好市多 (COST) 0 Q0 法說會逐字稿

Good morning.

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

At this time I would like to welcome everyone to the Costco Q2 earnings conference call.

(Operator Instructions).

Thank you.

I would now like to turn today's conference over to Mr. Richard Galanti, CFO of Costco.

Please go ahead, sir.

Thank you, Jodi.

Good morning to everyone.

This morning's release reviews our second-quarter and first-half fiscal 2014 operating results for the 12- and 24-week periods ended February 16 and our monthly sales results for the four-week reporting month of February which ended this past Sunday, March 2.

The discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and that these statements involve risks and uncertainties that may cause actual events, results and or performance to differ materially from those indicated by such statements.

The risks and uncertainties include but are not limited to those outlined in today's call as well as other risks identified from time to time in the Company's public statements and reports filed with the SEC.

To begin with our 12-week second quarter, for the quarter we reported earnings of $1.05 a share.

This compared to last year's second-quarter earnings reported at $1.24.

As noted in this morning's release, last year's earnings figure was positively impacted by a $52 million or $0.14 per share income tax benefit that was in connection with the portion of a special cash dividend we paid in December of 2012 to Company 401(k) plan participants.

Several factors impacted our second-quarter earnings beyond that.

These included lower sales and gross margins in hard lines most particularly during the four-week holiday period between Thanksgiving and Christmas, lower year-over-year gross margins in fresh foods, the FX impact of weaker foreign exchange rates year-over-year when reporting profits from our international operations.

This represented if you assumed no change year-over-year in the currency exchange rates, about $23 million pretax or a little over $0.03 a share.

For example this year in Q2 versus a year ago, the Canadian dollar relative to the US dollar is down 8% and Japan about 15%.

In addition on income tax even after excluding that tax benefit I just mentioned, it was still 1.5 percentage points higher year-over-year in the second quarter.

Last year in Q2 as I had mentioned then, there were a couple of positive discrete items that lowered last year's rate by about $10 million or $0.02 a share.

As well in both this year's and last year's second fiscal quarter, there were a few other discrete items that in the aggregate represented a year-over-year negative swing to our SG&A expenses by about 5 basis points or $0.02 per share.

So while earnings results for the first four weeks of Q2 were very weak, earnings in the subsequent eight weeks of the second quarter showed improvement.

In terms of sales for the quarter, total sales were up 6% and on a comp basis, up 3%.

For the quarter, sales were negatively impacted by gas price deflation as well a bigger impact by weakening foreign currencies relative to the dollar year over year.

That alone was about 200 basis points.

Excluding gas, the reported 4% US comp in Q2 would have been plus 5% and reported flat international comp assuming flat year-over-year FX rates would have been plus 7%.

(inaudible) the total Company reported -- which we reported again a 3% comp for the quarter excluding gas would have been plus 5%.

For the four-week month of February which included the last two weeks of the fiscal second quarter, comps came in at a plus 2%.

This consisted of a plus 3% reported in the US and a minus 1% internationally.

Again gas deflation and FX had an impact such that the 3% reported US comp increase for February would have been a plus 4% and a minus 1% international excluding same FX exchange rates year-over-year would have been plus 5% and the total Company, the plus 2% that we reported would have been a plus 4%.

I now mention which I haven't in quite a while, weather.

It has been all over particularly in the US, snow, rain, just crazy weather.

We estimate that the weather impacted February sales results represented about a 1 percentage point hit to the four-week reporting period.

In terms of new openings after opening 13 new locations in the first quarter as well as closing our Acapulco Mexico location due to the hurricane damage, we opened three new locations in the second quarter, two in the US, one each in Illinois and Texas and one also in Ontario, Canada.

All told, that puts our fiscal 2014 openings through the second quarter at 16 new locations and we now operate 649 locations around the world.

Between now and the end of fiscal 2014, we expect to open an additional 14 locations, three in the third quarter and 11 in the fourth quarter.

These 14 which again, this will be before fiscal year-end on August 31, six are planned for the US, two additional locations in each of Japan and Korea and one each in Canada, the UK, Australia and of course, our first location opening in Spain in Seville this spring such that we would expect to end the year with 30 new openings for the year.

This morning I will review with you of course our membership trends and renewal rates, our e-commerce activity and of course additional discussion about margins and SG&A.

To start off again, total sales were up to $25.76 billion, up 6% year-over-year and comps again was a reported plus 3% and a plus 5% excluding gas and FX.

In terms of the plus 3% reported comp sales, the average transaction was minus 1% for the quarter on a reported basis.

Again FX impacted that as well, would have been a little over 1% plus on a flat currency year-over-year.

Average frequency was a little over 4%.

For the three recent months, frequency was just under 4%, just under 5% and just under 3% for December, January and February and year-to-date shopping frequency continues to be in the 4.25% range.

In terms of sales by geographic region, both for the 12-week quarter and the four weeks of February geographically Southeast, Midwest and San Diego regions were strongest.

Internationally as well both for the quarter and the four weeks of February, the strongest regions in local currencies were Mexico and Canada.

For the second quarter in terms of merchandise categories, within food and sundries overall in the low single digits.

For hard lines overall in the mid-single digits; within that we are asked about consumer electronics, they were slightly positive for the quarter overall.

Within the mid single-digit comp range for soft lines and then in fresh foods up in the mid to high single digits overall with produce being strongest.

For February again the traffic was up just under 3% shopping frequency and again, the reported average transaction was down about a little over 1% but again a big impact from gas and FX.

In fact just during the month of February year-over-year, the average sale price for gasoline was down about 10% for the month.

From a merchandising category standpoint, food and sundries overall was in the low single-digit range; hard lines overall came in slightly negative with electronics being down in the mid single-digit range; soft lines was the strongest area in the mid to high single-digit range; and finally fresh foods mid single-digit range overall, again produce being particularly strong.

In terms of moving down the income statement in terms of membership fees, $550 million up 4% or $22 million from a year earlier, $528 million.

Again you have got the impact of FX.

If we assumed flat year-over-year FX that reported $550 million membership fee number would have been $563 million or up 7% year-over-year.

In terms of membership, our renewal rates continue at record levels and we continue to see increasing penetration of the executive membership.

New membership sign-ups in the second quarter Companywide were up 13% year-over-year again mostly reflective of very strong sign-ups in some of our international openings including recent new openings in Japan and Australia.

In terms of number of members, Gold Star, we ended the first quarter 12 weeks ago at 29.6 million, at Q2 end it was 30.1 million.

Business primary rounded both Q1 to end at 6.7 million, Business adds on at 3.5 million each.

So all told 39.8 million at Q1 end up to 40.3 at Q2 end and including the additional card, 72.5 million at Q1 end was up about 900,000 to 73.4 million at Q2 end.

Also at the second quarter end, paid Executive memberships were just over 14 million, an increase of almost 200,000 since Q1 end or about 16,000 a week in the quarter and again Executive members are roughly 35% of sales and a little over two-thirds of our sales -- 35% of our membership base and a little over two-thirds of our sales.

In terms of renewal rates as I mentioned, we continue to tweak up a little bit.

At Q1 end, Business membership's renewal rates were 94.1%; at Q2 end it was 94.3%; Gold Star 89.3% went to 89.6%, so all told, 90.2% up to 90.4%.

And of course that is US and Canada are 80% of our Company in our most mature markets.

Worldwide including all of the new countries over the last several years, 86.5% went to 86.8%.

So again continuing good trends in membership renewal rates.

Going down to the gross margin line, we were down year-over-year 6 basis points in the quarter from a 10.59% down to a 10.53%.

Again I always do ask you to jot down the following four columns and six line items to give you a little explanation of the components of margin.

The first two columns would be the Q1 2014 reported and Q1 2014 excluding gas deflation.

Columns three and four would be Q2 reported and column four would be without gas deflation in Q2.

Going across merchandise core reported in Q1 was up 12 basis points year-over-year but excluding gas deflation was up 3 basis points.

Again continuing across, reporting Q2 was plus 1 and without gas deflation, minus 1. Ancillary plus 5 and plus 2 reported and without gas in Q1 and 0 and 0 in columns 3 and 4. 2% reward minus 3 and minus 2 and then in the second quarter, minus 1 and minus 1.

LIFO, minus 1 and minus 1 and in the second quarter, minus 6 and minus6.

Other which I didn't need to add here was zeros across the columns there.

And all told in total in Q1 2014, we reported year-over-year gross margin up 13 basis points but taking out the affect of gas deflation, it was up 2. Again today, we reported minus 6 in lower margins year-over-year in the second quarter; without gas deflation, it would have been minus 8.

So as you can see again the minus 6, minus 8 without gas deflation and our quarter was essentially flat plus 1, minus 1 with and without gas deflation.

For the second quarter year-over-year food and sundries and soft line gross margins were up in the second quarter year-over-year in the 5 to 20 basis point range while hard lines and fresh foods margins were lower year-over-year in the minus 30 to minus 50 basis point range.

Ancillary business gross margins percentages were essentially flat year-over-year but again, you have got sales impact of a 10% year-over-year lower a gallonage comp -- gallonage in terms of price of gas.

The impact of the increasing Executive membership again a basis point hit just meaning more dollars going to the rewards based membership, Executive membership program.

In terms of LIFO in the second quarter, we recorded a $5 million pretax charge this year in the quarter.

That compares to a $9 million pretax credit last year so year-over-year a $14 million or $0.02 a share swing.

We are now 6 basis points year-over-year negative.

As I said when there is both either a LIFO credit or a LIFO charge or this type of swing positive or negative, the fact is is we really look at that as part of our core given that they work in tandem.

Moving down to reported SG&A, our SG&A percentages Q2 over Q2 were higher or worse by 13 basis points coming in at 9.83% as a percent of sales compared to a 9.70% last year.

The minus 13 translates to minus 10% ex gas deflation and again, we will put down -- I'll ask you to put down the four columns and this case five line items.

Again Q1, first two columns Q1 both reported an ex gas deflation and then Q2 reported an ex gas deflation.

Going across, core operations was a minus 9 in Q1 reported -- I mean higher by 9 basis points, 0 without gas deflation.

And Q2 was a minus 12 and a minus 9. Central in Q1 was a minus 3 and a minus 2, both zero and zero in Q2.

RSUs or stock compensation, minus 5 and minus 5 in Q1 and minus 1 and minus 1 in Q2.

Quarterly adjustments were zeros across the board and then total was a minus 17 year-over-year higher SG&A in Q1 reported but again ex gas deflation, was a minus 7 and in Q2 reported minus 13 becomes a minus 10 that I just mentioned.

In terms of these SG&A figures, the core operations again was at minus 12 but minus 9 ex gas deflation.

Within core, our payroll as a percent of sales was higher year-over-year by 2 basis points; payroll benefits and workers comp combined hit SG&A by about 1 basis point and utilities of course, a lot of cold weather was higher by 2 basis points.

Again as I mentioned earlier in both this year's and last year's second fiscal quarter we had a few discrete items that in the aggregate represented a year-over-year swing in our SG&A expense by 5 basis points or $14 million or $0.02 a share.

That generally is the luck of the draw sometimes that helps us, sometimes that hurts us but was a net negative year-over-year swing.

In central was flat year-over-year notwithstanding ongoing IT modernization costs which will continue which represented about a 3 basis point higher year-over-year hit to SG&A.

Next on the income statement line is preopening.

Last year it was $6 million, it is up $2 million to $8 million this year even though last year we had five openings and this year we had three but some of that is the timing of openings, preopening impacts several months.

A big chunk of it also is the more significant preopening expense related to our upcoming opening in Spain as we essentially are opening a new country.

All told operating income in the second quarter came in at $724 million year-over-year, down 2% from last year's $738 million.

Below the operating income line, reported interest expense was higher year-over-year by $1 million coming in at $26 million this year versus $25 million last year.

Virtually all of that is interest expense related to not only the $1.1 billion fixed-rate 5.6% interest debt that we have that will mature in March of 2017 but also the $3.5 billion debt that we issued last December which has a weighted average in the low 1% range.

Interest income and other was higher year-over-year by $4 million in the quarter coming in at $30 million this year versus $26 million last year.

Actual interest income was about half of that $4 million increase, $2 million higher year-over-year and the other component was a $2 million swing, $5 million plus last year versus $3 million plus this year so $2 million better year-over-year.

Overall pretax income was down 1.6% or $11 million in the second quarter, down from $739 million to $728 million this year.

Our tax rate in the quarter came in at 35.0%.

Last year it was 25.1% and as discussed earlier, a big chunk of that was the income tax benefit from that $62 million benefit in conjunction with a special cash dividend.

Excluding that one-time benefit, our tax rate last year in Q2, that 25.1% would have been 33.5%, still lower when compared to this year's 35.0%.

Again as I mentioned in last year's second quarter conference call, there were a couple of positive discrete items that went our way in Q2 last year to the tune of about $10 million after-tax -- (inaudible) tax line or $0.02 a share last year that we didn't have the benefit of this year.

Overall reported net income of $547 million last year in Q2.

Excluding that $62 million income tax benefit would have been $485 million and that compares to a $463 million this year, down a little bit.

Next in terms of balance sheet which is included in this morning's press release, I will note a couple of balance sheet items.

Depreciation and amortization for the second quarter was $240 million and $471 million year to date.

Accounts payable as a percent of inventories on a reported basis year-over-year is down from 98% to 93% although some amount of that is in the payables calculation is non-merchandise payables such as most importantly construction payables.

So looking at merchandise payables as a percent of inventories, the 87% last year would have been 83%.

Average inventory per warehouse is up about 4%, about $500,000 from $12.2 million to $12.7 million.

This increase was pretty much spread overall the departments, nothing that really stood out.

Overall our inventories are in good shape as well our mid-year fiscal inventories which we do at the end of the second quarter were essentially tied with last year's best ever results in terms of low shrinkage results.

So I think in our view a good indication of the inventories being managed pretty well.

In terms of capital expenditures in the first quarter of 2014, we had spent $574 million.

In the quarter just ended, we spent an additional $447 million so all told just a little over $1 billion year to date.

Total CapEx for fiscal 2014 we would expect to be approximately $2.3 billion, I think it is a little up from what I mentioned a quarter ago, up from $2.1 billion last year and again reflecting a little ramp up in openings.

In terms of e-commerce operations, we are in four countries, US, Canada, UK and most recently a few months ago we began e-commerce operations in Mexico.

For the second quarter, sales and profits were up over last year.

While we don't share the profit stuff specifically, the sales were up 20%, in fact a little higher given the local currencies given Canada, about 20% year-over-year.

Over the past 1, 1.5 years as you know, we have re-platformed the site.

We have added some overlaps, we have combined some e-commerce merchandise efforts within our in-line efforts.

We have added a few categories to e-commerce most recently apparel and some health and beauty aids.

We have improved the timing of shipments by shipping out of three depots instead of one.

We are currently testing -- not that it is specifically related to our e-commerce operations -- but we are testing in the Bay area one of several retailers with the Google Express and also testing a few other things that we will let you know more about as we do it.

Next on the (inaudible) list expansion, again we opened 13 in Q1, we have that closed in Acapulco with the Hurricane so net of 12; in Q2, 3; in Q3, 3, in Q4, 11, so 30 openings plus the Acapulco closing so far.

That will put us a net increase for the year of 29 which would be about a 4.5% square footage growth, 4.5% to 5%.

New locations by country for the 30 openings, 17 in the US; three in Canada; one in the UK; two each in Korea and Japan; three in Australia; and one each in Mexico and Spain.

As of second quarter end, square footage stood at 93,098,000 square feet.

In terms of dividends, our current quarterly dividend stands at $0.31 a share.

This $1.24 a share annualized dividend represents a total cost to the Company of about $540 million.

Lastly, our third-quarter scheduled earnings release date will be Thursday, May 29.

That will be for the 12-week quarter ending on May 11.

Before I turn it back to Jodi, one comment about Q3 I do want to make.

Last year in Q3, we had mentioned that there was a litigation settlement that benefited last year's third-quarter gross margin results by about $17 million pretax or about $0.025 a share and so we will be up against that comparison of course.

Let me just say that overall I hope we have helped you understand a little bit about the factors impacting our results this fiscal quarter, how the earnings performance trended positively during the quarter from a very tough first four-week period and continuing strength in sales comps, shopping frequency and the like.

With that, Jodi, I will turn it back over to you.

(Operator Instructions).

Dan Binder, Jefferies.

I was wondering if you could just discuss a little bit of your current thoughts on buyback?

And then separate question, any thoughts on international membership fees and whether or not they are due for a hike or not?

In terms of buyback again, while we let you guys know once a quarter when we have our quarterly earnings announcement, our intention is to start buying back some stock this quarter.

We continue to look at it but I think it is a good statement to say that we will be buying something this quarter.

As it relates to international, we are always looking at membership fees.

Given that you know us, we tend to be long-term focused and when things are very strong over there we want to keep pushing for even more memberships.

We have the added benefit in most countries of being the only club operator and we will continue to use that benefit to look at it.

But we are not in any hurry to do that.

And then lastly on the expense leverage or expense deleverage in the quarter, I mean obviously FX is hurting you a little bit but where do you think the level is this year for expense leverage in terms of the comp, where do you need to be on a reported basis?

Is it still closer to 5?

I think so recognizing nothing is perfect.

When you take those things that I pointed out that in the aggregate were 5 basis points and not trying to be cute here but there is always those things that add up or offset each other and this quarter year-over-year they didn't.

That is 5 of it.

The other thing is the biggest impact to our numbers were in those first four weeks.

It is a combination of things.

I think probably we budgeted a little aggressively.

Our numbers were still not bad for December for that four-week period but it was four, five less Christmas shopping days between Thanksgiving and Christmas just based on how Thanksgiving fell this year.

The other thing is some of the FX had a little less to do with it because that affects all the line items both sales and the margin dollars but I think some of it also is while sales overall were satisfactory, they were a little less than satisfactory in things like certain nonfood seasonal categories or the like and a little stronger in fresh foods.

So again as we mentioned, fresh foods margins were down more and then you had the double whammy in some of the nonfood categories.

So on this level of sales that we have now, those types of things make a big difference.

Again, I think overall our margins were a little lower than we had planned but some of it we are very conscious of as you know in some of the fresh foods areas.

And to get back to be leverage question, yes, I think a 4 to 5 should be able to do it but we had a few anomalies this quarter as well.

Thanks.

John Heinbockel, Guggenheim Securities.

So, Richard, I wanted to drill down a little bit on the fresh food category.

That margin pressure, how broad-based is that or was that a handful of items and what could you call out among items?

Is that more you making proactive investments or delaying price passthrough?

It is almost all us.

I would say aggressively it is all us.

And in terms of where it is, as you might expect it is particularly in the proteins.

We talked about chickens before.

We've held the price on that chicken -- and those 65 million or 70 million rotisserie chickens are just part of the chicken, I mean it is also frozen and fresh and we are seeing a little relief in some of the pricing there and some of the costing and that is just starting.

I think it is starting a little later than we anticipated six months ago but we should see a little bit of relief there.

Really beyond that, I don't hear -- meat is very competitive and beef is at an all-time high in some categories and that is raining on everybody.

Beyond that sometimes in produce, we have a little issue even though produce was the strongest, it depends when it hits and with some of the shortages that has impacted us a little bit.

But overall I would say meat, pork and poultry is the biggest culprit there and it is mostly us.

As a follow-up to that, when you look at having some more consistent markups than others, how do you guys think about strategically because of your strength in perishables we can or should operate with a somewhat lower margin because we get that traffic right which then feeds into all of the higher ticket non-foods that you might sell.

Is that holistic an approach or not really?

That is part of the approach but again without trying to be too granular here, clearly the comment about how the impact of margins and P&L of course in the first four weeks versus the subsequent eight weeks, that was dramatic.

And part of that again was seasonal markdowns, both being aggressive and proactive and then a little less sales in some areas.

While TVs overall I think in the quarter were pretty good, you have got other areas -- cameras industry wise are down quite a bit as you might expect with everybody using smartphones.

Laptops and desktops as well so there is some of that pressure and then I really think that we probably budgeted a little off given the five fewer days.

But at the end of the day, it is hard to know whether there is -- other than I can tell is a heck of a lot more of it was in those first four weeks and so trendwise, that's good but that doesn't tell you anything about the upcoming quarter other than that February was a little impacted by weather.

So we are starting off the quarter those first two weeks -- (inaudible) of February, which is the first two weeks of Q3, (inaudible).

And then lastly, would you say when you look at either gross margin or fresh food some of the individual categories, I imagine there is a fair bit of difference country to country or not and is there more pressure outside the US or less?

I would say overall there's a lot less pressure outside the US.

The US is clearly the most competitive with regard to the club business as well as competitive with -- supermarkets are probably the most competitive in the US compared to major chains everywhere.

So certainly that is the case but the US is 70 -- a little over 70% of our Company.

All right, thank you.

Charles Grom, Sterne Agee.

Good morning.

Just to follow-up on that last question, when you think about the progression of your margin performance and it getting better throughout the quarter, the hard line margins getting better I guess intuitively makes sense as you move away from the holiday markdowns.

But I was wondering if you could discuss I guess if that is the case?

And then two, was the same true for fresh foods?

Did margins in that category also improve as you progressed throughout 2Q?

I believe they did a little bit but again as you know, we are all about being competitive out there and being proactive in that and -- but we also want to make money and we want to hopefully show some improving margins but we are going to do what is right each day on pricing irrespective of how it is going to impact margins that day.

But overall clearly we looked at the first four weeks and we took some actions.

I am not going to tell you where but it showed some relative improvement and that we feel good about but again this quarter is a new quarter and other than sales starting off a little weaker, we will see where it goes.

A lot of that I think is weather.

We all got crammed in the Midwest and the Northeast and the mid-Atlantic.

The rain last week -- I'm not trying to make excuses but it has been unbelievable.

Japan, we had several locations actually closed for a few days with the snow, the worst snow they had ever had.

So lots of little things.

I will try to not remind you next when it shows a little better compared to those things.

All right.

Then just a follow-up to Dan's question earlier.

When you sit down with the Board every month or every quarter, what exactly is the push back to unleashing your balance sheet and getting more aggressive?

What is the thought process currently amongst the Board?

It is a topic that we always talk about.

I don't think there is a push back either way.

As you know, we did a little over $3 billion payout to the shareholders via the special dividend last year as the stock was ever increasingly strong.

As I noted in a couple of the analysts -- before the market open comments, we have been a little under consensus expectations although that is not our direction and clearly Q2 was a larger gap there.

So again, I think my comment that we plan to buy some this quarter is a step in that direction.

I don't want to be coy or cute about it but we will let you know in a quarter but we will be buying some and we will go from there.

The Board as you know, we have never looked at it as let's do this because it will be a positive message to the market.

But long-term, I think the Board as I am are positive about our Company and certainly it is accretive but by the same token, we try to be judicious about it.

And perhaps we've been a little conservative but we also had the $3 billion dividend that we did last December that helped us be a little conservative and I think you will see that change some.

Okay, good.

Just my last question and I will pass it on is just on the price investments, I know you guys have been doing it religiously for as long as I can remember, I am wondering with some of the new technologies you are putting in place, are you studying it a little bit more closely, do you feel like the elasticity is there to justify the increase in price investments by you guys?

We would never look at it that way.

We are out there -- I think again getting back to the simple [chicken] sample it is not unlike the hotdog example of years gone by.

When prices went up, we just saw that as the strength of that and the growth in the number of chickens we are selling, that gets people in.

We don't study it and say what if we took it to 549 and we had this many fewer shops or whatever.

We know it is the right thing to do.

And again, I think Q4 -- Q2 and that first four-week period it exacerbates everything because you had all those things, some weaker sales of some bigger ticket items, some margins on top of the ongoing fresh foods margins.

And I'm very emphatic about the fact that our fresh foods margins are us, are pricing and we will see some improvement there but we will do it when we feel good about it.

Okay.

Thanks a lot.

Paul Trussell, Deutsche Bank.

Good morning, Richard.

Just to go back to the comments you made about expenses, if you can just help us provide a little bit more clarity on how we should think about that going forward maybe an update on where you are on the IT modernization process, anything else of note on healthcare, payroll and some of the other items.

On IT, I think now it has been about six quarters that I mentioned it and it is probably on average [overages] scores, I remember telling me about a 4 basis point and so quarters five and six in this process are 4 on top of 4 or 3 on top of 5 or whatever.

So that will probably continue for another half a dozen quarters.

It is a five or so year effort with at least a three-year build up in those types of things.

There will be some quarters on a year-over-year basis when it is a couple of basis points and there will be some where it is 4 or 5 depending on when systems are being input.

But we have a lot going on, we are excited about -- the user groups are excited about some of the things they are seeing.

We are going to just start implementing some of the components of it starting in early summer to late summer.

And again I'm not going to try to be cute or coy here, it will take some time, but we have a lot going on.

And again, part of that is the fact that for 25 years we've prided ourselves with, I think, very simple systems, and they are still simple probably relative to others.

For us, it is an entire effort.

And again, so far so good, but we are a year and a half into it.

So that is going to still hit us for at least another year, maybe a little longer on that line.

Beyond that in terms of SG&A, sometimes it's just how the numbers work in terms of the fact that you have FX.

A lower weighted average of countries where some of the payroll percent as a percent of the sales in those respective countries and certainly the healthcare as a percent of sales in those countries, is a little lower weighted average when you have got the Canada rate down 8% year-over-year, the Canada exchange rate.

You have got Japan in Q2 down 15% with the Japan yen.

In Australia it is down 14.5% year-over-year in the second quarter.

So all of those things add a little insult to injury.

The underlying numbers, they were a little worse in terms of expense percentages.

But big chunks of this were the things that I mentioned.

Again, there's lots of little things and they all seem to hit at the same time, on top of the fact that in the quarter where you can get a lot of leverage, the four-week period where you get a lot of leverage was a little weaker than planned.

Understood.

Then if you can just comment on inflation, deflation, what you are seeing across various categories and just how we should think about LIFO; if you think that will still be a factor in 3Q like we saw here in the second quarter?

Well, if I look at the compared to year end, just our entire LIFO pool, at midyear it is up about 0.25%, so just light cost of all items.

There was a $100 item that we paid $100 for it at September 1, if you will.

At February 16, we were paying on average $100.25.

As you would expect, there is some deflationary pools like computers, what have you.

You've got probably the most inflation in food and sundries, a little over 1%.

You've got a shade of gas inflation although that is ticking down right now a little bit.

So it doesn't seem -- overall, there doesn't seem to be a lot of inflation but on a $4 billion plus LIFO -- and LIFO is a US concept only -- so on a $4 billion plus probably $5 billion LIFO pool, 1% would be $50 million, 0.25% would be $12.5 million.

I don't think it is going to be a lot and I don't have in front of me last year's LIFO numbers for Q3 and Q4, I thought I did.

Not that this tells you anything but in Q3 and Q4 -- last year in Q3 and Q4, LIFO was a credit, a benefit of about $8 million, $7.5 million, $8 million in each of Q3 and Q4.

So if it is a little inflationary, we will see that similar kind of swing that we saw in Q2 but we will wait and see.

Mind you when there is an LIFO charge, there is probably -- that is again I looked at the combination that would (inaudible) to because they tend to work not always but in tandem one closing the other but not a lot of inflation.

That is helpful.

Thank you.

Christopher Horvers, JPMorgan.

Good morning.

So two questions.

First, as you model out FX at the end of the period, when do you think that the FX might stop turn into a flat scenario of the total comp versus the core comps?

I don't know and I am not even a student of some of this foreign exchange stuff but when you see as an example in Japan, first-quarter year-over-year was down 20%, second quarter year-over-year, it was down 15% for us in terms of the Japanese yen.

So there has been a lot of weakening.

At some point it is going to bounce back a little bit but I can't tell you when.

Canada has been awfully strong for many years and it is now subsiding a little bit but who knows and then add to that the craziness in the world with events that did impact these numbers, usually when there is issues going on, world issues going on, the dollar strengthens and I think that is a little bit of what is happening now.

But also particularly in the case of Canada, I remember 20 years ago when the Canadian dollar was $0.65 on the US dollar, it had actually gotten above $1 on the US dollar and it has come down a little bit so kind of bounced off of that peak but I can't tell you when that is going to be.

Okay.

And then just as a follow-up, the ancillary business, the margins in that business had been a positive for quite some time and it looks like if I got the numbers right it was flat this quarter.

What piece of the business is changing and is there anything you could say about the outlook?

A lot of it has to do with gas deflation just the weighted average of that chunk.

Mind you, gasoline sales as a percent of our Company total sales is 11% or 12% and so it is a huge chunk and when you've got gas deflation that alone -- and gas needless to say, our reported gas margin is in the 10.5 plus range, 10% to 11% range.

Within that number, gas is in the 1% to 5% range each quarter.

So that weighted average coming down has an impact on that number.

So you have to look at it both ways.

Overall ancillary businesses were fine.

Our pharmacy business continues strong.

Our hearing aid business although smaller is very strong.

One-hour photo, as you would expect, continues to be a little weaker because nobody takes as many pictures so we have been able creative over there to try to do a few other things but it is still very profitable but not as profitable as it used to be.

So you add it all up, gas deflation was probably the biggest reason.

Okay, perfect.

Thanks very much.

Mark Miller, William Blair.

Good morning, Richard.

You gave us some additional detail this quarter on the four-week versus the eight-week and I want to make sure we have the right impression from this.

Given you said that the margins if I heard this right on hard lines and fresh foods being down 30 to 50.

Does that mean in the eight weeks of the quarter you would have actually had gross margins up overall?

And is it a fair impression that those first four-weeks, earnings are closer to the double-digit type growth range?

In the first four weeks, one of the things we talked about in the press release was those hard line categories, that was more impactful in the first four weeks whereas fresh foods was more again us and continuing through the quarter.

But the 30 to 50 range for those types of categories that were down year-over-year was for the entire quarter.

I don't have the detail by period here but directionally I would think given the first four weeks was worse, it clearly showed some improvement.

All right.

Has Costco done market research looking at the number of your members that also have an Amazon prime membership and do your merchants have any sense for how much this might be impacting spending at Costco?

Do think that might have been a bigger factor in the holidays with gift giving or do you think it is not a material change?

Actually I think some of you guys out there do more surveying of that than we do honestly.

I have read some research out there that talks about the overlap.

There is overlap.

My guess is clearly in areas like the books and CDs, that is a changed business over the last many years.

TVs frankly were not bad overall and particularly if you add our e-commerce to our in-line, we are up a shade for the quarter.

I can't tell you what happened in the four weeks of February because they were what we call majors or electronics was down in the mid single digits year-over-year but for overall, we probably fared better than most in-line and all of that stuff takes away a little bit.

We are looking at ways to get as we have now for a while, to get younger people in here as well.

We recognized that and we'll continue to do that.

The answer is no, there is not a lot of discernible concern at this point in that.

Okay.

Thanks, Richard.

Meredith Adler, Barclays.

Thanks for taking my question.

I will start by just jumping off from the last question about trying to get younger people into the warehouses.

Can you talk a little bit about what it is you have done or would consider doing to make that happen, what tools do you have?

First and foremost, we are not going to do anything rash but we are also not going to have our head in the sand here.

I mean one of the things -- the test as an example with Google among several retailers but the Bay area has been interesting.

I'm not going to even talk about in any detailed yet.

We have done a few things with some of the social media things out there.

One of the impacts which is what we do is the rise in organic; it is a big business, it is growing fast.

We can actually show a better savings on those bigger ticket price point items and we have seen that time and again whether it's organic ground beef or those giant packs of kale or you name it -- and milk.

I mean we are doing huge business with that.

That I think also is driving in some younger people.

One of the first systems going in our modernization effort is a new membership system which we will start rolling out in the US I believe June, July and again, there will be a lot more bells and whistles but as you know, our systems --and then pretty basic improvement -- we are not going to go crazy overnight on it but we are doing a few things and it works and we will keep doing some of those things.

So that is what I can tell you at this point.

Okay, thank you.

Then I just have a sort of bigger picture question which . It is obviously, it is your philosophy to provide very great value especially in fresh foods to your customers and you will absorb some inflation but what do you do -- I mean everything I've seen -- meat has been inflationary for a while, especially beef.

Do you have to sit down and think about your strategy if it looks like there are items that are just going to be inflationary for the long-term?

Well, part of the answer is, no.

We do what we do in part of it though is we also recognize that we need to -- our goal is just to maximize shareholder value and ultimately that turns into long-term driving earnings.

But we are not going to necessarily do something in the short term or a given quarter to do that.

Again looking at Q2, it was a combination.

I think probably said six or nine months ago using the simple chicken example, that there seemed to be in the few months looking forward six and nine months ago that poultry pricing costing was going to improve which would improve our margins because we are not lowering the price, we have just not raised it prior to that.

That is finally starting to happen.

So those are the kinds of things that we will do.

Strategically at the end of the day we have got to show improvement in bottom line.

Ultimately it is not going to come from 10% and 15% comps for a company, we are going to have good comps but at the levels that we have in assuming they are still going to be better than others is still going to require some margin over time.

And we looked at that but we are not terribly concerned about how it impacts a given quarter.

And so we -- organic helps.

The fact of the matter is I think you mentioned this as an example and one of the things that again talks about the younger member as well, what we found is when we tried fresh organic beef, I think in the first year we did $25 million plus in an item or two.

This is at a higher price point and a greater savings and a fair margin for us, a better margin for us relative to a more competitive regular ground beef.

The cool thing was that 80% of those sales were members that had not bought ground beef with us before.

They love Costco but they are organic.

On average, I would say they tend to be a little younger, that is my guess.

So those are the kind of things that I think are going to help us a little too.

The fact that increasing penetration of our Company is overseas over time notwithstanding the exchange rates this quarter, we generally tend to have a little higher margin overseas where you don't have -- even in the US when you don't have a direct competitor in the market a mile away or less, you are going to have a little better margin.

And so all of those things I think should impact us positively but we are not going to change what we do in terms of occasionally identifying those key items that we are just not going to budge on.

Okay.

Thank you for that.

One final question which is kind of related but you obviously saw softness in some hard line categories, electronics has been bad for a while.

Do you think at all you have to rethink how the products that you are offering because of that -- is there something else that you would be more aggressive on?

Would you take space away?

How are you thinking about that longer-term?

Well, as you know, electronics is what greets you when you walk into a Costco.

Certainly the online is part of that.

We do a strong business online.

Part of it is because they bigger -- not only bigger ticket but physical bulkier items.

We have a white glove alternative where -- installation as well so that business is growing.

But getting people in the door at Costco, we sell a heck of a lot of TVs as well that way.

But again, you have a few unusual things happening right now.

Cameras, I understand cameras are down 30-+% in the industry.

We are not that different.

In fact, we've got a -- very successful -- and it is still a big volume business but that has been weak year over year in a bigger way for the first time.

Desktops and laptops, we are starting to get some traction on pads, on tablets of late but I think that is a business that -- I don't think we are necessarily rethinking allocation of space.

If anything, it is still a strong area for us but it got hammered a little bit over that Christmas selling season.

Again, a lot of it wasn't TVs, it was some of those other areas.

Okay, great.

Thank you very much.

Robbie Ohmes, Bank of America Merrill Lynch.

Good morning, Richard.

Two follow-up questions.

The first, just on the gas deflation that you are now starting to see, can you remind us, historically does it impact your traffic trends as gas in general if it does get very deflationary and come down a lot, do you have to find other ways to drive that traffic comp?

Interestingly when prices are coming down, we actually historically save the member a little more because we turn it so fast and so we are buying it every day if you will.

And the guy down the street is buying it every six or eight days or nine days.

And so when it is going up, it is costing us a little more and we are competitive -- we are still the lowest price hopefully but there is a little less savings.

There is a little less news about it out there and so I think overall on a macro basis, our when prices are coming down even though we are saving the customer a little more, it is less newsworthy the fact it is not on the nightly news.

And so there is probably a little less positive there but given how big we are in that business now, it is not as impactful either way.

Got you.

Just a different question, could you remind us with your international business how you are thinking about new markets?

I think France you mentioned before.

Any update on timing of when you could open a new country?

Well, Spain is April or May, May and France is hopefully about a year hence.

And beyond that we haven't disclosed anything.

In terms of how, there is generally -- the three likely areas and no order is other parts of Europe, South America and China and we haven't really stated beyond France and Spain what our plans are beyond that nor do we plan to discuss that right now.

Got it.

Thank you very much, Richard.

Matthew Fassler, Goldman Sachs.

Thanks a lot.

This is Steve (inaudible) on for Matt Fassler.

Just a quick one on gross margins.

It sounds like much of the year-on-year decrease was sort of intentional or through price investments if you will.

And we just want to know how to think about that going forward.

In the next few quarters at a minimum, do you think the trend is likely to sort of stay this way or how are you guys thinking about that near-term?

First of all, let me correct -- with all of the different numbers going around here, in terms of Q2, fresh was intentional, the rest of it was not intentional.

Some of it is promotional some of it is we do what we do to have clean inventories, took some extra seasonal markdowns in some areas including a little bit in electronics and some of it was that.

So in terms of the trends going forward again, I have alluded to the fact that we are starting to see a little better costing on the poultry side, meat continues to be competitive and rising and then beyond that, I can't tell you a whole lot.

A big chunk of -- again, produce, meat -- not produce -- fresh foods was our proactive aggressiveness, the rest of it is doing what we do and responding to competition and responding to weak sales being a little weaker and getting rid of stuff.

Understood.

That is very helpful, actually.

And just on the membership fees, we seem to underestimate the impact of FX there, but it also does seem like if I think about FX and the overall comp that you guys talked about, sort of a 2 percentage point drag, it looks like it was more like 3 on member fees.

Is there anything you could sort of help us as we pick about the split there, international versus US, and how to get that right going forward?

I think the biggest impact FX wise was in Canada, which is 10%, 12% of our company.

And I think a higher -- a strong penetration in executive memberships which is the higher fee, so those things probably pushed it a little bit.

In terms of guessing in the future, your guess is as good as mine.

Understood, understood.

Just to confirm this, there were no buybacks in the second quarter; correct, and you guys are intending to buy back in the third quarter?

Correct.

All right.

Thanks a lot.

Bob Drbul, Nomura.

Good morning, Richard.

I've just got two questions for you.

The first one is can you comment a little bit -- Canada was strong for you fundamentally.

Can you just talk a little bit about the market and what is going on there with Costco's positioning?

The second question is can you just give us an update on the private label initiative and Kirkland Signature, and sort of new products or new categories that you guys are excited about looking forward?

Well, Canada is strong.

Canada thankfully is -- we're the only club in town, which is a positive.

It has historically, in the last several years ,everything good about it.

It has a good economy.

It didn't have the financial crisis issues that the US had.

It has got a -- of course, part of its economy is natural resource space, which has been on fire, so those are all positive things.

It has lower healthcare expenses as a percent of sales, just by the nature of the healthcare up there versus here.

So all those things have been positive for us.

And again, although we have an 8% decline year over year in the currency, that washes that away in terms of how we report it for the Company.

In terms of private label, I think some of the areas, apparel has been one that continues to be exciting.

I have talked ad nauseam in the past in the last year about the wool slack.

We have a great gabardine slack now that is, I think, $19.99.

I know we have some additional women's athletic items, and so that will be an area I think that will continue to grow for us.

On the food side, organic, we are doing a few more items, and I think in a lot of places it will continue to grow.

I think what probably over time we haven't appreciated is the strength of it, not only in the US or in Canada but these items being able to take them to other countries where when we take a regular branded international item to that country, we show an incredible savings where prices have always been high.

On these items given the quality level and the pricing, that strength is I think exacerbated even more, and that is a positive.

Great.

Thank you.

Peter Benedict, Robert W Baird.

Most of my questions have been asked.

Just a quick one on February.

Just you made the decision to call out weather and the impact there.

Was the weather materially different than what you saw in January?

And I know you kind of said there was some stuff that happened in Japan.

Is that what kind of tipped it, because in the US it just feels like kind of January and February were basically pretty similar?

Well, you probably live in that area.

No, it was more severe in February.

As an example, just in the last week of February, the Southwest got hammered with rain four or five days.

Japan to the Company was just another insult to injury, if you will.

I mean I think we ended up, what, 18 units in Japan.

I don't have the exact detail in front of me, whether it was half a dozen or 6 or 8 of them were impacted in the Tokyo market.

So again, that was just a little bit more.

But overall, yes, it was more extensive than we have seen before.

That was good color, thanks.

And then just on the club openings, it looks like you are going to kind of get to that 30 kind of gross number this year that you guys were hoping for.

What about as we look to next year, do you think -- are you still confident you can get that number north of 30?

Yes.

I mean Craig's goal -- Craig and Jeff Brotman's goal are to get into that low 30, 30 plus range.

I am sure now that I have said it, we will get 28 or 29.

But at the end of the day, we are shooting for 30 to 35 a year for the next five years.

Okay.

Sounds good, thank you.

Greg Melich, ISI Group.

I just had two questions.

First, on electronics and then on membership.

You mentioned it was up, but then you listed some categories like cameras and stuff that were all down.

Was it just TVs that drove CE, and was that ASP or volume?

Tablets were part of it.

Also, the quarter overall was different in February.

February was a little weaker electronics.

So if we look at the --.

The biggest chunk is TVs just by volume, and so that is partly why February, TVs were weaker in February relatively speaking than they were for the quarter, they were actually about flat.

I think the average sale price is about flat.

It had been up -- oh, Bob is saying it is up.

In the second quarter, the average price point looks like it was up a couple of percent.

That is probably because we are selling bigger ticket, bigger TVs, smarter TVs.

It's not inflation.

By the way -- no, no.

By the way one of the comments that I heard at the budget meeting last week was that the rollout of the next generation of technology in TVs has been a little bit delayed and it is going to be in a few months, April instead of January -- I'm being coached here.

So again that should help it a little bit but we will see.

Okay, great.

I don't think you need any coaching for the next question.

On memberships, I just want to make sure I'm getting this right, we finally have a quarter that's (technical difficulty) in terms of the fee increase so if we are up seven --.

In local currency.

Is it fair to say that in the US while membership renewals are great and you have the mix toward Executive that memberships for club in the US is actually trending down a little bit and if that is the case, has that shifted at all?

No, I don't have that detail here.

I would have to look.

To the extent that we have opened 14 or so US warehouses, it may be a little bit but actually I don't know if I am correct on that.

I will have to look.

Okay, we can follow up on it but conceptually, you still have the mix shift going on to executive.

By the way one of the things is I'll give you an example, we opened this a couple three years ago in Huntington Beach, California in LA, we have 50+% of the households are more in that Greater LA market where we've got 40 or so locations.

We may open up in a new market there with the eight to 15 weeks prior to opening, to sign up tabling activities.

As of opening day, we might have 5000 or less new members, new members.

In the meantime, that is a unit that may very well -- will exceed our Company average for the first year with -- do 150 million, 100 million of which is new and 50 million which is cannibalized so you've got members that are closer, they are going to shop more frequently for the first time.

Contrast that in Asia where again during those eight to 15 weeks prior to opening, as of opening day we see members in the 25,000 to 50,000 new member sign-ups with a bigger non-renewal -- a lower renewal rate the year hence, but none the less so that should be a big difference.

Okay, that is helpful.

Thanks.

My guess is that yes, it could be flat or down slightly but that would be expected in that example.

Given the cannibalization.

Got it.

Thank you.

Budd Bugatch, Raymond James.

My questions have been all asked.

Thank you.

Scott Mushkin, Wolfe Research.

I will be quick because it's at the end of the call.

I just wanted to follow-up on the inflation question and produce inflation, deflation and whatnot with the potential of some inflation working into produce you guys investing in price there, how is that going to work through as you work through the next quarter or two if we do get some spikes in produce inflation, how does that work through your numbers?

My guess it would help a little unlike meat as an example, meat is so much more (technical difficulty).

Produce, everybody has got different items, different pack sizes, different qualities and we can still show great savings but it is just not -- in my view it is just not the same type of level of competition.

So I don't think that is going to impact us as much.

The biggest thing in produce is when there is a drought or a freeze and when we are doing hundreds of millions of dollars of items be it strawberries or blueberries and when in a given month you did $5 million dollars in an item instead of $15 million during a holiday for that produce because of a freeze, that is more impactful than competition.

And then just one last one is a little bit more strategic and if you don't want to -- we can always talk off-line.

But you guys expand internationally that becomes much more a focus of the growth and we have seen other retailers try this and it hasn't worked.

Well, it is working well for you guys.

Just talk about the structure a little bit you are putting in place to make sure that you are keeping momentum up overseas.

First and foremost, we start any country with existing employees that are from our Company.

The woman running Spain is a seasoned operations person, executive from Canada for many, many years.

The guy running Taiwan goes back to the price club days in Southern California.

The guy running Korea started as a warehouse manager at Costco and before that I believe.

But when we go over there to -- when we go over we send a core group of half a dozen people, three or four people to merchandising operations.

I think the biggest thing to make sure everybody is on the same page is these individuals travel to Seattle every four weeks so 13 times a year for a day and a half budget meeting and they are typically here for an extra day and doing some other operations and merchandising specific things.

And then like Jim for many years, Craig and others are traveling to those countries often.

Craig is out of the country today.

And so the biggest way we do it I think is everybody being on the same page.

The other thing is I'll give you a good example.

When asked before why have we been so successful in several countries including some of these countries in Asia, we think part of it is not only is our value proposition more extreme over there and also that people actually do like big American stuff.

The fact is that some of these private label items that we are developing now have been huge successes in some of these other countries, those US sourced goods.

So I think all those things play well into our hand but that is going to change over time and so we do what we do best is we are constantly focused on it.

I mean when these heads of countries and the merchants of countries come to Seattle every four weeks, one of the things that each of the senior VPs of operations -- and every country has one; Canada has two and the US has eight.

With all of those foreign ones, they come here and one of the things that they report on is what initiatives in terms of global sourcing, procuring goods from a multinational manufacturer where the US buys a heck of a lot, perhaps Canada does because we are big and been around a long time.

But because I whatever it is, a licensing arrangement or regional pressure on their side, it is a work in progress and we are making good success there.

All those things are little things but they help us every day.

So I think that will continue.

It is really a lot of that blocking and tackling and just like we did when we went to Alaska for the first time and to Hawaii for the first time, we feel that we have really lowered prices in those markets and made them more competitive and we still shine better competitively versus other retail formats.

Given the fact that in some of these countries pricing has been a lot higher, I think that has helped us.

And then bringing goods whether it is the jumbo cashews or the fresh blueberries to countries where they are buying a lot more of it.

Perfect, thank you.

I'm going to take just two more questions if that.

Sandra Barker, Montag & Caldwell.

Hi, Richard.

I just wanted to clarify maybe you said this and I missed it but when you talked about the 30 to 50 basis points of gross margin impact, how much of that would have been those responsive price cuts versus proactive?

Well, I guess there is three things you are talking about.

I can't tell you exactly.

I know in fresh foods it us just wanting to keep the price where it is on key items and doing what we do.

Let's take hard lines, let's take -- whether it is electronics or clothes or whatever, if sales are a little soft, we are proactive to market things down to get rid of them before the season ends.

Structurally we have the benefit I think of being in and out of seasons early but that doesn't mean we still don't have to take some excess markdowns sometimes.

In terms of responsive, I would say proactive is more impactful than responsive the issue of needing to be responsive.

But there is some responsive too out there.

Do you see any changes in the competitive landscape and where is it coming from?

No, we really haven't.

There is still a lot of tough competition out there.

We wish that -- part of the challenge with the Internet and delivery (inaudible) included and what extra things, I think we are getting a little better at communicating what is the value in our product in terms of that extra controller or whatever it is or the shipping because when we do price shops, the least competitive ones are some on those that are on the Internet and I don't need to name names.

Okay, great.

Thanks.

Joe Feldman, Telsey.

Thanks for taking the question and sorry for prolonging this call but just wanted to ask you competitively, I have seen a lot from your other big major club competitor out there lately in terms of testing some stuff with online membership or being a little more aggressive in different countries.

And I am just wondering if you guys are seeing any impact of that or any pressure or just how you are dealing with kind of the competitive issues?

In terms of direct club competition, no.

I mean, they did -- I believe Sam's did a fee increase that they tested originally in Texas and they've rolled that out now in the US.

They are only by the way in the US and Mexico but we have not seen any -- Sam's is very competitive but we haven't seen any giant changes in that or us needing to respond to something that they have done.

Got it.

Thanks, guys.

Good luck with this quarter.

Thank you.

Thank you.

There are no further questions at this time.

I will turn it back over to management for closing remarks.

Thank you everyone and look forward to chatting in 12 weeks.

Have a good day.

Thank you.

That concludes today's conference call.

You may now disconnect.