Costco Wholesale Corporation
Q2 2008 Earnings Call Transcript

Published: 5 Mar 2008

[Operator:]

Good morning. My name is Keela and I will be your conference operator today. At this time, I would like to welcome everyone to the February sales release and quarter two earnings call. (Operator Instructions) Mr. Galanti, you may begin your conference.

[Richard A. Galanti:]

Year to year, Keela. Good morning to everyone. As Keela mentioned, this morning’s press release reviews our second quarter operating results for the 12 weeks ended February 17th and our four weeks of February sales results for the Sunday ended, four weeks ended March 2nd. As with every call, let me start by stating that the discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and that these statements involve risks and uncertainties that may cause actual events, results, and/or performance to differ materially from those indicated by such statements. The risks and uncertainties include, but are not limited to, those outlined in today’s call as well as other risks identified from time to time in the company’s public statements and reports filed with the SEC. To begin with, our 12-week second quarter -- for the quarter, earnings per share came in at $0.74, compares to $0.54 or up 37% from last year, recognizing that last year had some one-time items. This compares to our December 13th guidance, that First Call’s $0.74 figure at that time was doable and at the high-end of a small range. I know you’ve heard that before. And last year’s second quarter, again while we came in at a reported $0.54 a share, as I explained last year and I will do so again shortly, last year’s second quarter, what I’ll call normalized EPS was $0.66 a share, so really this quarter’s $0.74 figure represents a 12% year-over-year increase compared to that normalized $0.66. As you will see, it’s actually -- this 12% normalized figure I think we feel is pretty good, given the slightly, a very slightly weaker comp in Q2 versus Q1 and frankly a few items that in the aggregate probably hit us by perhaps a penny. I’ll talk about that later. In terms of sales for the quarter, as previously reported total sales were up 12% and our 12-week comp figure showed an increase of 7%. Of course, our comp figures continue to benefit from gasoline inflation and strong FX, primarily in Canada. We are also reporting this morning our comp for February. It too was a 7%, including a 5% in the U.S. Other topics of interest I’ll talk to you this morning, our opening activities; we opened a total of seven new units during the second quarter, four in Canada, one in the U.S., and one each in Korea and Japan, such that fiscal year-to-date through Q2 end, those 24 weeks, we’ve opened 13 net new units, as well as four relocations, those four relocations all occurring in Q1. At Q2 end, we operated 531 locations around the world and since February 17th, Q2 end, we’ve since opened three additional units -- Colorado Springs, Colorado; Woodland, California; and actually this morning, we are opening in Puerto Vallarta, Mexico, which is our 31st location down in Mexico and therefore our 534th unit overall. Also this morning I’ll talk about ancillary business results, Costco online results, membership trends, the impact of changes we made back in last February and March to our electronics returns policy, a quick update on stock purchases, a quick update on our balance sheet for the quarter just ended, and lastly I’ll provide you with some updated direction guidance for the third quarter and year, fiscal year. Okay, on to the discussion here for quarterly earnings -- again, for the second quarter, total sales were $16.6 billion, up 12% from last year. On a comp basis, I had mentioned they were up 7. The 7% reported comp figure for the second quarter, recognizing our quarter is slightly different than calendar month but essentially it was comprised of a 7% in December, a 7% in January, and a 7% in February, so all three of those calendar months were seven. This of course compares to an 8% reported comp figure in Q1. Again, as I mentioned, both on a quarterly basis and on a February basis, monthly basis, we are getting part of this -- essentially part of this increase relates to gasoline inflation as well as FX. In the quarter, basically gas inflation represented a positive impact of 185 basis points. That’s a little better than the 150 basis points in Q1 and the continuing weak U.S. dollar relative to foreign countries, that strong FX in Canada as an example, all told that was a benefit for the quarter of 220 basis points, which is a little less than the 250 basis points benefit in Q1. So you take those two things together, essentially the same impact in Q1 and Q2, about 400 basis points for both of them. For the quarter, our 7% reported comp figure, it was a combination of, of course the product of an average transaction increase and average frequency increase -- I’m happy to say increase on the latter part. The average transaction increase was about 5.5% for the quarter, with the average frequency increase being a little better than 1.5% up for the quarter. Included in the average transaction, of course, of 5.5%, you again you’ve got the impacts of the FX and the gasoline. Cannibalization, still a negative impact because we continue to in-fill markets. There’s about 100 basis points this quarter, a little better showing, if you will, there’s 110 basis point negative impact in Q1, so essentially the same in both quarters. For the month of February, again as I mentioned, the 7% reported comp. Again, almost like the quarter overall, average transaction increase while for the quarter it was a little over 5%, it was a shade under 5%, in the high 4s for the month of February, and average frequency was actually a little better, increasing about 2.5% for the month. And I might say that a little bit of a pick-up from December/January as well when we reported an increase in traffic of a little less than 2%. Cannibalization, about a 90 basis point impact in February, so again a little less negative, if you will, than it was for the quarter and for the last couple of months. The other thing I was going to mention and we usually don’t but it’s a combination of a couple of things; we were impacted in Eastern Canada and the Northeast and somewhat in the Midwest by weather. We estimate that the weather probably impacted us by 30 or 40 basis points. More importantly, even if you take that out, if you exclude that as an impact, we did have two calendar shifts. In Canada and Ontario, there’s a holiday called Family Day, which was a calendar shift, and so it was one less day. As well, in Taiwan and Korea, there’s the Lunar New Year calendar shift, again one less day. Those two very quantitatively are about 40 basis points as well to the four-week month. So those again, as I mentioned, it was a little weaker for the quarter versus Q1. Those things impacted February, although February was okay relative to the most recent couple of months, even with that additional negative, if you will. Also included in the average transaction for the month as I mentioned was gasoline inflation. Finally, we’ve seen a little pick-up in comps during the trend in February. Regarding February comps, the first two weeks averaged a 5.5, the last two weeks averaged a 9.5. The last two weeks actually were -- we had one week that was better than that, one week was less. That just had to do with some timing of some mailings but for the two weeks, I think clearly that 9.5 number was a better showing than the first two weeks. By the way, we are always asked given the economy about any mix change between business and Gold Star members. I think generally the feeling out there is this is a weak economy, given that most of our small business members tend to be little restaurants and diners and the like, and small businesses. There’s a concern about that. The answer is there has not been a change. In fact, in looking at both the last two quarters as compared to Q1 and Q2 a year earlier, there’s been an ever so slight pick-up in the sales mix to the small business member, less than a half-a-percentage point swing but nonetheless certainly not going in the other direction. In terms of sales comparisons geographically, in terms of what I’ll call the high volume mature regions like the Northwest, like California, certainly the Northwest is the strongest. Our Northwest comp, both for the quarter and for February is darn close to the company average. California, as I’ve mentioned in the past few months, is the weaker of those mature markets and some of that -- what we hear about in Southern California with the housing issues and the cost of gasoline, my guess is we haven’t seen any detriment relative to it. You know, it’s come down over the last few months and it’s pretty much hung in there at those slightly lower levels but nonetheless still positive comping. We also of course hit California with a little higher level of cannibalization than others, as a lot of our [inflow] has occurred there, so that could be a little bit of it as well. Other regions, the Northeast is fine, the Southeast is fine, new regions like the Midwest and others tend to be a little higher than the company average, notably because of the age of those locations and they are still continuing to grow nicely. Canada of course in local currency is in the mid-single-digits but when translated to U.S. is significantly higher because of the Canadian dollar year over year. As I mentioned, California, it continues to be in terms of the big volume mature markets, our toughest market for comp sales but again comping slightly positive. No real change in February as compared to the last couple of months prior to that. In terms of merchandising categories, you know, as people have asked, where do we -- how do we get our frequency up like that. Certainly we think food is a big piece of that, the fact that people still eat, have to eat and they come in and we’ve got a lot of good things going on there on the food and sundries side, as well as fresh foods. Both food and sundries and fresh foods have comps greater than the company overall, with hard lines and soft lines of course being the offset of that, being below that. A little color on Q2’s comps -- within food and sundries, we still have about 10% of food and sundries sales are tobacco. That’s really a drag on the comp, even though the overall food and sundries with tobacco is still again better than the company average. And I think that’s again a combination of the fact that we’ve anniversaried the Canada issue. It has more I think to do with the fact that in some locations, we’ve curtailed tobacco sales, a limited number of locations, about 100, and it’s really where we found virtually all the sales were small businesses coming in and just buying that. And we’ve not seen any impact there. The other thing is it’s very expensive to buy a carton of cigarettes these days, so I think that you are seeing some diminishment there. Within hard line -- all the other sub-categories within food and sundries were fine. On the high-end, our deli department again had the strongest comps, again food related. Within hard line’s comps, electronics comps were actually decent, up in the mid-single-digits. Sporting goods was actually the best of the larger categories, sub-categories, up in the low-double-digits. A slight -- potentially flat to slightly negative in areas like hardware and office supplies and a little bit of weakness, slightly negative in lawn and garden and patio. Again, in talking to the buyers and the merchants, they feel a little of that had to do with weather. In fact, in the last week, the comment yesterday from our head merchant was is that they’ve seen that pick-up. No real concern on patio -- maybe we end up taking the extra week or so to sell it but there is no real concern there. Within soft line comps, nothing terribly thrilling. Home furnishings was the weakest, with a negative comp. Similarly, a negative comp in jewellery and that’s consistent with what I think I’ve shared with many of you over the last few months, you know, discretionary type of non-food items tend to be weakest in this economy, even though overall we’re doing okay. Bright spots within soft lines included small electrics, media, which is you know, of course movies, CDs and books, and women’s apparel. I think women’s apparel is strong for a couple of -- for the main reason is there’s an availability of more branded stuff out there. We in fact are seeing quite a bit more activity from some of the variety of non-food manufacturers that historically would not sell us directly and I think that’s certainly a direct relationship to the fact that -- of what we read out there about weakness in mall-type sales and small apparel store type sales. Within fresh foods, again a little bit better than the company average comp. Deli is the strongest and produce -- actually, produce is the strongest, or again the stand outs, both deli and produce, but all sub fresh food categories were positive. Two final comments on sales -- overall, again as I’ve mentioned over the last, when people ask us about what’s going on with the customer and the weakness in the economy, you know, again where we’ve seen it is where you would expect to see it, relatively speaking, in areas like furniture and home furnishings and apparel. Home furnishings, a little bit of offset in the apparel area as I mentioned is in fact that there’s perhaps a greater supply of some previously unavailable branded stuff where we can get our hands on it. You can all see that if you walk into the warehouse. Also again, weak furniture and jewellery -- again discretionary items. Even within some strong categories like meat, which is about 6% of sales, what we call meat is meat, poultry, pork, and the like; we’ve seen a little bit of a mix shift over the last few months from higher -- from beef to things like chicken. Not discernibly but a slight shift, so all that is anecdotal but consistent I think with what is going on out there in the economy. Moving down the line items on the income statement, membership fees, you see we reported $342.9 million, or 2.06% this year. That’s up about 11% in dollars or about $36 million. As a percent of sales, it’s down slightly two basis points, still we feel a very good showing. Renewal rates are strong, we’re still getting increased penetration from the executive membership conversions and sign-ups. At Q2 end, we had 19.3 million Gold Star members; we had 5.5 million primary business members; and 3.4 million business add-ons, so total member households of 28.3 million, up from 27.8 million at Q1 end and 27.4 million at fiscal year-end. If you simply divided that by the number of warehouses, and I believe this number excludes Mexico, since we don’t consolidate those figures, about 56,000 members per warehouse, both at Q1 end and at Q2 end. With spouse cards, the 28.3 million households represents actually 51.8 million membership cards out there, including the spouse card. At quarter end, our paid executive members were 6.9 million. We added about 18,000 a week in the last 12 weeks of the quarter, or 214,000 during the fiscal quarter. So notwithstanding the fact that the program has been around for five, six years now, we’re still getting some increased penetration from that and we view that as a great long-term positive from the standpoint of member loyalty and sales growth. These roughly 24% of our membership base generate now over 50% of our sales. In terms of renewal rates, we again fluctuate between 86 and 87, depending on how it rounds. I think the end of Q1, it rounded ever so slightly down to 86. It was almost an 87. It’s now an 87. And again, I think in this economy, we feel good about the fact that we’ve been able to maintain our renewal rate. In terms of gross margin, last year a 10.49 -- again, that was impacted by some one-time things I’ll talk about in a minute, compares to a 10.73 this year, so up 24 basis points. As you’ll see in a moment when I ask you to write down a few numbers, what I’ll call the normalized gross margin excluding those non-recurring items in last year’s second quarter figures show a year-over-year improvement as compared to the reported 24 basis points improvement. I think the more correct number to look at would be an improvement on a normalized basis of 13 basis points up. Before I ask you to jot down a few numbers, let me give you an explanation of those items I talked about that impacted reported gross margin last year. There were two; one was a $10 million refund related to a decision in the federal excise tax I believe on telecommunications. Just like you as an individual got a small rebate, we as a big company got a $10.1 million rebate. Of that amount, about $8.7 million benefited gross margin last year in the quarter. We pointed that out last year so again, we would take that out in terms of looking at a normalized number when we compare it to this year. The second and much larger item related to an increase last year as you’ll recall in our sales returns reserve balance, which we determined at the time was appropriate to do after we performed -- we had performed a more detailed analysis of our historical return patterns. Last year in Q2, this adjustment resulted in a decrease to sales of $224 million and a related pretax charge to gross margin of about $48.1 million. As you will recall from last year, we had a similar adjustment as we completed that analysis in Q3, so this should be a fun year to try to get all the numbers correct for you and try to help you look at things on an apples-to-apples basis. So with that, I’ll ask you to again jot down my little chart and we’ll -- why don’t we do three columns

[Operator:]

(Operator Instructions) The first question comes from the line of Deborah Weinswig.

[Deborah Weinswig:]

Good morning. Richard, if we think about new club openings for ’08 and what you’ve done already, can you talk about what percent will be back-fills and what percent will be in new markets? And also, should we expect cannibalization for the rest of the year to be kind of what we’ve seen in the first two quarters?

[Richard A. Galanti:]

I think it’s more of the same, in terms of in-fills -- you know, we’re probably -- we’re certainly north of -- in terms of in-fills, existing markets we’re north of 75%. Not all of those are technically in-fills but I would say it’s more of the same there. Again, even though the most recent quarter had a disproportionate number of locations open in Canada, I think we timed it that way so in the dead of winter, we can go up there once and hit three openings in one week and it just -- again, timing of when construction starts, we were afforded that opportunity. I would say maybe a slight increase in existing versus new, recognizing some things that were new are not new anymore. Chicago is not new, Atlanta is not new, and Texas is not new, so -- Texas or Chicago might be a little harder than L.A. because we are sort of strong in L.A. but nonetheless, we are getting off to better starts there.

[Deborah Weinswig:]

Okay, and then in terms of private label, can you talk about some of the trends that you are seeing there? Maybe specific categories and also what penetration level are you at currently?

[Richard A. Galanti:]

We have to update -- I think we are about a 17% on private label, 16% to 17%, maybe a shade higher. It continues to grow. The biggest categories tend to be on the what I call the supermarket and drugstore side -- it’s health and beauty aids, it’s canned goods, it’s bottled goods, it’s paper goods and the other standouts, of course, would be in areas like apparel. I mean, some of the private label might be in areas -- may not have [inaudible] around it but some of the -- like leather coats or whatever. I’m trying to think -- are there any other things, guys, on the private label side? I would say more of it is on the -- again on the supermarket side than on the non-food side, but that’s nothing new. We still feel co-branding is more prevalent. We are probably in that part of what I would call the private label. We’ve been doing several co-branded items with -- from Martha Stewart to Quaker Oats to the Quaker Company to Jelly Belly -- I mean, some of the more exciting items out there.

[Deborah Weinswig:]

Okay, and then can you also -- you talked a little bit about Mexico but can you also give us some more color on the performance of your international markets?

[Richard A. Galanti:]

International is doing well. Overall, if anything, U.K. was a little bit anemic for the last couple of years and it’s finally started to show a little life. I wouldn’t call it a growth company yet but it’s growing and profitable. Probably the three standouts are Asia -- Korea, Taiwan, and Japan. Korea and Taiwan are nuts. We opened a unit in Korea and a unit in Japan three or four weeks ago. As I mentioned, we have about 56,000 paid members per warehouse and that means our whole company exclusive of Mexico, where the average warehouse does 130-plus million and the average warehouse probably is 15 to 18 years old, I guess. And usually in any opening, for the six to 10 weeks prior to opening, we’ll have a tent outside and people can come buy and sign up in advance so they don’t have to wait in line. We opened that location in Korea with almost 56,000 members. It had a five in front of it, and paid members. So -- now, recognizing you are talking about cities with 20 million people where there’s four or five locations. We’ve had -- this is more anecdotal than anything that you can invest in but at our budget meeting earlier last week, Mike, who runs our Canada operations, was over and was talking about -- I’m sorry, Japan. What did I say? Canada? I’m sorry, Japan operations. There’s a show in Japan that’s a national TV show, quite popular, that is similar to a show here called something -- Queer Eye for the Straight Guy, or something. And anyway, over there, translated it’s called Girly Man -- I’m not joking -- and apparently they filmed at Costco because they love shopping at Costco, these two people, and over there it was on national TV at primetime and it was their most highest rated show in the few years they’ve been on national TV, and we got a big pick-up from it. So we’ll take anything out there, guys, but I’d say our standouts are Asia, the U.K. is coming back a little bit, and Canada has frankly over the last year in local currency has come back a little bit. It had been a little bit anemic for the last couple of years and in the last year, it’s been in local currency low to mid-single-digits, which is just fine.

[Deborah Weinswig:]

Richard, thanks so much for the color. I really appreciate it.

[Operator:]

The next question comes from Chuck Grom.

[Chuck Grom:]

Thanks. Good morning, Richard. Any sense for why you think sales improved in the back half of February? And was this driven from both the U.S. and international, or one or the other?

[Richard A. Galanti:]

Well, again I did point out we had a mailer -- what we call a multi-vendor mailer, but that was -- that was more of a week off in timing. For the two weeks, the impact was in both years. In looking at -- let’s see here -- total international -- if anything, international, the last two weeks in international in U.S. dollars was on average a little better than the first two weeks but not as extreme. I mean, it was like mid-teens versus high-teens.

[Chuck Grom:]

Okay, so the strength was more U.S. driven.

[Richard A. Galanti:]

Yeah.

[Chuck Grom:]

Okay, and then when you look at the four merchandise categories I believe in the first quarter the upside was -- ranged anywhere between 22 to I believe 69 basis points. In this quarter, I think you said slightly higher to 79 basis points. Can you give us a little more color on the changes there? Are they sequentially the same within the buckets or is one moving higher, one moving lower?

[Richard A. Galanti:]

The changes aren’t that big. I mean, I’d say -- I don’t have last year in front of me but I would say hard lines has shown the most improvement in both Q1 and Q2, maybe even a little more in Q2, and a lot of that has to do with that well-known category called consumer electronics. I know that in -- when I look at just that one department, which is all of 6% of our total sales, so whatever, 20-plus percent of hard line sales, if I look in Q1, ’05 to ’06 and ’06 to ’07, we were down 100, 200 basis points year over year and in ’08 Q1, we were up 1.5 percentage points. Similarly in Q2 ’05-06 and ’06-07, we were down on average about 150 basis points. In this quarter, we are up 200-plus basis points. So again, I think that has to do with the fact that not only the -- a small improvement from the returns reserve but more importantly less things being returned, and that helps you a little bit. And again, the basic supermarket category is overall strong. Fresh foods, again without having it in front of me, it fluctuates. One quarter, meats are up a little bit, the next quarter, they are down a little bit -- again, year over year, still strong. One quarter, produce is fine; the next year, you know, blueberries and grapes were late and fewer, so that impacted you. It’s a little stranger.

[Chuck Grom:]

Okay, and then just one last one -- the core was up roughly 40 in the fourth quarter and then the first quarter and this quarter looks up like 29. There’s some speculation out there that Jim is backing away from wanting to earn a little bit more. Could you comment on this? It doesn’t appear to be the case but I just wanted you to at least address it.

[Richard A. Galanti:]

It is not the case. I mean, as I’ve said, again what probably spooked me the most was when I saw Q1 myself -- I’m sorry, Q4 and -- how am I going to temper everybody’s enthusiasm because nothing will be linear. My sense, and it’s a guess, is that -- well, first of all, it’s not a guess. I feel we feel comfortable that things are continuing as they have been. It’s going to fluctuate. It’s not linear. As I said to many people over the last couple of months, whatever X is on average, there will be times when it’s X plus 10 and there will be times when it’s X minus 10 and when it’s X plus 10, I’ll try to keep you from extrapolating it outward, and when it’s X minus 10, the concern will be uh-oh, it’s over. And that’s not the case and we still have some opportunities. The other question that I hear of late is what happens when we cycle Q4, and that will be a tough comparison. Yes, it will be. I don’t know what it will be. I still think that again, this is not like we took all of our gunpowder and said let’s try to do everything at once. Some of this stuff is seasonal. It changes every year. Again, I think getting back to Jim’s comments historically is we are a great company and deserve to make more money. We are not going to do it if it is impacting us competitively, but we are -- we think we are smart enough to finally figure it out. It took a few times and so I don’t see any big changes at this point, other than it will fluctuate.

[Chuck Grom:]

Great. Thanks very much.

[Operator:]

The next question comes from Bob Drbul.

[Hillary Morrison:]

This is Hillary Morrison calling in for Bob. I was hoping you could give us a little more detail on the make-up of your membership revenues, including renewals and sign-ups at senior stores and mature stores.

[Richard A. Galanti:]

I don’t have that in front of me. We historically haven’t given that out. What I personally look at the most is the renewal rate after one year. Keep in mind even on a -- every month in our budget meeting when Paul Latham, who is our VP of Membership and Marketing, gets up and presents numbers, one month new Gold Star sign-ups might be a little weaker than planned, a little weaker than it had been running. The next month, business sign-ups might be weaker. And then when you look into it, it’s because the limited amount of what I’ll call marketing budget that each warehouse has, these are the employees that go out and canvas small businesses, go to bigger businesses to try to get a large employee group to do an event or you know, tempt them to sign up. But there are several weeks a year where our relationship with American Express, for example, you’ll see tabling activities for the American Express co-branded card. Well, again, that’s not additive. That’s substituting and sure enough, we are somewhat reactive. When something shows a little weakness, we put a little more effort in it and the next month it’s fine. But overall, I think the renewal rate has been a good indication that things are fine at this point.

[Hillary Morrison:]

Great. And also, how much of the increase in average ticket would you attribute to inflation? Where were you able to pass increased commodity costs on to the consumer?

[Richard A. Galanti:]

Well, it’s a little hard to say. Recognize -- surely gas inflation, it’s easy. You see it. Certainly FX is easy, you see it. Those are the big chunks. I would argue that as we increase penetration of private label, there’s many examples. The one that comes to mind was a few years back. There was a 24 or 30 pack of Gatorade we sold for I think $15.99. Overnight, enter a competing product [for a signature] power drink. Right next door, same bottle, same colors, different manufacturer, same number of ounces, same packaging, you name it, and at $9.99. Almost overnight, half the unit sales went to ourselves. More importantly, or as importantly over the next few months, the price point that we sold Gatorade went from $15.99 to $14.99. Now, this is about three years old, this example, but there’s an extreme example of where huge deflation -- you don’t seem them in LIFO and you really don’t -- and by the way, an increase in gross margin dollars but nonetheless, you see that deflation. So my guess is while there certainly is more inflationary procurement costs and that’s increasing, my guess is there is an offset to that that is kind of hard to measure. Clearly just last -- just three or four weeks ago, two of the largest consumer product companies out there on certain paper goods again didn’t say hey, we’d like to talk to you -- they’ve been doing that for two or three years with small increases, occasionally. They basically came out with, on a variety of items, not every item but a variety of items, 4% to 6% increases effective between last month and the next couple of months. And as you would expect, we like many retailers will try to buy in where we can but there’s a limit to how much you can do that to at least maintain the price for a couple of extra weeks and be competitive. But at the end of the day, we and others will fight those battles, we and other retailers. Ultimately some of that has to be passed on but let’s see.

[Hillary Morrison:]

Great. Thanks so much.

[Operator:]

The next question comes from Gregory Melich.

[Gregory Melich:]

I guess following up on that inflation, just to put some numbers on it, obviously there’s the private label mix that really does impact or bring deflation effectively. But if you were to look at the like-for-like branded products, can you come up with a number? Is it 1%, 2%, 3% that you are seeing blended?

[Richard A. Galanti:]

I really can’t. I mean, when you look at a list of a hundred different things, there’s a 1% and a 13%. There’s a lot more 2 to 5s, but even on the 2 to 5s, there’s items that are missing that aren’t being included. And I think there’s one little added benefit -- I don’t know how important it is to us that we have versus let’s say the Safeway’s and the Albertsons of the world, or even the Targets and the Wal-Marts, is that we don’t have to carry every size and every brand. And if one manufacturer, whether it’s paper goods or toothpaste or cans of peas wants to try to push through an increase, we are still going to be opportunistic. And if the other brand out there is holding their price a little longer, all our purchases are going that way for the next month. And I think that probably helps us a little. In the long-term, it’s happening. It’s not just here. You see it out there and as we all pay twice as much for gas than we did a couple of years ago, it cost as much to run those facilities and to manufacture those goods.

[Gregory Melich:]

Sure. And on the ones where it is -- it is what it is, right? Say a basic paper towel or something, on that sort of stuff, is the objective ultimately to pass through the gross margin dollars and let the rate fall?

[Richard A. Galanti:]

I would say yes, if not a shade better. Some of it has to do with price points. Let’s face it -- s much as we are not a retailer, in some things we do we are a retailer. What happens sometimes, if it’s a [calculated] percentage is -- I’m making this up -- is $14.12, rest assured we’re not going to be at 14.12 or 14.19, we’re going to be at 13.99. Similarly, if something calculates out to 13.83, it could very well be it’s going to be 13.89 or 13.99, and my guess is those fall both ways. I would say historically, I would say it was more true that the dollars would stay the same and the percentage would fall. Given our margin initiatives, probably there’s a little less pressure to do that but I’m not suggesting or trying to be cute that it’s definitely the same margin percentage. I don’t know if we know yet.

[Gregory Melich:]

Okay, fair enough. And the last bit on that, you mentioned that LIFO, there is nothing yet because you’ve got the reserve but with what’s going on next year, that could change. How big is the reserve, or can you give us anymore insight on that?

[Richard A. Galanti:]

It’s not -- it’s bigger than a bread box. I’ve got my people here going like no, we don’t talk about that. And I’m not trying to be cute -- it’s a number that you have to have more than 3% or 4% average -- more than a couple percent average inflation.

[Gregory Melich:]

Okay, but you might work through that into -- the way you see trends now, you could work into that by the middle of next year, is that what you were trying to say before?

[Richard A. Galanti:]

If that’s a guess, sure, but it’s hard to say. What I’m really saying is I don’t think it’s this year, and whether it’s next year or the year after, it depends on what happens out there.

[Gregory Melich:]

Great, thanks, and by the way, the Girly Man comment got us to laugh out loud here, so thanks for that.

[Richard A. Galanti:]

No problem. We got a laugh at our budget meeting too and I anxiously look at seeing -- he’s going to bring the video to the next budget meeting.

[Operator:]

The next question comes from Peter Benedict. Peter Benedict - Wachovia I was hoping you could update us maybe on your latest thoughts on the membership fee structure. Now that you guys are coming close to cycling through the positive impact of the increase you did back on the Gold Star members in ’06, how should we be thinking about the outlook for that fee income growth line in second half? And also, any updated thoughts on how you see that $100 executive fee trending over the next couple of years? Thanks.

[Richard A. Galanti:]

Well first of all, there’s no -- there’s nothing on anything I’ve seen on anybody’s agenda here to discuss it right now. I think particularly given the -- certainly when we -- as you know, when we did the $5 increase on basic memberships a little over two years ago now, or about two years ago, we kept the $100 executive intact in part because in theory that took 3 million -- about 2.5 million members based on their prior 12 months of purchases above the break-even and so some portion of those might be incented to convert to executive. I would say at the time we did that, at some point we recognized that that 100 may change. Given the economy and given -- I think we don’t want to lose sight of the fact that we don’t want to be arrogant or not appreciative of what we are doing there, so I don’t see any real change in the next couple of -- in the next year for sure. Beyond that, who knows. And as it relates to the $5 increase on Gold Star, as history has shown that we do that every four to five years. One of the dictates there is California where over a third of our U.S. membership is, and they have some rules that a membership fee is not sales taxable unless it relates to two-tiered pricing or is deemed de minimis. They define de minimis currently at 50. Up until two years ago, for the prior five years they defined de minimis as 45 and five years before that, 40, so you get my drift. My guess is that recalibration, if and when it happens, is on a five-year tranche in the state so again, the economy certainly I think dictates right now nothing, but we historically haven’t done anything other than every four or five years there. And on the executive, I don’t see anything in the next year. There’s no discussions going on. Peter Benedict - Wachovia That’s helpful. And then just your thoughts on how the membership fee income growth would trend maybe in the back half of the year. I know it’s been decelerating. Does that continue? Does it level off at some point?

[Richard A. Galanti:]

Well, a little bit has to do with opening schedules. I think we are opening a few more in the second half than -- a couple more in the second half than the first half. That helps a little. I think the fact that we’ve cycled through the whole 23 months now, including deferred accounting for the $5 increase -- you know, it used to be before we had executive membership and when we did about every five years a $5 increase, you see a spike for a couple of years, a spike during those first 23 months because of deferred accounting. And then, over the next few years it decelerates as a percent of sales a little bit each year, implying that on that same fixed, each customer is buying more. I don’t see any difference in that trend. I mean, there’s a little tempering or offset of that and that’s the conversion. Frankly, I’m surprised we keep getting 15,000, 20,000 new executive members, which many are conversions, every week. We’ve had it out there for six years so I view that as a -- that will offset it. But I think in fairness, it’s probably -- given those two things, it’s close to flat this year and probably down slightly a few basis points next year. But we haven’t looked at next year yet. Peter Benedict - Wachovia Okay. Thanks so much.

[Operator:]

The next question comes from Christine Augustine.

[Christine Kilton-Augustine:]

Thanks. You mentioned during the call that there was a greater availability of brands and Sears has recently announced a restructuring where they are going to have I guess effectively brand managers and they will look for ways to maximize on some of their top brands, like Kenmore and Craftsman, so I’m wondering if you all would be interested in carrying those brands through Costco. Have you explored that idea at all? Have you had any talks with Sears?

[Richard A. Galanti:]

I’m not sure what talks or lack of talks have been had. Personally I love those brands. We have some good brands ourselves in a couple of those categories. I assume -- I really don’t know what we’ve done or if there’s been any conversation of us calling them or them calling us. To the extent -- our phone is always open and we’ll see, but I don’t know.

[Christine Kilton-Augustine:]

Thank you.

[Operator:]

The next question comes from Chuck Cerankosky.

[Chuck Cerankosky:]

Good afternoon, everyone. Richard, if you are looking at the club mix between traffic and ticket, what evidence do you see that you are picking up customers trading into the club or devoting a bigger percentage of their wallet to shopping at Costco because of the economy or whatever they are seeing out there?

[Richard A. Galanti:]

You know, Chuck, as you know us well, we don’t have a lot of statisticians sitting around here. If you look at our comp number relative to other retail, I think that we’ve shown that we are picking up a little bit. Our frequency as a company, as I’ve said many times, over the last 10 years and 120 monthly sales reports or however many years we’ve been doing it, when we -- whether the comp was an 11 or a 5, the reported comp, within that the product of transaction and frequency, frequency was never -- rarely if ever below minus one and rarely if ever above plus two. Frankly, as we’ve seen some relative weakness in comps as compared to the industry over the last six months, it’s the first time that I’ve seen some 2.5’s positive, so I don’t know if -- and arguing against that is the fact that gas costs more and people would try to shop, try to make fewer bigger shops. So I would like to think that there are some positives out there. We certainly, unlike that one TV show in Japan, we certainly are still getting positive impact from I think on a [local] basis when the consumer advocate on a local news station talks about where’s the best place to buy pharmacy or gas. Just two weeks ago, there was I understand a 30-minute episode of an evening magazine type show called Eye on the Bay in the Bay area, which as I understand is going to show one more time this month, how cool it is and how fun it is to shop at Costco and how do they do it and it’s -- as you know, we don’t have a PR department. So I think it’s positive. The numbers indicate the comps are better than others, so we are encouraged by that but I can’t tell you a whole lot more.

[Chuck Cerankosky:]

That’s helpful. Thank you.

[Operator:]

The next question comes from Neil Currie.

[Neil Currie:]

Good morning. Thanks for taking the questions. I wonder if you could just give us a flavor as to what is going on in consumer electronics between pricing and volumes in your stores compared to the trend of the last year.

[Richard A. Galanti:]

Well, the big item is flat screens and the big issue there is if you look back not only a year ago but two years ago, and again these are broad brush stroke numbers, but it seemed like units were up 20% to 40% and dollars were up 20% -- units were up 30 to 40 and dollars were 15 to 20, and a lot of that had to do with while the average price point was coming down, it wasn’t coming down as fast here because people were still trading up. Maybe a given TV was coming down in price but people were going from the 37 to the 42, or the 42 to the 50. The prices continue to drop. I think if you look at it in recent months, your units are up a small amount, dollars are flat to even down some, given the week and overall, I’d guess it’s close to flat over the last several months in dollars and maybe -- but units aren’t plus 30 to 40 anymore, but they are still plus. I don’t know if that’s the fact that everybody has three TVs now and six cameras or it’s the economy. My guess is it’s a little of both.

[Neil Currie:]

Okay, and in terms of the health of the Gold Star member versus the business member, what have you seen in the past quarter that makes you think about the health of those two sets of customers and what’s your outlook if the economy continues to be weak?

[Richard A. Galanti:]

Well, our accounts still, even net of inflation and FX, are positive. Our frequency is up at the higher end of that small range of late. Those are positives. Again, when I look at the percent of business done by business member versus Gold Star member this year, last year, it’s essentially flat, a slight improvement in the mix to the business member but again less than a half a percent delta. So again, I think -- and again, I don’t want to over-emphasize but I think that the positive press we get out there helps that as well. Some of you read 10 weeks or so ago in the New York Times food section about where the elite in the beltway shop for food, and it was talking about all the power people in Washington, D.C. and they are going to Pentagon City Costco to get their food for their fancy dinner parties. That week I understand it was the most hit article on newyorktimes.com site, despite everything else going on in the world. I think part of that is an affirmation and one member sees it and they send it to their friends saying see, look, isn’t this cool? That stuff helps and -- look, I am cautiously optimistic and very naïve but I hope the economy doesn’t die and -- all I can feel most confident about is whatever is happening out there in retail, we’ll tend to do a little better than that.

[Neil Currie:]

And what would your experience be in past slow downs or recessions? [Multiple Speakers]

[Richard A. Galanti:]

It’s really hard to know because the last real recession, if I have my facts right, was in the early 90s and gosh, in the early 90s, that was two years before Costco and Price Club merged and I know on the Costco side, we were running regularly 10% to 15% comps. So if we went from a 15 to a 12, was that the recession? I don’t know. So we really don’t have a lot of good data on that.

[Neil Currie:]

Okay, well, thanks a lot, anyway.

[Richard A. Galanti:]

Why don’t I take two last calls?

[Operator:]

The next question comes from Dan Binder.

[Dan Binder:]

Good morning. A couple of questions for you; two merchandise questions and then the first question is on AMEX, which is more of a financial question -- what are you seeing in terms of your AMEX cardholder spend versus the rest of your transactions? And then on the merchandise side, you talked about the greater availability of brands. I think you mentioned Crocs. I was curious -- is that now a direct buy or is that coming out of the [gray] markets? And then the second merchandise question was on office supplies. You indicated I think that that category was down. I was just curious what that looks like in the overall mix.

[Richard A. Galanti:]

Let me answer the first question and then I’ll ask you to tell me the second question again. In terms of AMEX, here, I’ve got a sheet here -- if I look at AMEX year over year, well, first of all AMEX is higher than the average individual. AMEX with Executive is the highest and if I look year over year for the first 24 weeks, as an example, the average ticket and cash is exactly the same year over year. The average debit transaction is up $1, the average check is up $2, and the average AMEX is the same. All those numbers are like one or two percentage points -- 0 to 2 percentage points, so I would say it’s essentially the same year over year. We certainly have more sales to AMEX through the AMEX tender. That’s up from -- in the U.S., 35% to -- from about 34.5% to 36.5% of our sales penetration. But that’s the trend -- that’s just as -- there’s more people with a co-branded card. As you may have seen on our gas pumps, if you use the co-branded card, you get an extra -- on top of anything else, you get an extra 3% off on your gas purchase at Costco.

[Dan Binder:]

Okay, and then on the brands, you mentioned Crocs. I was just curious; is that now a direct relationship or --

[Richard A. Galanti:]

We try not to say -- some are direct, some are diverted, and some are indirect and we don’t discuss what’s direct and not, recognizing some manufacturers would prefer us not to. I’m not suggesting we are or not with them, I just -- all I’m suggesting is there is more availability of stuff out there.

[Dan Binder:]

And then on office supplies, is that -- how does that look in the overall mix? I think you said the comps were down there.

[Richard A. Galanti:]

Yeah, now keep in mind, what I call office supplies excludes PCs and printers and monitors. This is pencils and scotch tape and [inaudible] holders, and some furniture, some desk chairs and stuff. You know, overall it’s down slightly. I mean -- I don’t have the number in front of me. Hold on.

[Dan Binder:]

Is that sort of like a low single digit number in the mix overall?

[Richard A. Galanti:]

Hold on. Everyone’s looking. Actually, for the quarter, it was down slightly. For February, it was up five, so when I was talking earlier, I was talking about the quarter. So again, my guess is it fluctuates a little bit but for the quarter, I think it was down slightly.

[Dan Binder:]

Okay, thanks.

[Operator:]

Your last question comes from Wayne Archambo.

[Wayne Archambo:]

Thank you. Black Rock. Could you talk about the competitive environment, specifically in the Northeast as you overlap with BJ's? It seems like they’ve rationalized the SKUs and since Zarkin’s come in a year or two ago, they seem to be performing much better. Are you seeing much more competitive environment with them?

[Richard A. Galanti:]

Yes. I think in fairness, there was -- and recognize we really compete -- we only compete with them of course on the east coast, essentially, where we overlap. In fairness, I think for three or four years there, up until a year ago I was -- I’m not so sure how often we even competitively shop them anymore on a regular basis because it had gotten out of hand and we were so much under on a lot of items. They are tougher now. It’s still on a relative basis not as extreme as Sam’s and we really again think it’s a little bit of a different customer. On a macro basis, if they are closer, it’s an impact but again, we do monitor them more closely now as we used to for many years and I think there’s plenty to go around.

[Wayne Archambo:]

Thanks, Richard.

[Richard A. Galanti:]

One last comment though that Bob mentioned -- as you look at our comps even for the last month or two, in the Northeast, relatively speaking the Northeast has picked up a little. I don’t know why and I’m not suggesting it’s BJ's, but we’re doing fine against them.

[Wayne Archambo:]

Do you think you are taking share away from grocery, perhaps?

[Richard A. Galanti:]

I think we take share away a lot from a little. Clearly if you look at our merchandise mix, 60% of it is what I’ll call supermarket and drugstore and health and beauty aids and paper goods and food and the whole bit, which includes also the institutional side of that business. In addition to a three-pack of cling wrap, we’ll have a thousand-foot roll of it for the deli. But certainly I think over the years, a big chunk of that business has come out of the supermarket with lesser pieces from everybody else.

[Wayne Archambo:]

Thanks.

[Operator:]

Are there any closing remarks?

[Richard A. Galanti:]

No, well, thank you. We’re -- Bob and Jeff and I are around today, so thank you for my long-winded explanation of things and we’ll speak to you soon.

[Operator:]

Thank you. This concludes today’s conference. You may now disconnect.