question is on international club expansion.

Can you just help us look out a few years?

I mean, the returns are absolutely terrific.

And is there a speed limit we should think about with the infrastructure?

I mean can you get the international club openings up?

When can that surpass the US, for example?

Could you get it up to 20 per year?

I think it will be a few years.

The way I looked at it is probably over a four or five year periods.

If I think, it's just like the three countries in Asia where we are now, we currently have 23 warehouses I think between the three countries.

And probably for five years running, we've averaged between the three countries a total of two or three a year.

This year, we'll open five or six.

And my guess is over the next five years it could be five or six a year, maybe six or seven or eight but let's say five or six a year.

That's a dramatic increase in rate of increase.

It still doesn't get you to your 20.

As we open in a second or third European country over the next five years.

But again, as you've seen from every other new country we've operated in, over five years we might open three to five units in total in a given country.

So we're still pretty hands-on.

Infrastructure-wise as it relates to getting them opened, again, I think first signal is we have ramped up but not to 20 a year.

But we're ramped up, and let's see how the next two or three years go.

Thanks.

Next question comes from the line of Bob Drbul from Barclays Capital.

Hi.

Good morning.

Richard, I guess the question I have is on the membership fee, the potential for membership fee increase?

How should we think about I'd say attrition, if you were to increase hypothetically, the Executive membership by 5% or 10% or $5 or $10?

Given historical attrition on just a Gold Star increases that you have done over the years.

Well, A, who knows.

But in the five increases in 25 years, we've never -- I think we've budgeted as much as 1.5% or 2% attrition and I don't think we've ever exceeded one even.

So it's really never been an issue.

As you know, nine years ago and five and-a-half years ago, five years ago, we did -- when the original executive started at $100, we were at $40.

And then we went to $45 and then kept the $100-100.

And then went to $50 with $100-100.

The theory being is, is to get more people to convert.

And that's happened.

I don't know if and when we looked at increasing the base fee, what do we do with the other fee.

Really, I'm not trying to be coy or cute.

We'll let you know after we figure it out at some point.

But as it relates to your question of attrition, we don't lose a lot of sleep over that, quite frankly.

Alright.

And I guess I was just curious on another just like inventory availability from some of your vendors, I guess the one that gets a lot of mention these days is the television category.

Was wondering if you might be able to talk a little about television category?

And then we would also be interested in hearing more on the soft lines inventory availability.

Well, there's a few different things.

First of all, TVs are fine.

Cameras have been a little -- certain high-end cameras I understand have been -- there's been some availability issues because of chips or whatever components.

These are $1,000 plus digital SLR cameras.

The TVs, the availability is back.

But recognizing TV sales overall have been down a little bit for us.

I assume they have for everybody.

In terms of apparel, the second thing, first of all is the issue with importing from Asia.

There has been some challenges with shipping that affects all of us, not just Costco.

So far, we've done pretty well through that.

In some cases there's been a week or two additional lead time which the buyers have been able to build in.

By the way, it hasn't impacted our inventory results or our feel of control over inventory, so that's not been a big issue.

Probably the single biggest thing right now that's a little bit of a pain is some of the electronic toys, the X-Box, the Kinect.

We, like everybody, are being allocated some of the Nintendo items.

It's a high quality problem to have, but we all would sell more if we had it.

One last question from me, Richard is give us an update on any of the healthcare cost trends that you're seeing in the business currently.

Nothing big right now.

Again, as I mentioned in Q1 the rate of increase was a shade higher than top line sales growth.

It was closer to $10 and $12 than it was $15, $17 in terms of dollar increase.

So that's encouraging a little bit.

We're tweaking a few things that we're allowed to tweak without impacting losing the grandfathering of all the new requirements over the next several years.

Again, I think we're finally breathing a little sigh of relief after two years of really big growth in healthcare costs, exacerbated by opening fewer units, having less turnover, and with fewer units, having fewer new hires, because it takes up to six months for an employee to be benefits-eligible.

Part-time hourly is up to six and a half months, full-time hourly up to three and a half months for full-time hourly.

So without having all of those new openings, you have less freebies in the calculation for those first few months, so again, as we ramp up expansion, that helps a little bit.

I think that just dampens that dollar rate of increase a little bit.

Thank you very much.

Your next question comes from the line of Rob Simone from Cowen and Company.

Hey, guys, it's Rob Simone in for Laura.

I just wanted to touch on the membership fee increase again one more time.

I believe on the Q4 call, you guys called out a weaker economy and due to that, you're not feeling a lot of pressure to increase the rate in the near term.

And I know you just said that you're not going to be increasing that rate, or you haven't announced that yet, but could you comment at all on how your view of the macro backdrop has changed?

Thanks a lot.

Well, I think the comment I made was that anecdotally, I remember sometime in mid-2009, mid-to-sometime in the summer of 2009, I just rhetorically asked Jim, right now, all things being equal, if now is the time in our own mind that we should historically, every five or so years, we take that fee if we fill it's appropriate, given the backdrop of the economy, would we?

He said, no, there's no pressure to do it now, and given the economy, even though we have no concern about its impact on attrition and impact on member loyalty, there's no need to rush into it.

And lord knows that, whatever our underlying earnings numbers are expected over the next several quarters, whether we needed it or not to improve our earnings, we wouldn't do it for that reason, we only do it when we're ready to do it, and we feel comfortable, and certainly the backdrop of the economy tempers that enthusiasm.

Not from a standpoint of ability to accomplish it and accomplish it with very low attrition or disloyalty, but the ability to, why be aggressive about it?

Let's wait and see.

So again, as you know around here, whatever the issue is, whether it's this or any issue out there that we're thinking of doing, it doesn't take us a long time once we decide to do something to do it.

We haven't talked about it yet, other than anecdotally, like what I just said.

So I'm trying to beat around the answer of the question, because at this point, we haven't decided what we're doing, and when we find out, we'll let you know.

Okay, great.

Thanks guys.

Good luck.

Your next question comes from the line of Greg Melich with ISI Group.

Yes, hi guys.

This is [Mike Montoni] in for Greg.

My question was actually on ticket first, which was, just looking back historically to mid-2009, we saw 3% to 4% decline in ticket, if you excluded FX and gas, and obviously now, we've gone slightly positive.

So number one, just trying to understand if you can help us with the drivers and it seems like inflation is an obvious one, we're getting a little bit of mix, but is there also some improvement in units per basket as well that you can speak to?

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

The units per basket haven't really changed dramatically, other than, as frequency goes up, part of it is, I used to always say that the typical family member at Costco was coming in every 2.5, 3 weeks, but each of those families were still going to the neighborhood supermarket three times a week.

Well, I think what happened is that three became 2.5 weeks at a Costco, in terms of more frequently, and they're still going to the supermarket, but they're buying more of their food items at Costco, and if they're coming more often, they're buying a few less items, or maybe an equal number of items, but some of those food items, so a little lower basket.

Again, if the recent relative pick-up in the average basket is, I think less inflation, because it's really just starting, and more the strength of some of the non-food categories, offset by more frequency.

Okay, and then, following up on that would be, getting back to TVs for a moment, obviously, last quarter, I believe the outlook was for slightly positive TV dollars, and you haven't quite seen that as of yet, but looking ahead, it would seem that that's one way certainly to get ticket a bit higher.

As you see the units improving a bit with accelerated ASP declines, is there any reason to think that we still wouldn't be able to do positive dollars into 4Q?

Yes.

I was ruffling through my papers to find the answer, Bob gave it to me.

In November, units were actually up a little bit, there was a little bit more than that amount in deflationary pricing, which is, by the way, last couple of months, the first time for most of the first half of 2010, there was inflationary pricing included, so I think, everybody's got a lot of TVs, and we're seeing some strength, the price points keep coming down a little bit, that helps, that's been driving it a little bit, but not a lot.

But I'm really -- I'm sure you can come up with this answer, guys, because I don't have any detail in front of me, other than talking to buyers in general.

One of the things that have driven our TV business is the coupon mailer, what we call the multi-coupon mailers throughout a lot of this current calendar year, there's been fewer of that as there was inflation, there was a lot of pressure on vendors to have to provide some of the incentive.

We're starting to see a little bit more of that, not as good as it used to be, but we would expect that to improve.

So that factor bodes well for electronics sales in calendar 2011, but I don't know how that's offset by how many TVs does everybody already have.

3-D is not exactly changing the face of TV sales overnight, so that's a much slower process.

Okay, and just lastly, actually had a question, it's somewhat of a macro question, but if you look at the accelerated depreciation provided for in the new tax package, so basically 100% expensing of business purchase of CapEx.

Is there a way to think about that as it relates to your business, just given obviously the business member penetration that you have, especially I would think around certain office products, furniture, PCs, et cetera.

Have you thought about that, or done any work to quantify it all?

I have not.

I'm not sure if our buyers have, either, yet, since it's pretty new.

Again, it can't hurt.

It hopefully will help a little.

But I'd be remiss if I tried to guess where that should be.

Keep in mind, each of these departments are small percentage departments of the total Company.

So it helps us, it doesn't -- if furniture and cash registers and PCs and things like that would benefit from this, it will help those department a little bit, but office products for us, as an example, or majors for us, as an example, is about 6% of sales, and probably half of that is business related, and half is not.

So, if it impacts that a little bit, it's great, but it's still a small piece of the action.

Great, well thank you guys.

Good luck.

Why don't we take two more questions?

At the last, we have one more question from the line of Neil Currie from UBS.

Thanks for taking the question.

Congratulations on the great quarter.

Just wanted to ask about internet sales.

Most of my questions have been answered.

But when you look across some of the larger retail businesses, and you look at the internet sales, they tend to be significantly ahead of store sales.

US sales haven't gone badly, they were 6% last year, 9% this year, but not significantly outpacing what you're seeing in your stores.

I'm just wondering what your approach is, and whether you might see any changes to your online sales, whether you're not too worried about developing online or whether you think this is a good performance?

I think we could do better.

Keep in mind, the average ticket on-line is still in the high-$300s for us, and it's virtually all discretionary stuff.

That's by choice in our case.

We are doing a few things right now, to work a little bit.

If Jim were sitting here, he would say, first and foremost, we have to have the right items at the right price, so it's all about merchandising, but I think we can do a better job in several other things.

I'm not promising anything other than we agree even though 9% is better than 6% and 6% is better than a slight negative the year before, arguably, a lot of that because of the nature of the discretionary big-ticket items we sold, we think there's opportunity there, and we are working on that.

We really are working on that, but it's not going to happen overnight.

And just on -- you talked about Asia, but I was just going to ask about the UK.

In terms of those numbers you gave a few years ago in terms of potential store openings, are you still on track for those or is there anything in the UK economy that you see that causes you to revise your outlook and perhaps allocate the capital elsewhere?

Well, you know, fortunately capital is not a big allocation issue for us.

I think in the UK the fact that the economy has been in the doldrums for a couple years.

Keep in mind, there's one other unique thing that UK has in our operation.

To make it work for us from the beginning of time, many of our locations are located in -- I don't know the exact term over there but they are not -- they're not retail zones.

They're PPG6.

And so because of that, there's a limit to how much of our sales can go to the Gold Star member, if you will.

It has to go to the trade.

Those numbers are typically in the roughly two-thirds of the sales range.

A little bit higher than our Company average.

We don't market a lot to Gold Star members.

So structurally, it's been a little different business all along, but a good business.

I think the fact that the economy's gotten hit hard over the last couple years there has -- I don't think that we have cancelled anything.

There's also a lot of limitations and process to go through.

I think I used to say that we might be working on four or five sites, hoping we get approved for one that will get opened three or four years from now.

There's still a harder real estate environment for us over there and the fact the economy's been -- my guess is five years ago, we had said, five years hence, which is now, 21, 22 locations there, what will we open in the next five years, my guess is that number's down a little bit from what we would have guessed five years earlier, but we're looking at openings and have plans to open new sites over there.

I think we've got three or four that Jim and Jeff have approved, our two co-owners, and we're working on them.

How would you compare the real estate environment there compared to Japan?

Difficulty getting sites and opening them?

I'm guessing a little bit here, Neil, but I would think that the process, Japan's more expensive, but the process of getting them is easier.

Great.

Thank you.

At this time, there are no further questions.

Thank you very much, everyone.

Thank you, Debbie.

You're welcome.

This concludes today's conference call.

You may now disconnect.