好市多 (COST) 2015 Q2 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the second-quarter earnings and February sales conference call.

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

(Operator Instructions)

Thank you.

Mr. Richard Galanti, Chief Financial Officer.

Sir, you may begin your conference.

Thank you, Brandy.

Good morning to everyone.

This morning's release, we will review our second-quarter and first-half fiscal 2015 operating results for the 12- and 24-week periods ended February 15 and our monthly four-week sales results for the four-week period ending this past Sunday, March 1.

The discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements involve risks and uncertainties that may cause actual events, results, and our 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.

Forward-looking statements speak only as of the date they are made and we do not undertake to update these statements, except as required by law.

To begin with, our 12-week second-quarter fiscal 2015 operating results, as you saw this morning, for the quarter -- reported earnings per share came in at $1.35, up 29% from last year's $1.05.

As noted in this morning's release, this year's net income was positively impacted by a $57 million or $0.13 a share income tax benefit.

This was in connection with a portion of the $5 per share special cash dividend paid by the Company last month to Company 401(k) plan participants.

Partially offsetting this reduction to the income tax line was a $14 million or $0.03 a share income tax charge related to an ongoing overseas income tax matter.

The net impact of these two discrete tax items to our reported second-quarter earnings -- $1.35 earnings per share -- was $43 million or $0.10 a share to the positive.

So excluding these two items, EPS for the second quarter would have been $1.25 or up 19%.

Other factors that impacted our second quarter when you are comparing year-over-year results -- gasoline operations.

As was also the case in Q1 2015, we benefited from strong margins and profits in our gas business.

I'll speak to this a little bit more when I discuss our gross margin.

FX as compared to a year ago, in Q2 this year, the foreign currencies where we operate weakened versus the US dollar in all countries, but primarily in Canada, Mexico, and Japan.

This resulted in our foreign earnings in Q2, when converted into US dollars, being lower by about $32 million pre-tax or $0.05 a share than those earnings would have been had FX exchange rates been flat year over year.

So again, another relative weakening of these foreign currencies relative to the US dollar.

Third, IT modernization costs.

As discussed in each of the past 8 or 10 or so fiscal quarters, our major IT modernization efforts will continue to negatively impact our SG&A expenses through this year and into next year and possibly a little beyond, especially as new systems are placed into service and depreciation begins.

In Q2 on an incremental year-over-year basis, these costs impacted SG&A by an estimated $22 million or about $0.03 a share.

Fourth, stock compensation expense.

This was higher year over year in the quarter by $14 million or $0.02 a share.

While this charge was about a 4 basis point hit to SG&A, it was a much smaller year-over-year impact to SG&A this quarter than it was in Q1, when the year-over-year delta was $38 million or $0.06 a share to the negative.

Lastly, interest income and other.

This number was lower year over year in Q2 by $10 million in pre-tax or $0.02 a share.

The decrease primarily related to the revaluation and settlement of US dollar payables, primarily in our Mexico operations.

As you know this line item, if you will, it goes back and forth sometimes.

It helps us a little sometimes; it hurts us a little.

Under GAAP, these adjustments are recorded to the interest income and other line.

Now in terms of sales for the quarter, reported sales were up 4.3% and our 12-week reporting comps sales figure was up 2%.

For the quarter, sales were negatively impacted by significant year-over-year gas price deflation.

-- this had about a 323 basis point impact to the number to the negative, and by weakening FX foreign currencies relative to the US dollar.

This was just under 250 basis points to the negative.

So excluding gas, our reported 4% US comps sales increased in Q2 would have been plus 8%.

Our reported minus 2% international comp, assuming flat year-over-year FX rates, would have been plus 8% as well, such that total comps, again, reported 2% for the quarter.

Plus 2%, excluding gas and FX, were plus 8% for the quarter on a more normalized basis.

For our four-week month of February, which included the last two weeks of the fiscal second quarter, reported comps came in at plus 1%, consisting of a plus 2% comp in the US, flat international.

Sales again were negatively impacted by gas price deflation, almost 400 basis points for the month to the negative, and weakening FX just under 300 basis points to the negative.

So excluding gas, the plus 2% reported comp for February would have been a plus 7%; the reported flat international comp would actually been a plus 12%.

And there's a little benefit in there from the switch in the Lunar New Year, I believe, that impacted a couple of the Asia countries for us, such that total Company comps, the reported plus 1% for the month would've been a plus 8%, excluding gas inflation and FX.

In terms of new openings, after opening nine new locations in Q1, including one re-lo, we opened no new locations in Q2.

All told, that puts our fiscal 2015 openings through the second quarter still as 8 net new locations and we now operate 671 locations around the world.

Between now and the end of fiscal 2015, we expect to open an additional 20 new locations -- just a couple in Q3, which will end in early to mid May, and then 18 planned for Q4.

Of these 20 additional openings before our August 30 fiscal year end, 10 are in the US and 10 will be international, so we will most likely end the fiscal year with 691 total locations.

Now a few of those near the very end of the fiscal year could slip into Q1 of 2016, so my guess is is that additional 20 stores, maybe 17 stores, 18 stores -- who knows.

Also this morning, I will review with you our e-commerce activities, our membership trends and renewal rates, a little more discussion on margins and SG&A in the quarter, our recent $5 a share special cash dividend and the related $1 billion debt offering, and our recent announcement related to the planned changes for our US cobranded credit card offering.

For our second-quarter results, sales for the quarter -- for the 12 weeks ended February 15 were at $26.87 billion, up 4% from last year's $25.76 billion.

On a reported comp basis, as I mentioned, Q2 comps were up 2%, but up 8%, excluding gas and FX.

Now for the quarter that reported plus 2% was a combination of an average transaction decrease of a little over minus 3%, but again, taking gas out of that number, the average transaction increase would have been -- taking gas and FX out of that number, the average normalized transaction increase would have been a little over 2% to the positive.

And average frequency increase of a little over 5.5%.

So year to date, shopping frequency is up a little over 5%.

In terms of sales comparisons by geographic region, for the quarter, in terms of geography, our Midwest, Southeast, Northeast regions were the strongest.

Internationally local currencies, Japan was the weakest, still impacted by cannibalization of 2 units we opened in the last 12 months on a base of only 20 units over there, with Taiwan, Korea, and Mexico being strongest in local currency comps.

In terms of merchandise categories for the quarter, for the second quarter, within food and sundries, overall in the mid-single-digits.

Candy, meat, deli, beer and wine were the relative standouts, then hardlines overall in the low single digits.

Departments that were the strongest were tires and electronics.

Consumer electronics was up in the mid-single digits.

Within mid-single-digit softlines comps, domestics and apparel were standouts.

And in fresh foods, where comps were in the high singles, meat showed the best results, although impacted by inflation there.

For February, traffic was up again 5%, while average transaction on a reported basis was down 3.5%.

But again, getting really impacted by FX and even weaker gas year over year.

Gas prices during the four-week month of February year over year, the average price of a gallon of gasoline we sold was down to 31.5%.

In terms of geography, Midwest, Southeast, and Bay Area regions were the strongest during February.

And internationally, in local currencies, Taiwan and Korea were the strongest.

As I mentioned previously, the shift in the Lunar Year Holiday from January to February negatively impacted January comps and positively impacted February comps for the Company probably about 50 basis points each way.

From a merchandise category standpoint, ex-FX, food and sundries overall for the month was in the mid-single-digit range.

Hardlines overall came into the mid to low single digits, which was consistent with what electronics did during February.

Softlines was up in the mid-single-digit range.

And finally fresh foods, up nicely in the low teens over all, with meat being the strongest.

And again, as I mentioned, seeing quite a bit of inflation in that area.

Moving on the line items down the income statement.

Membership fees were up 4 basis points and up 6% from $550 million a year ago in the quarter to $582 million, or up $32 million.

Take out FX, the up 6% in dollars would have been up 9%.

In terms of membership, we continue to enjoy strongly renewal rates.

Our US and Canada renewal rates still is at 91%, I think just a shade under that, averaging up to 91%.

And for the first time, our fully captured worldwide rate is rounding up to 88% instead of down to 87%.

Continuing to increasing penetration of executive member, of course, helps us as well, as those members tend to be the most loyal.

New membership sign-ups in Q2 Company-wide were up 9%.

In terms of members at Q2 end, in terms of GoldStar, we ended Q2 with 32.7 million members, up from 32.0 million, up about a little under 700,000 from the end of the first quarter 12 weeks earlier.

Primary business inched up from 6.9 million members to 7.0 million members.

Add-on remained at 3.5 million members, so total member households: 42.5 million at the end of Q1 and 43.2 million at the end of Q2.

And representing total cardholders going from 77.5 million to 78.7 million over the 12-week fiscal quarter.

At Q2 end on February 15, paid executive memberships were a shade over 15.4 million, which was an increase of 188,000 memberships during the quarter or about 15,000 memberships a week.

And that is both new member sign-ups as well as conversions.

The executive members, as I mentioned before, a little over two-thirds of our -- about two-thirds of our membership base -- a little over two-thirds of our membership base and just about two-thirds of our sales.

I'm sorry -- about one-third of our membership base and about two-thirds for sales.

In terms of renewal rates, they continue strong.

Again, from business member renewal at Q1 end was 94.5%.

It tweaked up to 94.6% at the end of Q2.

GoldStar was 89.8%, inched up to 89.9%.

And total was -- remained at a 90.7% and worldwide the 87.3% went to an 87.9%.

You'll see a little bit bigger increase there, because when you start at a lower base, that tends to improve a little bit faster in those first few years.

Now I'll comment on this past Monday's press release regarding Costco entering into a long-term co-brand credit card agreement with Citi and our acceptance and co-brand agreement with Visa.

As the press release stated, we've entered into a new co-branded credit card agreement with Citi and then a acceptance and co-branded incentive agreement with Visa.

These agreements are subject to the purchase from American Express of the existing co-branded credit card portfolio by Citi and wouldn't be implemented until next April 1, 2016, at the end of our current co-brand arrangement.

While there is not a lot of specifics I can give you at this point, I can tell you the following.

Once issued, the new co-brand Costco Visa credit card will be accepted throughout the United States and Puerto Rico.

The new rewards-based card will be fee free.

The new card will, needless to say, provide generous rewards to Costco members utilizing the new card.

And again, I can't tell you a lot of specifics about that, but we certainly look forward to telling you and our members more about it, but it probably is not going to be until several months down the road this calendar year.

The new card, of course, will also serve as the member's Costco membership card.

Again, there is not all the detail we can give you at this point.

Needless to say, what we do is ultimately for the long-term benefit of our Company and our members -- in this case the co-branded credit card holders as well.

Going down the gross margin line, gross margins were up 54 basis points on a reported basis, from 10.53% to 11.07%.

As I always ask you to do, I'll ask you to jot down four columns and six line items.

The columns, of course, will be Q1 2015, both reported and without gas deflation, and then the columns three and four would be Q2 2015 reported and without gas deflation.

Going across those line items, the first one is core merchandise.

And reported in Q1 was minus 6 basis points year over year.

Without gas deflation, it was minus 13 basis points.

In Q2, reported was plus 10 basis points; without gas deflation, it was minus 20 basis points.

Ancillary plus 22 basis points and plus 20 basis points in Q1 and plus 46 basis points and plus [39 basis points] (corrected by company after the call) in Q2.

2% reward -- minus 1 basis point and minus 1 basis point and then minus 5 basis points and minus 2 basis points.

LIFO plus 1 basis point and plus 1 basis point.

And then in Q2, plus 3 basis point and plus 3 basis points.

And then other plus 6 basis points and plus 7 basis points in Q1 and zero basis points and zero basis points in Q2.

All told, in Q1 2015 year over year to Q1 2014, we had a reported gross margin improvement of 22 basis points, which is the sum of those line items in column 1. On a gas neutral basis, it was plus 14 basis points.

Again reported for this quarter, it was plus 54 basis points and on a gas neutral basis, excluding gas deflation, it was a plus 20 basis points.

Now as you can see, again, our overall gross margin was outsized at plus 54 basis points and even at plus 20 basis points without gas deflation.

Again, a lot of this has to do with gas sales penetration, which were way up as well, even though the lower price per gallon.

Our core merchandise gross margin was up 10 basis points year over year, but again, excluding gas, we see in this chart it was down 20 basis points.

Again, this is a function of both increased sales penetration and strong gross margins with our gas business.

If you look at the core gross margins as a percent of the various departments of their own sales -- and then when I talk about core, I'm talking about food and sundries, hardlines, softlines, and fresh foods, which account for about 80% plus of our total sales -- on their own sales, they were down year over year by 3 basis points in the second quarter, with food and sundries and hardlines being up year over year a little, and softlines and fresh foods being down a little.

Frankly, margins are fine.

We are driving sales and certainly gas prices give us plenty of room to continue to be aggressive, although with gas prices going up the other way right now, we are -- don't expect to see various outsized gas profits in the next quarter.

Ancillary and other business gross margin was up 46 basis points on a reported basis, 39 basis points without gas deflation.

Again, our gas business accounted for nearly two-thirds of this Q2 year-over-year increase, but we also showed higher year-over-year margins in optical hearing aids and pharmacy.

The impact of the increasing executive membership was good.

It hit margins by 5 basis points or 2 basis points without gas deflation.

And again that's that 2% reward feature.

This just generally reflects continued increased sales penetration from the executive members, which, again, as I mentioned, buy more and are more loyal and shop more frequently.

LIFO in the second quarter, we recorded a $4 million credit pre-tax compared to a $5 million pre-tax charge last year, so about a penny a share benefit -- a penny a share or 3 basis points benefit year over year for $9 million to the gross margin.

Moving onto SG&A, our SG&A percentage Q2 over Q2 was higher or worse by 11 basis points, coming in at 99.4% this year versus a 98.3% last year.

Again, we will do the same 4 columns reported and without gas impact in Q1 2015 and then for columns 3 and 4, Q2 2015, both reported and without gas.

Five line items.

The first one is core operations or just operations.

Plus 8 basis points was reported in Q1.

That means -- and a plus year is a positive, meaning lower year over year -- plus 16 basis points without gas deflation.

In Q2, it was a plus 3 basis points and a plus 29 basis points.

Central: minus 1 basis point and minus 1 basis point.

And in Q2, minus 10 basis points and minus 7 basis points, so higher year over year in [net mum].

Stock compensation: minus 11 basis points and minus 11 basis points and then minus 4 basis points and minus 3 basis points.

There are no quarterly adjustments, so the last item will be total.

And again, we reported a minus 4 basis points -- year over year SG&A higher by 4 basis points in Q1, both on a reported -- on a reported basis, plus 4 basis points or lower by 4 basis points in Q1 without gas deflation.

Again in Q2, higher or minus 11 basis points and then better or lower by 19 basis points, so a plus 19 basis points without gas deflation.

Now a little editorial on SG&A here.

Again, the operations component of SG&A was better by 3 basis points in Q2 on a reported basis and better by 29 basis points year over year, excluding gas deflation.

Again, gasoline sales penetration and very low SG&A in the gas business certainly helps that number.

Within operations, excluding gas and other warehouse businesses, so taking all that out, payroll and benefits represented an improvement of 16 basis points of this 29 basis point improvement.

So again, strong sales overall certainly helped us improve payroll and benefits as well and get some leverage there.

Central expense was higher year over year by 10 basis points or 7 basis points without gas inflation.

As I mentioned earlier, increased IT spending for our monetization.

This was a 7 basis points on a reported basis, 5 basis points without deflation and FX.

And lastly, in both years, we had a few discrete items to the tune of about minus 5 basis points, but that is what it is.

Finally, within SG&A, our stock compensation expense, as I mentioned, was higher or worse by 4 basis points on a reported basis, 3 basis points without gas deflation.

Next on the income statement line: preopening expense.

$8 million last year, $9 million this year.

Last year, we had 3 openings.

This year, we had no openings, but we have got plenty of openings coming up, so you've got quite a bit of preopening expense already started and there's lots of little things that go into that number.

No real surprises.

All told, operating income for Q2 came in at $877 million, 21% higher year over year or higher by $153 million compared to last year's $724 million in the quarter.

Below the operating income line, reported interest expense was essentially the same year over year, coming in at $26 million last year and $27 million this year.

As I mentioned earlier, interest income and other was lower by $10 million, coming in last year in the quarter of $30 million to the positive.

This year, only $20 million to the positive.

Actual interest income for the quarter was higher by $3 million.

The other swing was a minus 13 basis points and again, most of that relates to year-over-year swings in various FX things.

In this case, I think the biggest piece was the revaluation settlement of dollar payables, US dollar payables, primarily in our Mexico operations.

I think that was a small positive last quarter.

Overall pre-tax income was higher by 20% or up $142 million from $728 million last year in the quarter to $870 million this year.

In terms of income taxes, our Company tax rate this quarter came in at -- needless to say, on a reported basis -- at a very low 30.2% versus 35.0% last year.

Again, the income tax line benefited primarily from a $57 million tax benefit in connection with a special cash dividend.

Dividends paid on Costco shares held by our employees in our 401(k) plan, which total about 29 million shares, are deductible for US income tax purposes.

And we recognized a one-time income tax benefit of approximately $75 million related to that.

As I mentioned, there was an offset to that benefit of about $14 million after-tax charge to the income tax line related to an ongoing income tax matter.

Excluding these two items, our Q2 tax rate this year was actually up -- would have been up a tenth of a percent to 35.1%, just slightly higher compared to last year's 35.0% on a normal basis.

Overall, reported income was $463 million last year compared to a reported $598 million of net income this year.

Again, this year's net income on a reported basis was up 28%, 29%, taking out those two tax items, up about 19%.

For a quick rundown of other topics, while the balance sheet is included in the morning's press release, a couple of balance sheet information items.

Depreciation and amortization for Q2 totaled $260 million in the quarter and $514 million year to date.

Accounts payable ratio and accounts payable as a percent of inventories on a reported basis, it showed improvement year over year from a 93% figure to a 97%.

There's a lot of construction payables in that.

It has shown a comparable improvement from an 83%, if you just do merchandise -- accounts payable as a percent of merchandise inventories -- merchandise accounts payable as a percent of merchandise inventories, 83% last year, up to 87% this year in the quarter.

Average inventory per warehouse was darn near flat, coming in at $12.8 million this year on average per warehouse, up about $20,000 compared to a year ago, so pretty much flat.

Ex-FX, year-over-year inventory levels were up -- would have been up about $350,000 or about 2.7% of sales on, again, an 8% sales increase.

So I think there's control of our inventories.

And inventory is in good shape.

Midyear physicals came in just fine.

Physical inventories.

I'll respond at this point to questions received in the past few months about the work slowdowns.

As you know, on the West Coast ports, there's -- a week and a half ago, I guess, there was a new agreement.

So things are getting back to order, although the view is that it will take four to eight weeks, if not a little longer, to get through the backup there.

We, like I'm sure every other importer of containers, try to identify which ones have priority where we can.

And really, pretty much the impact of that is over.

When we talked to our heads of merchandising in different areas, the view is in Q2, we probably got hit by $100 million, $200 million.

Nothing to really speak of in terms of sales and it's probably a little worse for some others out there.

In terms of CapEx, in Q1, we spent $555 million on CapEx.

In Q2, we spent $619 million, so quarter to date, just under $1.2 billion.

For the year, we still expect to be similar, in the $2.5 billion to $2.7 billion range, which is up from $2.0 billion last year.

In terms of Costco Online, we continue to operate it in the four countries: US, Canada, UK, and Mexico.

We're also doing things -- not really online, but through Ali Baba T-Mall in Asia.

But in terms of the four countries online, there's costco.com.

Sales and profits, needless to say, were up during the quarter.

Sales were up 23% in the quarter.

Comp sales in the US were similarly up right around 23%.

Foreign sales in the other three countries were up on a local currency basis 20% and more as well.

But again, with currencies being down, there's some impact there.

But overall, continued good results and sales strength on our dotcom efforts.

In terms of expansion, as I mentioned, we planned in Q3 to open 3 units, including 1 relocation, so net of 2 units.

And have current plans for 19 units, which includes 1 re-lo, so net of 18 new units in Q4.

Assuming we opened those, we would be at 28 net new units for the year or about 4.5% square footage growth.

And by country, assuming we get to 28 units, it would be 17 units in the US, so a little under two-thirds there.

One in Canada, 1 in the UK, 5 in Asia, 1 in Korea, 1 in Taiwan, and 3 in Japan as well as 1 in Australia and 3 new in Mexico.

As of Q2 end, total square footage stood at 96.4 million square feet.

In terms of stock buybacks, in Q1, as you know, we started the process and bought a little bit -- we bought $18 million worth or 139,000 shares at an average price of a little over $126 a share.

In Q2, we expended $92 million to buy 642,000 shares at an average price of $143.21.

Now, a bunch of that was done before the dividend date, the $5 ex-dividend date.

In terms of dividends, our current quarterly dividend stands at $035.5 cents a share or $1.42 per share annualized.

That represents a total cost to the Company of about $630 million.

This regular dividend, of course, was in addition to $5 per share dividend, which amounted to $2.2 billion that we paid out last -- on February 27.

And in fact, both dividends were paid to shareholders on February 27.

As I mentioned, we also completed a one -- to pay in part for the $2.2 billion special dividend, we did a $1 billion debt offering a few weeks back, a $500 million of five-year fixed and $500 million of seven-year fixed at attractive market rates.

Lastly, just a couple of other items of note.

The March comp sales reporting period for this year will include 34 selling days versus -- which is a day less than the 35 days last year -- reflecting the calendar shift of the Easter holiday.

In addition, beginning next month, we will start reporting comp sales one day earlier than we have historically done.

So March comp sales will be announced on Wednesday, April 8 after the market close, around 6 PM Pacific Time and 9 PM Eastern time.

Hopefully, that will help our East Coast friends.

And similarly our Q3 scheduled earnings release date will be Wednesday, May 27 for the 12-week third quarter ending May 10.

Again, the release will occur at 6 PM Pacific Time, 9 PM Eastern Time that Wednesday, with the earnings conference call still occurring the following morning.

Before I turn the call back to Brandy for Q&A, hopefully I've helped everyone understand some of the factors impacting the number.

Overall, I think we had -- certainly the outsized gas profits helped, but there were lots of other little things that went the other way.

So overall, still we felt pretty good quarter and certainly strong sales, membership renewal rates, and the like.

With that, I'll turn it back to Brandy for any Q&A.

Thank you.

(Operator Instructions) Charles Grom, Sterne, Agee

I guess my first question is when you look at your gas business today, clearly it's a bucket for you guys to pull from to invest back in pricing for you guys to be like Costco, if you will.

Is there a way to quantify that this quarter?

Clearly, the core margins within the 80% of the business being down 3 basis points, was there some impact from you guys being more aggressive on price or if you could maybe just speak to it thematically?

I think qualitatively, it allowed us to be a little more aggressive.

We didn't just say hey, take this extra money and put it all there.

We didn't.

We certainly benefited from it in the quarter.

Again, it's not like we looked at it and says well, that would be an offset to FX, as an example, because we know that FX has got to -- even if FX rates continue to stay where they are right now and don't get any relatively weaker, it's still on a relative basis and Q3 and Q4 going to be relatively weaker.

So yes, we recognize that Q3 and Q4 will be a little more challenged in that regard, but certainly could margins have been up a few instead of down a few?

Probably, but who knows.

Okay.

Fair enough.

And then when you look to March of next year and the change in tenders, it is my understanding there is roughly 750 million US Visa cardholders today and there's roughly 50 million AMEX holders today in the US.

How big an opportunity this could be for you guys to expand your membership base when you move into next year?

We will see.

There's a lot of unknowns.

The first order of business is for Citi to work with American Express and figure out the account portfolio.

And a lot hinges on that.

We expect that to happen, but there's big guarantees.

And again, there's a lot I'd like to tell you.

There's a lot we will it figure it out now.

We know the bucket of dollars, if you will, in our mind of what we can use to drive usage of that kind of card, to recognizing there will be some cannibalization, somebody that has a Visa mileage card in their wallet.

They may want to use that instead.

Just like there's cannibalization now, there's people who use a non-cobranded AMEX card.

Similarly, there will be other places where there's outside spend increase because your neighborhood dry cleaner, one card is accepted and another card is not.

So I think there's lots of opportunities.

We got to get there first.

And first order of business is the transition itself and there will be a lot more to say once we get there.

Okay.

And then just last question on e-commerce, up 23% in the quarter.

Can you just remind us number of SKUs online today relative to a year ago?

And where you think that can go -- or how much is crossing through your depots versus not?

And then just margins on e-commerce relative to the Clubs.

Thanks.

There's probably approaching 8,000 regular SKUs -- excluding some data, that we have a lot of tire SKUs, based on all the sizes.

We've got a lot of office products SKUs through a third party.

But core SKUs on our side is 8,000, probably 1,500-plus more than a year ago.

And I am guessing there, but that's probably a good number.

And where this increases are, a lot of sundries items, some apparel items, things like that, trying to get you to come back on a more frequent basis.

Smaller ticket items, a lot of the items we've added are items, like I've mentioned, versus $300 to $2,000 televisions and furniture sets.

Okay.

Any color on profitability?

Excuse me?

Just margins in the e-commerce business?

Margins over all are probably a shade lower.

SG&A is a lot lower.

So profitability-wise, e-commerce is a very profitable operation relative to the Company as a whole.

Okay.

Thank you.

John Heinbockel, Guggenheim Securities

So Richard, two-part question to get at kind of the same thing.

You've got some very busy Clubs and you keep increasing traffic mid-single digit every year.

Do you guys spent a lot of time looking at quality of experience in the Club and maybe different parts of the Club, like fresh?

And with that in mind, is there an opportunity to open more Clubs in the US than you might have thought before, maybe cannibalize yourselves, gain share, improve the experience, if some of them are too crowded?

Have you guys done much work on that?

Yes, in a lot of different ways, but not in terms of let's sit down and do that today at one time.

First of all, the quality of experience, as you I think know, I'm sure you know, our operators and our merchants are in the warehouses a lot.

Craig and a random set of merchandising and operating victims just spent two days schlepping around part of the country visiting warehouses, both us and competition and other things.

And looking at new sites.

So I think certainly, the member responses that we get every day, the types of throughput per hour at a front end register, all those things go into that.

And I got to tell you, when a member writes a little complaint -- doesn't have to be nasty, just a complaint -- it gets heard.

And recognizing we are always going to have some challenges.

So we are constantly looking for that experience.

We are constantly looking for that -- to get you out of there faster and to make it a better experience.

I got to tell you, we still get probably more positives than negatives in terms of emails that are sent into senior management about positive experiences with a member with a particular employee who was -- they were helped in the warehouse or somebody went above and beyond.

So we have no illusion that we are doing everything right, but we are pretty steadfast of looking at all those things.

In terms of willing to open more units, absolutely.

If you would have asked me 5 years ago, when we were opening about 20 units a year and probably -- I don't have the numbers in front of me -- but probably it was 70/30 US, and you said Richard, 5 years hence, where are you going to be?

And I would say well, we're going to be about 30 and we actually got there, pretty close.

And if it's 70/30 US back then, it is probably 50/50 heading to 30/70 over the next 5 years.

And here we are, almost 60/40 still in the US.

I think that's a reflection of we are finding probably more opportunities than we thought possible.

Some of it is what you mentioned -- opening up in busy -- that quality of experience, the units that are 250 and 300 and even a few that are 300 plus, trying to get those in, trying to balance that, because cannibalization does cause a little heartburn for a year.

But a lot of it also is is, I think surprising how many units we can put in some of the newer markets -- newer is a relative term -- newer markets over the -- in markets that we've been in for the last 5 or 10 years.

And so I think it's a combination of all that.

Again, last year, I think of the 20 -- in fact, I have it here, hold on -- of the -- of fiscal 2013 -- oh, sorry.

Last year, of the 29 net openings we had, I think 16 were in the US.

And this year, of the 28 -- or 16 units or 17 units were in the US, so a little over half.

And this year it is -- what did I say?

17 units out of 28 units, so almost two-thirds.

And so I think you'll -- probably 5 years from now, as we go from, let's say, 30 units to 35 units, probably still half are in the US and we are finding more opportunities.

Do you think you can get to 1,000 there ultimately or have you not gone out that far?

We haven't gone out that far.

If you add -- you ask -- if you added 30 -- even 30 units a year for 10 years, you are essentially there.

So yes, I think so.

That's certainly not out of the realm.

All right.

And then secondly, what is the thought -- at least, it seems like anecdotally, maybe in certain items or categories, there may be a Kirkland introduced, maybe the brand or brand is no longer carried.

I don't think there's a conscious effort to -- although the quality and value of Kirkland certainly outstrips a lot of the brands -- a conscious effort to get more Kirkland items in the store, more space to them.

Is there a conscious effort or that is just -- kind of it happens.

You put it in, it's where the demand is, and so maybe it squeezes out some brands along the way?

I think there is an ongoing conscious effort to -- there are people that are in charge of coming up with new Kirkland stuff in each merchandise category.

And their job is to try to find new things, just like any buyer's job is to find good, exciting branded items.

And ultimately, an item -- it is our cousin, it has Kirkland name on it, but it has to live and die like any other item.

I think if we have added 30 or 40 items in the past 12 or 18 months, I bet you we've subtracted 20 or 30 items that ultimately didn't work out.

Then we bring back some a few years later that worked better.

I remember years ago, we had an organic peanut butter, Kirkland Signature, that didn't set the world on fire.

I think we are now testing it again and it's a pretty good item.

But we'll see how long pretty good meets.

So it has to -- we recognize the strength of our concept is both KS and brand.

And I don't think if you said Richard, you are in the mid-20s now in terms of KS.

You ever see it going to 50?

That is a stretch.

Even our numbers internally, when we say how we get it from 25 to 30, there is no formal game plan how many years is that going to take.

It's what items work.

And certainly, there's not a lot of low-hanging fruit.

There's lots of $20 million and $30 million and $50 million items over time, not a lot of $300 million and $400 million items, like paper goods or water or things like that, or K-cups.

Okay, thank you.

And last comment before getting to the next question out there.

In terms of cannibalization, even as that has ramped up a little bit, I was just looking over the last few years.

If you go back to fiscal 2013, what we called cannibalization, that's just not here, that's opening three units in Japan.

That affects three or five other Japanese units.

Total cannibalization in fiscal 2013 was 65 basis points and [14.58].

And for the first half of this year, it looks like it's about something in the low 40 basis points.

So it's going to fluctuate between 35 basis points and 75 basis points, depending on what we do and where we do it.

But my guess is something in the 40 basis points to 50 basis points range is kind of -- we are not going to be able to move that number overall a lot.

Okay.

Next question.

Dan Binder, Jeffries

My first question is related to the gas business.

Can you just give us an update on where the comp gallons were in the quarter, where gas is as a percentage of the total sales?

And then you mentioned that the gas margin would start to be a little bit less favorable, given where prices -- what prices are doing.

Can you help us just to understand what the excess margin may have been to EPS this quarter?

Yes, just on that line item, it was two-thirds of the margin improvement of all ancillary businesses.

It could be 200-plus basis points of extra margin.

Our margins in gas on a daily basis over the years could be anywhere from a 0% to a 5% or 6% and it's all over the board.

It might even be a little higher sometimes.

But it really ranges.

And frankly, when it's a little higher, we are saving the customer more money.

In terms of gallonage comps, I remember for a couple years, when the US overall -- not Costco, but all US vehicle gallonage comps -- consumption -- was in the low single digits.

And maybe when the bad economy hit, it went to the low negative single digits.

And we went from -- we remained at 4%, 5%, 6%, 7%.

Right now we are in the midteens.

So we're getting a lot of people coming into Costco to buy gas and that certainly drives them into the warehouse as well.

Then on the IT spend, you mentioned -- I think you said it was $0.02 this quarter.

As you look at Q3 and Q4, what do you expect that impact to look like?

It's hard to guess completely.

I know we've had a couple of -- some of the original modules -- and modules make it sounds like it's a small number -- these are big numbers -- but you have projects that are $50 million, $60 million projects that the day they are put into service, they then, over the next, in our case, 65 four-week periods, over the next five years, generally, you take a little under $1 million a month hit.

And some of those are starting to hit.

So my guess is it will -- is it that much, is it a little less, a little more.

It's hard to say.

But still over a several year period, incrementally, recognizing your denominator sales keep getting bigger too, but even with that bigger sales, we had indicated something in the low- to mid-teens of basis points.

I could be off by a couple of basis points, but it ain't cheap.

And then my last question was related to organics.

Can you just give us an update on how many SKUs there are in the Club at this point, what the mix is of sales, and how that performed in the quarter?

Kind of what you are thinking about that business going forward?

Yes.

It's still a small percentage of Costco.

It's a rising -- but it's a fast-growing area, as it is with a lot of other retailers as well.

You're going to see more and more of it.

Part of that is availability.

There's -- we and everybody else could sell a lot more if there was more out there.

I think we're doing a pretty good job of lining up our sourcing.

And I think I mentioned last quarter that for all of 2014, organic was approaching $3 billion, which was more than twice what it was 2 years earlier, or a year and half earlier.

It's growing fast.

I don't know if it's 50% a year, but it's certainly growing at a high --at a mid -- a low mid or a mid double digit number.

And it's great for us, because we show even a better value on that stuff than some of the things that it replaces.

When we can do organic ground beef, where everybody footballs regular ground beef and everybody makes a lower-than-average margin.

This is the item that everybody tries to make more on.

And so we can make a little more, not a lot more, and show a greater value to our member.

So it will keep growing.

Sorry I can't be more specific.

Okay, thanks.

Christopher Horvers, JPMorgan

Hi, it's Mark Becks on for Chris.

Congrats on the fantastic quarter.

Just a follow-up on a couple of Chuck's questions, actually.

So it doesn't look like you are getting into too much specifics about the change in the credit card to AMEX, etc.

Just curious what has been the response that you've seen from our friends up north?

I knew that changed over in January -- maybe what the reception has been there?

Well, it has been good so far.

We are getting a lot of people to switch, recognizing it is people's membership card as well.

And if anything, our view of the US should be -- I guess I can't get into a lot of it right now.

We wouldn't have done this if we thought there was a lot of risk associated with it.

We think it is a big positive over a long period of time.

But recognize, big positive to us means giving most of it back to the customer, in this case most of it back to the co-branded user of a credit card.

And that's going to happen.

We are really not going to be able to tell you a lot about it for a number of months.

Okay.

I guess I'll switch back to the gas prices then.

Historically, the adage has been you guys benefit when prices go up, but it looks like just based on gallonages and miles driven, which has only been up a couple percent, so you guys are actually capturing a lot more share now then in history period.

Is that something you would agree with?

Yes, no.

There's two parts to that, just so everybody understands.

When prices go up, we make less and save the customer -- we still save them, but we save them less.

When prices go down, we save them more and we make more.

Certainly prices going down, we save the customer more and that's positive and we make a little more -- or a lot more, right.

That has changed in the last few weeks, but we've made a lot more in the last few quarters.

If you go -- the other thing -- the thing I think you are talking about is is when it was in the press every day as prices went from $3 to $4 to $4-plus dollars a gallon, it was on the news every night in every city.

That helped us, I think.

The offset to that would be as prices are less important, how can it help you.

I don't know, other than it is.

And it is a lot, because our gallonage is quite a bit up.

Did you see what the volume and gallonage was/ I think it was, call it, up 11% last quarter?

It was in the mid teens, I think we mentioned.

Okay, yes.

So pretty big acceleration there.

And just finally on geography -- go ahead, sorry.

And by the way -- just getting back to that comment.

I think people ask us why.

I think it's because we do a good job of being the most competitive priced.

And there's that third party, there is a gasbuddy.com, that 40 whatever million people input their price of what they bought gas for for two years in a row, since they started announcing best overall low price out there by $0.14 or $0.16 a gallon across the country.

Now you're going -- that's not every station, every day, everywhere, but on average, with all those data, points, we are it.

And I think that kind of publicity helps us as well.

No, that makes perfect sense.

And then just the last question on geographical differences, it looks like you called out the Midwest and the South areas as the strongest.

Obviously, a lot of moving pieces there, with the Chinese New Year as a help, but then the port shutdowns, which on our math comes out to 60 basis points roughly.

Maybe just what you are seeing, elaborate a little bit geography, and then maybe the Northeast?

I know we have seen some pretty severe weather here as of late.

Thanks.

Well, look, I think you summed up what we summed up on the port strike and the Lunar New Year switch.

I think the big deal is weather has played a role, although it did last year as well.

But if I look at the Northeast as an example, the four weeks that comprised February, the first two weeks were mid-positive single and the last two weeks were mid-negative single digit.

That's a huge swing, but other areas did just fine.

The Texas region got hammered the last week with the weather, but overall, it's -- we've done okay.

Great.

Best of luck.

Simeon Gutman, Morgan Stanley

Couple quick ones.

On the credit card, I know you not going to share a lot of details.

Is there -- besides probably some savings just from some slower interchange fees or credit card fees, is there any elevators, such that if there are certain volumes met, you could see further benefits down the road?

Or is this the lower fees, you will see a benefit upfront?

And then from there, just how much business you do?

As you are asking, I'm looking at my wall behind me and there was a handwritten note from many years ago, when our securities counsel was sitting here.

He quickly, if somebody was asking a question, he wrote we have no comment beyond the release.

The reality is is there is lots of buttons that you push on these agreements.

There is all aspects of it.

At the end of the day, whatever our current arrangement -- as we look at it, whatever our current arrangement is with our current provider, both what we pay, what we receive to offset some of that, what our member using that co-branded cardholder is rewarded, we start with a premise of how much is that to start with, where we think it can go to.

At the end of the day we can -- whatever that bucket of money is, it can go towards lowering merchant fees, raising rewards, or using some other place in our Company.

We will figure it out.

We think it's an exciting bucket and we'll do a lot with it.

But just like I've told people in the past, if we can save $1 on buying a product better, whether it is detergent or coffee or anything or due to packaging or raw materials costs or energy costs, we going to give $0.80, $0.90 back to the customer.

And rest assured, there will be -- whatever benefit X is, a little bit it will accrue to our P&L and a lot of it will accrue to the member in some way, shape, or form.

But none of that can be -- we can't really tell you until next year.

That's fine.

That makes sense.

On membership, I know you don't say a lot on international versus US, but can you just speak directionally to whatever growth rate you are seeing in membership, whatever trendline has been occurring, how has that -- has it changed much?

Is it the same in the US versus international?

It's higher international, because we are newer, needless to say.

And I think I have shared in the past, if you take the total number of members divided by our total number of warehouses, you've got roughly 59,000, 60,000 member households per warehouse.

In Japan, you've got a number that has -- it's a three digit number.

It's the low hundreds.

You also have a higher -- a lower renewal rate in those first few years.

So it tends to balance out over time, but we operate over all in other countries on a membership fee as a higher percent of sales, particularly in Asia.

But whatever prevailing growth rate there has been in membership in the US, up until second quarter or up until the first -- meaning, has that run rate stayed the same in the US?

Yes, yet a lot of it is dictated by new openings.

And again, it's going to be dictated more -- like when I said new member sign-ups in the quarter were up 9%.

There have been times when it has been almost flat or down a little bit, because a year earlier in that quarter, you opened three units in Asia, where you might have -- and again, I talk about an average of roughly 60,000 member households per location.

We've had locations that will have new member sign-ups as of opening day.

And that as of open day means during the 8 or 10 or 12 weeks prior to opening, when the parking lot is kind of set and we have the flags and the tabling activities out front.

You could have anywhere from 25,000 to 40,000 members signed up.

Now 40% of them aren't going to renew a year later, but in terms of new members coming in and buying a membership -- and that really distorts that number.

So I don't know how much meaning -- that plus 9% is a function of that as well, but we always point that out.

Okay.

And then just very quickly, can you just remind us -- the e-commerce business, is there -- are there member-only items or is there items someone can just -- who is not a member can just come on the website and purchase as well?

In this crazy world, there are some items that we have online where we have agreed not to show the price unless you are a member.

Okay.

Not to show the price, but the only person who's buying on your website is a member?

Yes.

Okay.

Thank you.

Paul Trussell, Deutsche Bank

I wanted to just touch on membership as well.

Certainly, with consistent and strong traffic and you certainly are saving people money at the pump, how are you thinking about the value proposition of your membership currently in the US and international?

What may be the timeline in terms of you kind of reassessing what you think the value of the membership should be?

Well, I think in a roundabout way, you were asking about when do we see any possibility of a fee change.

Historically, that's really what we think about last.

We drive prices and value every day at everything we do.

And I mean it.

You come to our budget meetings every four weeks and you've got a day and a half and half of that time or a third of the time is merchants.

And we are figuring out how to improve the value and lower the price and raise the quality.

And historically, using US and Canada as 80% of our business, first of all, and probably 80%-ish -- a little different in that number, pretty close in terms of percent of members -- you have -- we have done a fee increase about every five or six years.

The last one we did was in very late 2011, very early 2012.

So during most of the calendar year of 2012, those renewers for the first time in 5 or 6 years of a fee increase from $50 to $55 and from $100 to $110 on the executive in the US and Canada.

If history repeats itself, 5 to 6 years from January 2012 will be January 2017 into January 2018.

So that is, again, based on history doesn't mean we going to do it or not going to do it.

We have chosen generally to hold memberships fees at whatever their prices are in most of the other countries, in part because it is so darn strong to start with and why not continue to drive the business.

And so again, I think it's generally the last thing we look at, but something we've looked at regularly over 30 years.

And I'm sure we will look at it again when the time is right.

Sounds good.

And then just circling back to gas profitability.

And I know you have addressed this a few times on the call, but given the spread between the Street's forecast and the actual for 2Q, I just wanted to touch back on your comments around the third quarter.

You mentioned that gas prices have started to trickle back up, but frankly, can you help us just kind of think about our expectations for the back half of the year?

Should it be closer to a more normalized cadence around gasoline profitability or do you continue to see a little bit of tailwind, given the favorable mix?

Well, if you look at history, when we, each quarter for the last several years, will share with people that gas helped us a little, hurt us a little, helped us a lot, hurt us a lot.

It is virtually all -- it's pretty much in proportion with the trend of gas prices per gallon.

And so as you know, the constant drive down has stopped and it's actually been up a little bit.

So a lot of that party is now behind us for right now, but I can't really tell you what it's going to be, other than historically, that's what it has been.

Understood.

Thank you.

Matthew Fassler, Goldman Sachs

First question relates to the special dividend.

I guess this is our first conference call since you announced the last one.

What the prior special dividend that was around the time of tax policy change and many companies pursued that tack.

As you take a bigger picture look now at capital allocation, understanding that you did accelerate the stock buyback a bit, how are you thinking about special dividends, perhaps as a recurring element of capital allocation?

And any other light you want to shed on your decision to issue that one last week?

Well, we now have two data points instead of one.

We did it -- and you are right, the motivation -- or one of the motivations for doing it when we did it was reading about it in the Wall Street Journal every day and just before people expected dividend tax rates to go up dramatically, so it made sense to be not only shareholder-friendly, but shareholder-friendly in a way that might help people as well if tax rates were going to change and be proactive about that.

I think we appreciate the fact that it was perceived as being shareholder-friendly.

As you might expect, both management and the Board want to continue to do things in that regard.

And it's not like we sat down and did this giant study of exactly when, how much, and what should we do.

I think we liked it the first time and it seems like our shareholders liked it the second time.

I'm not trying to be cute or coy about it.

They are a little independent of each other.

I think when we did the first one, which was a little over $3 billion worth, it was quite sizable.

It was a time when, I guess in retrospect, we could have bought some more stock back.

It would've been a smart thing to do, given where it's at now.

But we tend to do both and we tend to look at all things first and foremost CapEx.

How can we ramp up CapEx?

And we have done that.

Second would be our regular dividend, what are we going to do with that every year.

Again, there's no guarantees, but in each of the last spring periods over the last 9 years, I think we have raised it on average around 13.5%.

We looked, as you know from your models and our models, we are generating more cash than we can use in CapEx.

And so we will continue to look at ways to be shareholder-friendly.

But there is no reason to think it will be two years hence, we will do another one.

But there is no reason to think we won't.

We will see.

It's interesting -- even though you're running with several billion dollars of cash on the balance sheet, you haven't gotten to the debt markets, which I understand is opportunistic.

Should we think about the cash balance that you have today as something that you feel you need to be comfortable with or is that a number that you could whittle down over time?

It's a number we can whittle down.

Mind you, and I am looking at quarter end -- this number might be a shade different than the balance sheet number, but I think we had cash and short-term investments of -- hold on a second.

I think we had cash and short-term investments at the end of the quarter of $7.4 billion, roughly.

And I had a number that wasn't completely consolidated, of like $7.2 billion, but if you look at that roughly $7.4 billion number, about $2.5 billion is real cash in the US.

Another $2.5 billion dollars, $3 billion is real cash outside the US, where we are spending it, frankly.

And in addition, we announced last year that we brought back some of the cash in Canada.

So I think we could whittle the number down, but some of it is cash equivalents.

If you think about from the time banks close on Friday night to the time they open on Monday morning, all those debit and credit card receivables, which could be upwards of $1 billion, $1.5 billion, $1 billion-plus, that is a cash equivalent, but it's not cash.

Got it.

That's very helpful.

And then just a very quick follow-up.

We are seeing the LIFO creep up.

I know it's only a couple basis points, but it's a nice change from year ago, when, I guess, you peaked out at around 8 basis points hit.

Could you just talk about what the moving pieces are in driving that?

And I know you feel like you are fully marked at the end of any given quarter, but if you had to place bets on which direction it would go for the rest of the year, it would be very helpful.

I don't know.

Gas has come up a little bit, although it's still below where it was at the beginning of the year.

So that is still probably -- as of today, it is LIFO creditable.

I don't think it is going to be a big giant number either way, but it is a little bit of a crapshoot at this point.

Got it.

Thank you so much.

Yes, by the way, Matt, part of that is, some proteins are inflationary right now for not all reasons related.

And then some other things, we are just to starting to see the beginnings of some deflationary pressure on items manufactured with oil -- plastic bags and the like.

So some of that is starting to finally flow-through, so there will be some things that are inflationary and some that are deflationary.

Thanks for that color.

Kelly Bania, BMO Capital Markets

Not sure if it's too early to ask this, but just curious about the members that you brought in via the Living Social promotion several months ago?

Just curious if you are tracking them?

Are they following that typical spending pattern of a new member in terms of spending and frequency?

I'm in a pud, because I don't know the answer to that.

But if you hold the question for next quarter, I promise we will have some numbers.

I know that we are tracking it, I just don't have the detail on it.

I know that on average, they are little younger.

I don't know spend habits.

Okay.

Then just another one.

You mentioned the Bay Area as I think a strong region either in the quarter or for the month.

I know that's an area where you have more robust offering in organics.

And I was just curious if that's part of it.

And maybe how plans are to kind of bring that more robust organic offering to some more Clubs in the rest of the country.

Well, and that's probably a little piece of it.

I think weather overall has helped.

The West Coast -- as bad as it has been in Texas and the Midwest and East Coast, it has been offsettingly good over on our side of the country.

And I'm sure that has helped some.

Clearly, I think some of the merchandising efforts we have done on organic have helped.

Part of that -- we are doing it more in other parts of the country.

Part of it is supply issues and it will still take time for that to grow.

Great.

Thank you.

Scott Mushkin, Wolfe Research

I want to get back to e-commerce and maybe the ancillary services ex-gas and just explore -- I know I think you said that the margins are great.

Did you give us a number on how big e-commerce is?

No, it's -- you mean total size of e-commerce?

Yes.

It's about 3% of our total.

3% of your total sales?

On an annualized basis, I think last year, it was like $2.9 billion something -- $3 billion and growing at 20%.

$3 billion and growing 20%, 25%.

And then from a gross margin perspective, how do we think about SG&A associated with that business?

Is there much of it?

Is it like fractional?

Couple percent?

How do we think of SG&A when you look -- I know a lot of the stuff just goes directly to the consumer, about 60% of it.

Is there really a lot of SG&A associated?

No.

There's -- margins are a shade lower, not a lot.

And SG&A is a lot lower.

Okay.

And then from a philosophical -- everyone has always ragged on -- or not ragged on; that's a bad way to say it -- everyone's always -- some people have criticized Costco because they don't let enough flow through to shareholders.

How do we think about that?

I think the gross margins are -- what you are saying, they're a little bit lower.

SG&A is a lot lower, so net-net, we got much better operating profit in the e-commerce business.

Is that okay with the Company or is that something that you would try to make look like the rest of the business?

No.

We are a retailer.

There's different parts of it.

No, we are happy to make a little more there.

We're still making -- first and foremost, are we as competitive as we can be relative to others?

And we feel that we are very competitive.

We also recognizing that e-commerce is supported by the buying strength of the warehouses.

As we brought in line electronics and furniture and some of those bigger ticket categories, that buying strength, how do you compensate -- how does e-commerce, if you will, compensate for that.

So it's all part of the same thing.

The fact that it's margins over all are little lower than the warehouses I think is indicative -- is a function of that and we will continue to do that.

We work on strong profits in some of the other ancillary businesses, but they also have different either costs associated with it or purchasing powers.

Pharmacies -- of course, you've got pharmacists and pharmacy techs that make more than your average hourly employee.

So you've got a higher cost structure there as well as all the regulatory and billing stuff in that business.

So we work on a higher margin to offset some of that, but we also work on a profitability number that is good.

So it's all part of the equation, if you will.

So then just one last one.

So I think you said you are up to 8,000 SKUs.

One of the things that we think benefits Costco hugely on the e-commerce is that you are basically letting me use your people to do the shopping for me.

In other words, like the fact that there isn't 2 million SKUs like there is on Walmart's site I think is a great attribute.

So what is your thought about where the SKU count goes, kind of balancing Costco being a personal shopper versus wanting more, maybe more SKUs?

Where do you think it goes?

I think it probably goes up a little bit, but not a lot.

The fact that it went from 4,000 SKUs to 8,000 SKUs or something in the last few years is a lot.

But part of that was is trying to drive business, adding some categories to get people -- for people to think of it as top of mind or near top of mind instead of not at all.

If I had to think about a comment from a very loyal shareholder and somebody who loves Costco, with three kids at home, three teenagers and said look, I love Costco and I know when I go into a warehouse, I know I'm going to get the 10 items I plan to get in the food and sundries area and the other 10 items that I didn't plan to get.

But I know I'm going to come out with 20 items and I'm going to be sated.

And I'm know I'm going to have great food samples and I know I'm going to get three other things in the nonfood area that I had no plans to get and I'm excited about that.

But I knew going in it, I was going to get three or four items that I didn't plan on getting.

But when I go -- I don't know why -- when do I go to costco.com.

So part of our challenge in the last year on costco.com is not only driving sales of those bigger physical ticket -- bigger dollar ticket and physical ticket items that not everybody wants to schlep home, like furniture and big-screen TVs -- and have a great price and a great, in many cases, white glove service delivery.

And we are driving that business.

But also how do we get you there more regularly?

And whether it is K-cups and other items for your office or home or some apparel items -- as you know, the 5.5 million KS dress shirts that we sell every year, which is a great value, if you're -- I always joked, if you are really tall with short arms, we cannot serve you, because we don't sell all the sizes -- size and sleeve and collar combinations.

Online we do.

So trying to get different reasons to get you onto the site more often is part of the equation here.

And I think we are doing a pretty good job of doing that.

But -- I don't see -- if you said Richard, do you think you can 50,000 SKUs one day?

Gosh, I don't see it in my near future.

Thanks for the answers.

Really appreciate it.

Oliver Chen, Cowen and Company

Congrats on such solid results.

I just had a bigger picture question about holiday.

Did you have -- would you prioritize any major learnings from holiday in terms of where you might look to do things differently next year?

And then on the core merchandising margins number, what should we look at as helpful drivers for that positively going forward?

Or what kind of run rate might we expect there?

Thank you.

What were you saying -- what was the second part of that question?

The core merchandise margins.

What are some of the positive drivers we should look for in terms of optimism on the core merchandise margins, whether it be inventory control.

Or is the run rate at a slight negative kind of realistic for us to model?

On the latter part, we don't provide specific direction on that area.

I remember several years ago, when our margins were just down year over year every quarter for a couple years.

And every quarter, we would say margins are fine.

We can tweak them a little bit if we want to and when we want to.

I think that sentence and that response is still there.

I think we continue to get excited by strong sales and strong loyalty and strong conversion to executive member.

And all those things will continue to take front seat to a little margin improvement.

But if we want to get a little bit, we think we can while still being very competitive.

In terms of what did we learn or not learn during the holiday, I think when we look back, I think we did a -- we think we did a pretty good job of planning for the port slowdowns.

And arguably, it is probably easier to do a better job when you are managing fewer items.

And so while we thought we got hurt by a little bit, I think we probably mitigated that hurt.

Beyond that, again I think we are comfortable when raw materials prices in bakery and food court and the like go up, that we not going to change our prices.

And if it hurts our margin a little bit, it hurts it.

We can get it elsewhere.

So I don't think -- this was not -- given our strength, we didn't -- there weren't a lot of things necessary to learn as it relates to did sales soften and we drive more sales by more markdowns or something.

I think we thought we came out of this season pretty good.

And if anything, continue to be aggressive in terms of the types of products, the price points of products, that our member wants great value on great items and we'll continue to drive the value proposition in upscale items.

Yes.

That sounds encouraging.

And inventories were nicely growing versus the sales, like under [penny] sales.

Is that a trend we should also model going forward in terms of the spread being neutral?

Probably a little bit.

Again, I wouldn't read too much into one quarter.

For a number of years here, we have generally -- again, taking FX and gas out of it, but just the walls of warehouse inventories on a non-FX diluted or increased basis -- generally speaking, we have had sales greater than inventory per warehouse increases.

If sales were up 8 or 9, inventories were up 5 or 6. I think my guess is is Q2 was a little better than we thought, but luck of the draw a little bit, but still trending in a positive ratio there.

Okay.

In our last question, you gave a lot of great details on the e-commerce and the evolution there.

What about flexible store fulfillment and reserve and pick up and ship from store.

Is that on the horizon?

Is it something your customer appreciates and will that be a material driver of traffic?

At some competitors, e-com contributes 100 basis points or more to comp.

Well, 23% growth on $3 billion is like $60 million or whatever -- no, $500 million.

So that's like a little under 0.5% of comp to the Company.

First of all, we don't do it right now, with the exception of the eight or nine Costco Business Centers that we have, that we both deliver and order for pickup.

Some of the things that we are testing with like Google and [decart] are something enhanced, but it's not like -- you can't call Costco or go online at Costco and say I want to order this stuff and I'll come and pick it up.

So I don't know if our member appreciates it.

I know there's a lot of effort out there doing it.

Our first order of business is get -- we just are installing the membership module, which includes a lot of hooks to things, but I don't see us doing that certainly in the next year.

Okay.

Congratulations all this momentum and excitement.

Thanks a lot.

Best regards.

Michael Lasser, UBS

One, have you seen any evidence that gas prices correlate either to customers' willingness to spend more on food, sundries, and hardlines in your stores or your ability to sign up more members at your Clubs when gas prices are either moving up or moving down?

It used to be when prices were moving up and it was the topic du jour every night on the -- from the consumer product and the consumer activists on the local news stations, when prices were skyrocketing is when we saw some real sign-ups related to it in that market.

Conversely, you see less of that right now.

Certainly, we are seeing -- the answer is I don't know completely.

But certainly, we are seeing more traffic to the gas stations, more and continued strong shopping frequency in the four walls of the warehouse.

And some of that has got to be related to that, but I couldn't tell you how much.

Okay.

And my second question is on the credit card.

Can you give us a sense of what the private-label credit card penetration is in your Clubs?

I don't think we disclose that.

Total credit card -- in the US, total credit card is about 40%.

Debit is about 40%.

Cast, check, and other is about 20%.

And -- but presumably a big portion is private-label?

Certainly more than half, but there are people that choose -- either -- usually our current thing.

There are people that choose to get Starwood points or Delta points on a different AMEX card than the Costco one.

Our goal, though, is to certainly drive more of it and we have successfully historically and hopefully we can do that in the future to drive more of it to this top-of-wallet card.

Got it.

Thank you so much.

Meredith Adler, Barclays.

There is no response from the line.

Bob Drbul, Nomura.

Just have two questions for you.

The first one is when you look at the impact of FX this quarter throughout the P&L, can you just help us understand a little better, like what we should expect both on MFI and on SG&A over the coming quarters as we look at the foreign exchange where we are today?

And the second question is, with gas prices rising a bit over the past few weeks, are you adjusting the merchandise pricing that quickly to reflect the movement in gas, as you were opportunistic this quarter.

With gas prices going up, will you change things as we go into the next few weeks, given the rising prices?

Well, the answer to the last one is no.

And again, I can't tell you all exactly what, when, and where and how, but did it give us a little bit of cover to be aggressive?

Yes.

Did it give us a lot?

No.

It gave us a lot of cover, but we choose not to use it.

So it's not like we were going to say hey, let's take all this and go use it.

So yes, as gas profits come down, that was part of our improvement.

It so happens in this quarter -- one of the reasons I pointed out all those other things, some of which will continue to hit.

You guys can figure out FX based on where the currencies of each country are.

If it weakens a little bit relative to the dollar from a year ago, it's a little more impactful.

If it weakens a little less, it's a little less impactful, but still with a negative in front of it.

Interesting coming out of there is a little bit of a crapshoot.

It goes both ways.

Gas, we know, is going to be less outsized profitable in the coming quarters.

And there's no reason to -- hopefully, that sales will continue to drive in the right direction.

I think over all, I would look at Q2 and taking all the good of gas out and the negatives of some of those other things, some of that will go away in Q3, but if we can drive sales and frequency, we will be fine.

Okay, great.

Thanks, Richard.

I'm going to take two more calls.

Gregory Melich, Evercore ISI

Two questions.

One is -- and I realize there's a lot of moving pieces, but if you were to look at gas and how much that helps EPS this quarter, could you give a range or if it was $0.10.

And then sort of think about it going forward, if gas was steady, is that something you have to cycle, it comes back, or is it something that is a new plan?

And then my other question was on gross margin.

I think I heard you say that in ancillary, there was pharmacy and maybe something else where there was some margin expansion.

Could you help explain that, if I heard that right?

Thanks.

Sure.

We are not going to give specifics on gas.

It was very profitable; a little bit can be an offset to other margins.

A lot of it is just outsized, but then we also had a few other things that went the other way.

So that outsizedness was a little less outsizedness.

In terms of gross margin, optical and hearing aids.

Again, just looking, just like I say in the core, gas was the big one, but several other key ancillary businesses also had slightly improving margins year over year: pharmacy, optical, and hearing aid.

And what drove that?

Was there a mix issue or --?

I think some of it -- I think it's driving sales.

A big chunk of it is driving sales.

I think in hearing aids -- and I'm guessing here, because I don't know -- our success of our Kirkland Signature, which is an incredible value and quality.

I am told that the penetration of that is huge.

Generally, we make more margin and save the customer more money on our private label.

But I am guessing at that one.

And I guess just because it is linked a little bit, where are we now with inflation for the whole store?

If you were to roll it together?

Does it meet enough in electronics now and all that kind of stuff.

Year to date, we are about 0.5% deflationary.

That's a LIFO index for US inventory, so what were all-like items cost us on day one of the fiscal year and what are these same items cost us on day 180-ish or whatever of this year.

And if on day one, it was 100.00, at the end of 24 weeks, it was 0.995.

So literally 0.5%.

You had a little bit of inflation in some sundries and apparel and domestics.

You had deflation, as you expect, in majors.

You have deflation in gas and you had deflation in food and sundries -- in food a little bit.

Sundries were up a little.

Food was down a little.

So not a lot of deflation.

Okay, that's great.

Thanks a lot.

Joe Feldman, Telsey Advisory

Wanted to just ask about international for a moment.

I think you have been in Spain now for about a year.

Just was curious for a little update there, update on what you are thinking about new countries.

I believe France was going to be next.

And also just more generally, just store productivity.

When you are opening internationally, are you still kind of achieving and exceeding the targets that you have set out?

In Asia and Australia, historically, we have achieved and exceeded, recognizing whenever you go into a new country -- and I will go back -- I use Japan as an example.

15 years, 18 years ago -- 15 years ago -- our original plan there was to open a unit a year for five years and just to achieve breakeven at the end of year five.

I think we ended up opening six in five years and we achieved breakeven at the end of year four, roughly.

And a lot of that has to do with you've got a $5-plus million a year net on central expense.

Buyers, carrying department, small IT department, you name it.

And then, of course, all the inefficiencies of starting up.

Membership-wise, we are doing great in Spain.

We have one unit, mind you.

Sales-wise, we are little under our plan, but it is starting to finally grow nicely.

I think now that we are there to stay, we've got two openings planned for the remaining part of this calendar year, both of them in the Madrid area and -- one is in September and one is later that year.

I think they are both in the fall.

And again, what we find, even if it's a different cities, once we are there, you start getting more local vendors willing to sell you, because we're going to be around and you get a little more play in the press.

So we will see, but we feel good about going so far.

France -- we are still at least a year away from opening.

I think when we first sat down four or so years ago, the view was is that Spain would take three to five years and France would take three to eight years and it is.

So it's a long, drawn out process of permitting and the whole appeals process over there by third parties.

Got it.

Thanks, guys.

A lot of the other questions we had were answered, so thanks and good luck with this quarter.

Well, thank you.

And thank you for listening for an hour and a half and have a good day.

Thank you.

This does conclude today's conference call.

You may now disconnect.