Costco Wholesale Corporation
Q3 2008 Earnings Call Transcript

Published: 29 May 2008

[Operator:]

Good morning. At this time, I would like to welcome everyone to the third quarter and year-to-date conference call. (Operator Instructions) Mr. Galanti, you may begin your conference.

[Richard A. Galanti:]

Thank you and good morning to everyone. This morning’s press release reviews our third quarter of fiscal 2008 operating results for the 12 weeks ended May 11th. As with every recall, let me start by stating that these 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 third quarter of fiscal 2008 operating results for the quarter, our earnings per share came in at $0.67, up 37% from last year’s reported earnings of $0.49 a share. Of course, this compares to our March 5th guidance, that First Call’s then $0.65 figure for this quarter was doable and at the high-end of a very small range, so a couple of steps above First Call and our comments. In last year’s third quarter, while we came in at a reported $0.49 a share, as I explained last year and I will do so again shortly, in last year’s third quarter what we believe to be normalized EPS was not the $0.49 reported but rather $0.56 a share. So this quarter’s $0.67 figure really represents a 20% year-over-year increase on a normalized basis. In terms of sales for the quarter, total sales were up 13%, 12% excluding last year’s third quarter increase to the estimated reserve for sales returns, and our 12-week comparable sales figures showed an increase of 8%, continuing to benefit, of course, from both gasoline inflation and a weak dollar, or strong FX, primarily from Canada. We consider it a pretty solid underlying comp number, given the current state of what’s going on out there. Please note that we’ll report our four-week May comp results next Thursday. That’s for the four weeks that ends this coming Sunday, June 1st, and that will be next Thursday morning, on June 5th. Other topics of interest I’ll review this morning -- our opening activities and plans. We opened five new units during the third quarter of fiscal 2008, three in the U.S. and one in Japan, along with a new location in Mexico which we do not consolidate into our numbers as we are only a 50-50 interim partner. That was opened in Puerto Vallarta. Fiscal year-to-date through third quarter end, we’ve opened 17 net new locations, 18 including the Mexico location. As well, we’ve opened -- we’ve done four relos this year. We have several additional relocations happening this current fiscal fourth quarter. At third quarter end, we operated 536 locations around the world and by this weekend, we will have opened four additional locations this quarter, two new locations and two relos, to put us at total locations of 538 at that time. Our fourth quarter openings to date, the two new locations a few weeks back in San Dimas, California, and this morning in Manahawkin, New Jersey, and two relocations, one in the Vancouver, B.C. area and tomorrow morning a relocation, a new opening of a relo in Kendall, Florida. Also this morning I’ll review with you our ancillary results, Costco online results, membership trends, the impact of changes we made last February and March to our electronics returns policy, a few comments on recent inflationary trends, update on our recent stock repurchases, of course our balance sheet summary, and lastly I’ll give you a little updated direction guidance for the fourth quarter of the fiscal year. Okay, in terms of discussion for the quarterly earnings, sales for this year’s third quarter, as I mentioned, for the 12 weeks ended May 11th were $16.3 billion, up 13% from last year’s 14.3, or up 12% on a normalized basis. On a comp basis, Q3 comps were up 8%. The 8% third quarter comp, while not exact months here, but as you’ll recall we reported 7% in February, a 7% in March, and an 8% in April, so the 7, 7, and 8 essentially compares to an 8% for the quarter and that’s up slightly from the second quarter comp number of 7%. As has been the case for several months now, our quarterly comp figures greatly benefit from high gasoline price inflation, a shade under 200 basis points, about the same in Q2 and a bit higher than it was in Q1, and from the continuing weak U.S. dollar, or a strong FX showing, about a little over 200 basis points, both this quarter year over year and in Q2 year over year. For the quarter, our 8% reported comp figure was a combination of an average transaction increase of a little over 4.5% and average frequency increase of just under 3% for the quarter. I believe that just under 3% frequency is about the best frequency number we’ve had in -- on a month -- on a quarterly basis or a monthly basis in a number of years. Typically it ranges from anywhere from minus 1 to plus 2, although probably the last year it’s been in the 1% to 2% plus range, so approaching the 3% was a little better than that. Cannibalization negatively affected our comps, as it always does, a little bit under 100 basis points this quarter, similar to the cannibalization we’ve seen in recent quarters. We’re certainly seeing a little more impact from inflation, not only in gasoline, which we of course call out to you, given the size of that business to us, which is now I think over 10% of our sales, which we break that out for you, but across many food, paper, canned goods, sundries items. Some offset, of course, by increasing penetration of our private label items, which offset a little of it, as well as the deflationary trends in some of the electronics categories. In terms of any mix change between our business in Gold Star members, we really haven’t seen any. We’re asked that question quite a bit. Some I think feel that in the weakened economy, are small businesses being impacted by that -- we have not really seen a big difference in the sales penetration of our business member versus our Gold Star member. In that comment, I exclude gasoline, recognizing that’s more of a consumer item. In terms of sales comparisons by geographic region, pretty much the same it’s been for the last few quarters. Our Northwest continues to be strong relative to the older, higher volume mature regions. California continues to be a little weaker than it had been, although it’s trended up slightly from its weakest points a couple of quarters ago. All the rest is as expected. The East Coast has been fairly good, the Southeast being a little stronger than the Northeast, and of course newer regions like Texas and the Midwest tend to do a little better, in part because they are younger units. All told, our U.S., as mentioned, was a 6.25 and as I mentioned, we’ll report the four weeks of May next Thursday. In terms of -- you know, we greatly benefit from -- in terms of reporting comps, or sales results the weak dollar in Canada, while the -- as translated into U.S. dollars in the mid- to high-teens, it’s in the low-single-digits, as it has -- low- to mid-single-digits as it has been for the last several quarters, so pretty consistent in local currency. Other international is more in line as it relates to dollar versus foreign currency, both in the low double-digits. Again, I think overall our numbers have been fairly consistent and a little better than we see out there. In terms of merchandise categories, as I mentioned on previous calls, the last couple of calls, the basic categories of food and sundries, which is about half of our sales, and fresh foods, which is about 13% of our sales, so call it roughly 60% of our sales, those are the categories that are having comp numbers greater than the company overall and that’s offset, of course, by slightly weaker than our reported total numbers on hard-lines and soft-lines. A little color on the comps within food and sundries -- tobacco continues to be a slight negative impact. I think the fact that the prices of tobacco keeps going up and up and it’s very expensive and with all the health issues and the restrictions out there of where you can smoke, we like everybody out there are seeing a reduction in demand there, so a slight negative impact there. Otherwise, all sub-categories within food and sundries were up year over year on average mid- to high-single-digits, with the strongest departments being things like the deli departments and the canned foods and what have you. Within hard lines, electronics comps continue to be slightly negative, in the mid to high singles. The highest -- offset by stronger comps in health and beauty aids, which is a hard lines category for us, as well as automotive products. Other things that you’d expect to be weak are light garden patio, hardware, and furnishings. Within soft lines, not a whole lot there. The stronger areas, stronger categories for us are things like small electrics and certain categories within apparel, particularly men’s apparel. Again, mid- to high-single-digits. The remaining sub-categories are flat to down slightly, again nothing that different than what we’ve seen in the past. Areas you’d expect, you know, jewelry, home furnishings were down the most. Although jewelry is not as down as much as it had been in the last couple of quarters but still has a negative sign in front of it. Fresh foods, as I mentioned, continues to be good. All sub-categories within fresh foods are just fine. Moving down the income statement line, we reported membership fees of $350.9 million, up about 10.5% or $33 million. As reported, down about six basis points year over year. I think that’s in part due to the fact that we’ve had some pretty strong sales, top line sales results but nonetheless a pretty good number for us. In terms of number of members at Q3 end, we had 19.7 million Gold Star members, up from 19.3 million at Q2 end. Primary business, 5.5 million. Rounding to the same 5.5 million but slightly up in terms of actual numbers. Business add-ons consistent at 3.4 million, so total members, member households, 28.7 million versus 28.3 at the end of the previous quarter. And including add-on spouse cards, 52.6 million members versus 51.8 million. At quarter end on May 11th, our executive membership continued to do well, just under 7.3 million members. That actually is an increase of 380,000 new members, or a 5.5% increase just in the last 12 weeks. That represents about 32,000 new executive members per week, which is a combination of new sign-ups as well as member conversions. All of those have been pretty strong of late and helped by a lot of things -- more effort on our part, as well as some exciting things from some of our partners, like American Express, who is currently running a 3% cash back on gasoline when you use their co-branded card at Costco gasoline pumps, and given the top of mind of that, that helps as well. In terms of membership renewal rates, they continue to be strong. At Q3 end, our business member renewal rate was 92%, Gold Star, 86, so -- at 87, I must say that it’s a strong 87 and one day we might get lucky and go up a little higher but for the time being, we round down to 87. Going on to the gross margin line, third quarter gross margins were up 33 basis points year over year. Last year a 10.21 versus a 10.54 this year. Again, as I’ll mention in a moment, what we believe to be the normalized gross margin, excluding certain non-recurring items that occurred last year in the third quarter, what I think is a more relevant increase year over year is not the 33 but a 17 basis point increase. Before I ask you to jot down the numbers, let me give you an explanation of the non-recurring item that impacted us last year in the third quarter. This related to an increase in our sales returns reserve balance. Last year in the third quarter, this adjustment resulted in a decrease to sales of $228.2 million, and a related pretax charge to gross margin of approximately $46.2 million. The two impacts to the margin comparison year over year in Q3, the first of course is last year we took the $46 million hit, so you really add that back in. Secondly, last year we reduced sales for kind of an aggregate catch-up of the $228 million in sales, so in calculating last year’s gross margin percentage, of course, you had a lower than normalized, if you will, denominator in that calculation. So both of those things I’ll to point out to you as we compare to Q3 here. As I always ask you to jot down a couple of charts, this is the first of those two, the margins, and we’ll go ahead and go back to -- we’ll have four columns, Q407 and Q108, Q208, and Q308. And the line items would be core merchandising, second one would be ancillary businesses. Third would be 2% reward. Fourth would be a federal excise -- IRS federal excise tax claim, which was an anomaly last year, last quarter, a year ago in the second quarter. And then the last two line items would be the returns gross margin adjustment -- that would be the $46 million I just talked about as an example -- and then the last line item would be returned sales adjustment, which would be the $228 million number, and then of course, total. Now reading across here, the core merchandise margin, in Q407 it was up year over year by 34 basis points; in Q1, by 44 basis points; in Q2, 29 basis points; and in Q3, 27 basis points. Ancillary

[Operator:]

(Operator Instructions) Your first question comes from the line of Dan Binder with Jefferies.

[Dan Binder:]

Good morning, Richard. Just a question on California -- you talked about that business bouncing back a little bit. I was just curious -- are you seeing more of a bounce-back in the sort of non-discretionary areas versus the discretionary areas? Any color on that would be helpful. And then, also generally speaking if you look at the company more broadly, are you seeing more of the strength in the core comp coming back from the more food and consumable type items versus other areas?

[Richard A. Galanti:]

Yes and yes. I mean, first of all in California, I don’t think -- as it relates to where it’s coming back, it’s still weak everywhere. I haven’t looked at it lately but I also haven’t heard anything pointed out specifically in the California regions in our recent budget meetings. So as it’s come back a little, I would expect it to be in both areas but again, the discretionary tickets being still a little weaker. And the second part of that?

[Dan Binder:]

Well, I was just trying to isolate California specifically and then overall as a company, the core comp had bounced back a little bit last month and it sounds like May has gone okay, so I’m just curious if you are seeing more of that bounce back and -- or that strengthening in the food and consumable area or in the more discretionary areas.

[Richard A. Galanti:]

What really stands out when I look at the 27 or 30 sub-categories that comprise our four main categories, it’s in stuff that you -- it’s the staples. It’s your food categories. It’s your fresh food categories and the one anecdote I mentioned earlier was while jewelry is still negative, it was not as negative. It’s still nothing to write home about. So generally speaking, your furniture, your jewelry, even your electronics are all still weaker and what really stands out is the mid- to high-single-digit numbers on many of the basic canned goods and paper goods and fresh foods and things like that.

[Dan Binder:]

And then just a second question on gross margin; in terms of Q4, tough comparison. It sounds like gas might add a little more pressure. Should we be thinking about that as more of a flattish type margin year over year? And then also with regard to just get a little more clarity on the LIFO situation, are you suggesting there could be a charge in LIFO in the fourth quarter, or are you just going to be sort of even year over year?

[Richard A. Galanti:]

Again, my guess is only slightly better than yours. I’ll give you two anecdotal comments. We still have some credit, not a lot, going into the fourth quarter. In talking to the senior merchants, particularly on the food and sundries side and the fresh food side, where over the last six months we’ve seen big increases in lots of things, all paper goods generally were up 4% to 7% about three months ago -- two to four months ago. Given that it just happened, in talking to the Tim Roses and the Jeff Lyons of the world, their view is they don’t expect to see these manufacturers coming back in the next few months. So anecdotally, my sense is is that we are going to be fine in Q4 but getting it -- if inflationary trends continue and gas and energy costs continue, and commodities prices continue, then you’d expect to see something in fiscal ’09. But that’s our best guess now. We don’t anticipate anything meaningful, if anything, in Q4 but part of that is you know, it’s not like they come -- the manufacturer comes at you every month with an increase. They come at you -- it used to be that they came at you -- they’d only accomplish half of it, it might be two or three years before they come back. Now they come at you, they get more of it, but it’s not going to be two or three years, but it’s not going to be two months, either.

[Dan Binder:]

Okay. So barring any potential LIFO charge, gross margins year over year should be able to hold, is that reasonable?

[Richard A. Galanti:]

I would hope and think so, recognizing the caveat is gas, taking gas out of that equation. I would feel stronger with that.

[Dan Binder:]

Okay, thanks.

[Operator:]

(Operator Instructions) There are no further questions at this time. Do you have any closing remarks?

[Richard A. Galanti:]

Wow. Okay. Are you sure there’s no more questions? I’ve never had only two questions.

[Operator:]

Okay. We have a question now from the line of Todd Slater from Lazard Capital.

[Jennifer Davis:]

Hi -- Lazard and it’s actually Jennifer Davis for Todd. I just had a quick question -- it looks like, if I’m doing this calculation, that maybe May comps are trending even above 8%, if your quarterly comp is 8% now.

[Richard A. Galanti:]

Well, because the 8 for the quarter was a 7.78. I wouldn’t read a lot into that. I don’t think anybody has to -- there’s not going to be any great changes in either direction, or we would have announced something, of course, but we’ll have to wait and see until next Thursday.

[Jennifer Davis:]

Okay. All right, thanks.

[Operator:]

Your next question comes from the line of Susan Anderson from Citigroup.

[Deborah Weinswig:]

It’s actually Deb Weinswig. I don’t know. My line wouldn’t work, as it appears others didn’t either. So Richard, you had mentioned on the call that general merchandise is doing fine based on certain initiatives and also improved availability. Can you elaborate on that?

[Richard A. Galanti:]

Well, on the initiatives, I mean, things that we’ve talked about really back in Q2 and Q3 a year ago, when we finally saw some starting in Q4 and into this year. You know, I think Jim’s comments in the past is we deserve to make a little more and we are going to do it our way and still not compromise our competitiveness. And we’ve been able to do that in certain -- probably a third to 40% of our items aren’t the commodity critical competitive items like paper good and milk and cheese and detergent and soda pop and Snickers bars that we and Sam’s and others are fiercely competitive on. And you are not going to win or lose the game because we are both making very competitive low margins on that stuff. One area where -- you know, we all have -- even though we all have Christmas items in and wrapping paper and gift items and gift baskets, and even though we all have patio furniture and doormats and bedding, they are all different items in each location, at us versus a competitor. And on many of those items, we have to make sure that we, even though if we have a stated 14% or 15% cap on our margin, make sure that we are costing it right and one of the things historically that we really didn’t do and chose not to do was run our depot operations, which we view as a major competitive advantage, structurally in our industry and exaggerate it at Costco because of fewer items and more palette load quantities that we -- and the same thing with our department, that those deserve to be, make some profit sometimes. And we can still remain very competitive on the items. I’m beating around the bush a little bit basically to make a little more margin on selected items, and given that when you are talking about 4,000 items, 60% of which you are not going to touch anyway, they are fiercely competitive commodity items every day, it’s pretty easy to manage on an item-by-item basis, and there’s only a few people, starting with Jim and Craig, the head of merchandising, and the senior merchants below Craig, that with Jim as the governor, we are going to still maintain our integrity and maintain the integrity of what the buyers do but still be able to learn a little bit more. On the availability of additional goods, I’m not going to do what I did last quarter and use examples, real examples. You all go into the warehouses and you will very well see many branded items you’ve never seen before in apparel, in tools, and many of these items are great for us, and because they are high quality, high-end brand items that typically you only see at the high-end department stores and specialty stores, and in many instances because of the weakness of what I’ll call the mall business right now, there’s goods out there and they’ve got to get rid of them. And we are the highest end discount operation out there and we’ll take it all. And there are many items out on the floor right now that if they retail for a buck and wholesale for $0.50, we are going to sell them for $0.55 or $0.56 or $0.57 and save you $0.45. So one, I think that’s -- when you look at apparel, even though apparel -- I don’t know, you know what the retail apparel number is down in the retail apparel industry. It’s probably down 5% to 20% at different stores. At Costco, it’s up a few to 10%. And that’s because of availability of those items.

[Deborah Weinswig:]

Are you seeing, as you mentioned, you did refer to this last quarter as well -- are you seeing improved availability even over last quarter?

[Richard A. Galanti:]

I’d say continually.

[Deborah Weinswig:]

Okay. And then last question, actually kind of two questions in one -- from a square footage growth perspective, can you elaborate on how we should think about fiscal ’09 and going forward? And then secondly, as part of that question, what are you seeing with regard to availability of real estate and also pricing?

[Richard A. Galanti:]

In terms of -- if you look at unit percentage where we were up 6% in units or 6.5% in square footage in ’07, and I think we started ’08 with the assumption we’d be kind of the same percentage but if we were going to have net new units in the low 30s and we ended up at 25, inevitably one or two may have died but most of them were just pushed. We are aggressively trying to get them into the year and for whatever reasons, they got delayed, which happens every year, as you guys know. My guess would be is that it’s more likely -- I haven’t seen any finalized budgets for ’09 but my guess is in terms of net number of new units, if it were 25 in ’08, it will be at least in the high 20s in ’09 and we’ll probably start with a budget in the low 30s and work down from there a little bit. So my guess is it will either be a stronger 5% unit increase or average up to a 6. In terms of availability, I think two things -- one is we probably have gotten a little tougher on ourselves in some of the new markets to make sure that we are not just opening to try to get them open but make sure that we try to balance new markets versus existing markets. I know that we are in a few shopping centers now, which we were never invited in shopping centers -- recognizing when I say in shopping centers, typically it’s on the parking lot premise adjacent to or barely connected physically to a mall. And guess what? They like it. We bring on average 3,200 front-end transactions to our warehouse, which means on average probably close to 5,000 upscale members to that parking lot. And we may sell a diamond ring or a strand of pearls but from what we’re told by the shopping center developers, the Neiman Marcuses and the jewelry stores and the apparel stores like the traffic, notwithstanding the fact that we might sell a few of those items. So I think there will be a little more of that in the future. In terms of pricing, I spoke to Jeff [Rottman] just last week on that question and he says pricing is not going down; availability is going up. And it’s -- but it’s not a wholesale supply sale, or -- recognize too is we want prime spots and even in a down retail real estate economy, prime spots don’t go down as much. But we are seeing more availability.

[Deborah Weinswig:]

Great. Thanks so much for the color, Richard. Appreciate it.

[Operator:]

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

[Adrianne Shapira:]

Thank you. Richard, can you just give us or update us on the couponing efforts? What are the members’ reactions? How important are those coupons? Are they redirecting visits to when they get the books in the mail?

[Richard A. Galanti:]

You know, it’s funny -- years ago, and you all have known us for a while, have heard me quote before Jim talking about couponing is like drugs. You take it and it works, but you keep needing to do more of it. And we went from what was originally probably an eight-week summer passport to a 10-week to a 12-week and then we started with a six-week winter wallet, it’s now 12-weeks. And a few years back, we did a mailer for those three days after Thanksgiving and we do some handout coupons. We are trying -- over the last year, we’ve tried to not increase it and to wean ourselves a little, recognizing we still want to be in the net [landed cost to low] business, but we can’t sit here and say that it doesn’t work. The vendors like it. They see directed sales on those items. There are times when during that two week or whatever week period it is, they will see anywhere from a two or three times increase to a 15 to 20 times increase in their sales, particularly when it’s a new item that’s a recurring purchase, like a food item. There’s nothing better, a food item or a disposable item, whether it was years ago the Swiffer mop or a new cleaning agent. So the vendors love it. I don’t see it going away. I don’t see it being incrementally big. We probably are doing a little better job of also fine tuning it and not just massing out the same thing to 20 million members but being a little smarter about segmenting, and the key word there is little. We still want to keep things simple and do it our way, but it’s here to stay. You know, we look at the wallet and the passport and then we also look at what we call these multi-vendor mailers. I’m sure you’ve seen them in the mail, hopefully -- if you haven’t, call me. And again, these are more segmented to specific items. The fence, as an example, when you walk into the warehouse, one week it might be summer stuff and the next week it might be vitamins and then next week it might be an entire fence of P&G items. So there’s lots of vendors across many categories that really see very dramatically the impact of that and hey, it’s great for our members and we just have to recognize that there’s a limit to how much you can do forever.

[Adrianne Shapira:]

Okay, so is it fair to say when you look out for the remainder of the calendar year, we should expect flat year-over-year?

[Richard A. Galanti:]

Yes, but I think that we’ve seen that this year. There hasn’t been any big changes this year. I think we may have done -- well, as an example, this is week four of a four-week multi-vendor mailer -- a three-week multi-vendor mailer that for us was a week off but it’s in the same four-week month that we report next week, so you guys, we won’t have to explain it to you.

[Adrianne Shapira:]

Okay, and then just -- appreciate your commentary on near-term margins, kind of expecting flattish in the merchandise margins near-term, but can you just revisit for us the longer term? You’ve always talked about it not to expect it to be linear but that longer term margin targets, you know, the 3% or -- where are we and where should we expect over time to get to? Thanks.

[Richard A. Galanti:]

Let me -- I think the best way to tell you the story in a vague a way as I can is back a year ago when we talked about prior to hitting very strong margins in Q4 last year but you know, back in Q2 and Q3 when I started talking about the margin initiatives and we’re going to do it this time and the whole bit, and at the time on these very same conference calls, some of you would ask well, do you think it could be 15 basis points or 20 basis points a year for the next three years? And of course, I’d say something like “I wouldn’t touch that” and then finally somebody would say do you think it would be 10 or 15 a year for a couple or three years? And I’d say maybe, but recognizing we don’t know, exactly. We’re not there yet. And then the question became once we hit 25s and 35s year-over-year improvement, the one [facility] we started before we had last year’s -- reported last year’s fourth quarter that total consensus out there, buy-side people, sell-side people, us, you name it -- everybody was on the same page and over the next three years, we could get 10 or 15 a year and let’s round that number to 40 for three years. I’m just making this up as I go along. If it was 40, the next question you would expect me to get is over the last few quarters, as we’ve gotten 30-plus a quarter, they are saying oh my god, is there only five or 10 left? And my comment has been when asked that question, either on a big call or on a little call, is my guess is it’s more than that. But is it still 10 or 15 a year? I don’t know. What I do know is in talking to merchants and Jim, and Jim will be the first to start every sentence with we are not going to do things that compromise our sales. We are a top line company because that’s -- only good things -- only bad things happen when you’ve got lower sales, only good things happen when you’ve got higher sales. But we are, as he said time and again, smart enough to figure out how to do it. I think and I believe that talking to merchants and to Jim, that there is more on the table but we are going to do it our way and until we get to these next few quarters post anniversarying the first year, it’s going to be hard to know exactly how much. I’m not trying to be cute. I’m trying to be honest and I would say it has a plus sign in front of it but I can’t tell you how much.

[Adrianne Shapira:]

Okay. Thank you.

[Operator:]

Your next question comes from the line of Charles Grom with J.P. Morgan.

[Charles Grom:]

Thanks. Just to move down the P&L a little bit on SG&A, clearly your best performance I think in almost four years. Most of it looks like it’s core and central 12 basis points. I’m wondering how sustainable you think that is in the fourth quarter and beyond?

[Richard A. Galanti:]

I think for the fourth quarter, the closer to now that I look out, the more confident I am, and recognizing sales help that number. The higher sales from gasoline inflation alone hurts margin and helps SG&A, so it’s a wash to the pretax line, but -- and certainly we are continuing to have inflationary gasoline. If you just did a simple calculation, I don’t know if it’s completely correct, and just took out the inflation component of gas year over year in Q3, any number on our income statement divided by, assuming flat gas prices, same gallons with flat gas prices, was like four basis points or something, even plus or minus and again it averages out to zero. And so my guess is that we now have anniversaried the dollar an hour increase, we have no plans to gut-punch you next quarter on anything specific, so yeah, I think that -- will it be 12? I don’t know. I’d be thrilled if it was five or 10 or zero -- as Bob just said, zero to 10. I’m not trying to bring you down because we know anything more but we’ll have to wait and see. But my gut tells me it won’t be 12 but it will be something.

[Charles Grom:]

Okay, fair enough. And then on the core 27 basis points, you spoke to some categories being low doubles and then some [the size of a hundred]. I wonder if you can get a little bit more granular, if that’s even possible, I guess.

[Richard A. Galanti:]

I don’t have it in front of me. I think that within the categories, I’m sure hard lines was a little better because of strong improvement in electronics, again because of our change policy, and fresh foods. So off the top, I would say those are at the higher end. I think soft lines was at the lower end.

[Charles Grom:]

Okay, and then last question would be just on the gas -- I’m wondering if you guys have done any sort of studies in terms of the rub-off on people coming in and what the conversion is of people that actually come in to purchase or buy gas that actually enter into the store and how that’s maybe trended over the past three quarters, given how strong your traffic is?

[Richard A. Galanti:]

Recognizing we don’t want to know too much, it’s dangerous, internally -- you know, and we’re not going to do anything to change it but about 30% of the people that buy gas go into the warehouse, and the question is were they planning to go to the warehouse and got gas? I can tell you as a consumer, even when I plan to go to the warehouse and I said you know what, I could use some gas too. I look at the line and I said I’ll do it tomorrow, so my guess is -- I can’t even guess. I know that number, the 30 -- about 30 people out of every 100 that buy gas shop.

[Charles Grom:]

Okay. All right, thanks very much.

[Operator:]

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

[Mark Wiltamuth:]

Good morning. Just to follow-up on your margin commentary on the food there, is the food margin itself up in that category or is the mix up because the food margins are higher than the rest of the business?

[Richard A. Galanti:]

I would say it’s both. Keep in mind your most leverageable margin opportunities are in fresh foods. You know, in your bakery, your raw materials are a fraction of the total sales dollar, your labor and electricity and depreciation are another fraction that if you sell one more dozen of something, you make a bunch of money on it. And given that many of our, as an example, bakeries are higher volume to start with, as people are in theory coming to us because of food, or we are adding members because of food, I think that you probably get the [inaudible] for your month on those numbers. Does that make sense? Hello?

[Operator:]

Your line is still open.

[Richard A. Galanti:]

Okay. Thank you.

[Operator:]

Your next question comes from the line of Peter Benedict from Wachovia.

[Peter Benedict:]

Richard, first can you revisit the fourth quarter of last year? I was a little unclear. What was the gas impact on gross margin last year? I now you said gas margins were strong but when you kind of take it in with the mix and everything, what was the impact on gross margins last year?

[Richard A. Galanti:]

Right before the call, I was looking at the transcripts. We didn’t say specifically. What we said -- it was a question I think by Chuck Grom in the transcript last year that asked what portion of the margin, this incredibly strong margin for the first time year over year, was initiatives? And we said it was somewhere around a quarter to a third, implying that other things were a little over half. And that’s as granular as we got.

[Peter Benedict:]

Okay, that’s fair enough. And then you mentioned that 60% of the 4,000 SKUs that you guys carry are basically not part of these initiatives. Of the 1,600 SKUs that you can work with on margin, can you give us a sense of maybe how many you guys have touched at this point?

[Richard A. Galanti:]

Not really. Keep in mind also, a lot of it is seasonal stuff. You know, when we bring in lawn and garden, us and Sam’s, while we both will carry the same Tide detergent and the same M&M’s and the same Snickers, 36 count of Snickers bars, when we bring in swing sets and patio furniture and doormats, or at Christmas time when we bring in a different SKU or pack size of wrapping paper or ribbons or snow globes with the music box, or gift packs, all these things are unique and what we’ve done is to say hey, we deserve to make more money as a company. We’re not going to make it by trying to make more money on fiercely competitive commodity items, which is -- you know, you are just not going to do it competitively and where we can do it is on certain import items, certain seasonal items, and it is more of an item, just like our company is, an item driven basis of where we can do that. You know, I use the example of, even of some produce items, I think we do one of the best jobs of being in season for more weeks a year on seasonal produce. The example that I’ve been given by our people here is grapes, which is a $100 million plus business for us now and if the food chains in the country, the supermarket chains are in grapes -- and when I say in grapes, they are in big sizes at reasonable prices half the year or 20 weeks a year, we are in grapes for 40 weeks a year or 35 weeks a year and we can make a better margin, particularly during those weeks when nobody else can sell the size and quality that we sell. I think the recent presentation I saw, we are now procuring produce from 28 different countries and utilizing some of our international sourcing from our regional or international operations. And we can use our global buying power when somebody in Asia is going out to get some of those items in other parts of the world. So you know, it’s nothing brilliant. It’s structurally I think we are unique in a lot of ways and that’s just one of the benefits we have.

[Peter Benedict:]

That’s fair enough. Thank you. And then just a last question -- in April I think your average gas selling price was a little over $3.40. Can you give us a sense of what your assumption is as we look out to the fourth quarter? I mean, I know you can’t forecast gas but in your outlook for the fourth quarter earnings, $1.01 being towards the higher end of the range, what type of gas price are you guys assuming, at least at this point?

[Richard A. Galanti:]

I think gas, the swing in gas year over year could be anywhere from -- I’m going to be very wide here -- $0.03 to $0.07 difference from last year. I mean, off, and you just don’t -- and again, I’m being conservative but I -- you just don’t know.

[Peter Benedict:]

Okay. Thanks very much.

[Operator:]

Your next question comes from the line of [Lisa Warner] from Bernstein.

[Lisa Warner:]

Good morning, Richard. I wonder if you can please give us an update on how the newly opened international units are working out, and maybe an outlook on how you are progressing with other international expansion over the next few quarters?

[Richard A. Galanti:]

On the first part of the question, the recent openings, I think we’ve had two or three openings in Asia in the last few months. They’ve done particularly well. I think I made a comment last quarter that one of our units, either in Korea or Taiwan that opened, if you took the average number of members that we have per warehouse in our whole company, recognizing the average warehouse does $130 million plus in sales and the average warehouse is 15 to 20 years old, so it’s been around for a long time, that I think we have about 56,000 or 55,000 members per warehouse. We opened a couple of units in Asia in the last few months which had more than 50,000 paid sign-ups on opening day, recognizing we collect -- you can come in and sign up usually during the six to 10 weeks prior to opening once we have a tent outside and the balloons and the parking lot that they can park in. So we’ve never experienced anything like that anywhere in our company, other than when we did freebies in new markets. So those units are starting off strong. I don’t recall other international units -- you know, Canada, while it is international, it’s so much like the U.S. in terms of maturity and success and predictability that we really don’t get surprised. Those are good, successful units for us from the get-go. But in terms of new markets, I would say we’ve only opened up I think one in the U.K. in the last year, if that. So overall, I’d say they’ve gone well. We have been -- when we see, and I think back to even a market like Chicago, which is not foreign but was new for us, and we opened our first Chicago unit at least 15 years after our competitor, Sam’s, had been there for a long time. And once we had one or two units, they did okay but they were certainly below average, recognizing it was a new market and in the first few years. But it seems like whenever we go into any new market, be it a foreign country or even a major metropolitan area like Chicago, once you get past the three or four units, recognizing we don’t advertise but people know us better and we start to see all of them build a little bit faster. And we’ve seen that in a selected few markets that I can give you examples, like a Chicago here, and we are clearly seeing it I think in like a Taipei and a Seoul, Korea.

[Lisa Warner:]

And how is Australia progressing?

[Richard A. Galanti:]

By the way, my final comment on that was and these are countries, by the way, that have no gas sales, which is a big boon here in any market we go into because of it’s top of mind. Australia is going. I don’t know -- does anybody have the -- spring ’09 would be the first unit and the second unit following within six to 12 months.

[Lisa Warner:]

That’s helpful. On a different note, how about your Internet sales? Could you give us a little bit more color on what’s been driving the strong sales growth and what’s going on with May?

[Richard A. Galanti:]

If I recall, our average ticket has been in the low 400s -- I want to say 425, 440, and I think in the last couple of quarters, it’s come down slightly. It’s still above four. I recall that from the last couple of budget meetings. I think when we started the year back in the fall, comps were in the 40-plus range. Now they are in the mid-20s, but I have to tell you, one week it’s 10 and one week it’s 50. It’s just -- I think it depends partly on what we are selling. I think part of it is we are still getting much better comps online in electronics, as an example that in-store, that’s what we sell. So we are still doing it our way. It’s a limited selection. It’s 80%-plus of the goods are not overlapped with the warehouse. They are extensions of what’s in the warehouse and it’s -- you know, $1.6 billion is nothing to [shout about].

[Lisa Warner:]

Thank you, Richard.

[Operator:]

Your next question comes from the line of Mitch Kaiser with Piper Jaffray.

[Mitchell Kaiser:]

Good morning. You mentioned that you showed gross margin expansion in all four categories anywhere from low double-digits almost up to 100. Would you be willing to just kind of rank those?

[Richard A. Galanti:]

No, other than what I already mentioned. Certainly fresh foods and electronics, the hard lines, are at the higher end and soft lines and -- soft lines is at the lower end. And basic food and sundries is half the business, so it’s got to be somewhere. It’s the whole company, all four of those together was 27. It can’t be that different than that.

[Mitchell Kaiser:]

Okay, sounds good. And then, did you quantify how much food inflation hurt margin?

[Richard A. Galanti:]

No, because I don’t know if we have calculated it out that way. Our MO is again pretty simple and straightforward. We are going to hold prices as long as we can, and as long as we can means if we bought in, we are going to keep it longer than everybody else at the lower price and not make anything, but -- whereas some retailers will choose to bring up the price quicker. And also we are going to be subject to what our competitors do. Even if we feel we need to raise the price on a very competitive item, we’re not going to be the first one to do it. I think the good news there is that we all are in the same boat. We all have inflationary cost expenses to deal with and I think the expectation of our customer is that there’s some inflation out there that has to be passed on, but we are always going to be the last to do it. Now, last doesn’t mean we’re waiting a year. Last could be we’re waiting until after they do it and then we are going to -- it’s also subject to see if there’s a big impact on sales volume, but again I think anecdotally, the story I told before about a couple of years ago with rising commodity costs increasing for wood and pulp and energy costs related to producing all kinds of paper goods, from Pampers to toilet tissue to paper towels to copy paper, you had to -- I remember hearing the stories here internally back in early ’06 that the manufacturers are talking to the retailers, be it us or I’m sure Wal-Mart and Target or the supermarkets as well, that we are going to have start raising some of those -- they are going to have to start raising some of those prices to us. And I think it was the purchasing power of us collectively that was able to A, hold off on some of those increases and B, when they came through, they probably were less than the manufacturers originally wanted to. Ultimately, they said next Thursday, this is the new price. We did our job of holding them off as long as possible. I think in today’s environment, we see more manufacturers just bringing you increases. Now, we have a little bit of an advantage in the sense that we don’t have to sell all four brands and all six sizes of something, so if anything, we can push a little harder, knowing that we are prepared to sell Brand A instead of Brand B, because they are both high quality, national brands. But I think probably there’s an expectation out there that you know, there’s nothing you can do with energy costs and production costs and freight costs going up like they have.

[Mitchell Kaiser:]

Okay, and then lastly, and I know there’s been some discussion on this but I just want to make sure that I’m clear, we should be thinking -- and I know that there’s a number of factors, particularly gas that could swing things one way or the other. But in terms of thinking about the fourth quarter, kind of flattish merchandise margins and then potential to leverage SG&A similar to the fourth -- the third quarter, rather?

[Richard A. Galanti:]

You know, I haven’t -- I think if you take gas out, we should show some improvement even with some -- even with some -- the fact that we are anniversarying against some improvement from the initiatives. But we’ll have to wait and see.

[Mitchell Kaiser:]

That’s on the merchandise margin that you are referring to?

[Richard A. Galanti:]

Yes, and then on the SG&A side, again I think sales, assuming comps remain as they have been and the fact that we’ve anniversaried the dollar-an-hour increase, there hopefully shouldn’t be any big surprises there that -- again, I think earlier in the call, somebody said do you think you can still get 12 like we did this quarter in the eight and the four, and my guess was is it won’t be 12 but it won’t be zero, under those assumptions.

[Mitchell Kaiser:]

Okay. Fair enough, thanks. Good luck.

[Operator:]

Your next question comes from the line of Joseph Feldman from Telsey Advisory Group.

[Joseph Feldman:]

Just a question about the government’s rebate checks, if you’ve started to see any impact from that and if not, what maybe you are expecting for the next couple of months from the rebate check.

[Richard A. Galanti:]

It can’t hurt but we really haven’t seen any impact from it, as we hadn’t a few years back when there was a government rebate check. And if I recall a few years back when there was that government rebate check, it was the dollar only stores, $0.99 only, Dollar General, it was the Wal-Mart and K-Mart stores that tended to benefit from it, and it was the higher end retailers, as well as the Costcos that indicated they really hadn’t seen any. So we really don’t expect a lot from it. We are not doing anything to promote it. It’s not really -- our view is that our average member is sticking it in the bank and again, on a macro marginal basis, it can’t hurt but it’s not a big deal. They are not coming to us to buy that big ticket.

[Joseph Feldman:]

Got it, got it. And then just as sort of a separate question, the television category for you guys has been a bit soft the past several months, and just wondering what you think -- if you could update us as to what is driving that and what your expectations are for the balance of the year in terms of product flow and what type of availability and maybe pricing pressures that you might see?

[Richard A. Galanti:]

Well, I think -- I believe it’s two things. I believe that the economy is hitting big ticket sales and even -- and the other thing is as flat screens went from $4,000 to $3,000 to $2,000 to $1,000, that people were buying them, so a combination of a weaker economy and the fact that everybody always has two or three of them, that all those things together impact it. I give the story personally that for 10 years, let’s say throughout the 90s, our family had one big expensive $2,000 Mitsubishi 35-inch, plus a couple of little TVs, and one camera. I think since 2000, we’ve got three or four flat screens and five cameras. Every time they come out with more megapixels and a smaller size and they give the old ones to the kids and you -- so I think everybody’s got a bunch of this stuff. Even things like Blu-Ray, not everybody is rushing out to buy Blu-Ray yet. People are tired of spending several hundred dollars on a new machine and they don’t want to do away with everything yet. So I think consumer electronics will continue to come out with great, cool stuff and it will -- it’s been so strong for so long, in my view it’s almost like a breather, and there’s still a lot of great stuff coming out but in these trying times, even if what you perceived was a -- well, you know, you can get a great laptop now for under $1,000. It wasn’t two years ago that it was over $2,000. And so I think that even though it is under $1,000, you are not just rushing out to get the new and latest and greatest because your old one does movies and Internet, e-mail, just fine. And not everybody needs 28-gigahertz, or whatever.

[Joseph Feldman:]

Right. Great, thanks very much and good luck.

[Operator:]

(Operator Instructions) Your next question comes from the line of Robert Drbul with Lehman Brothers.

[Robert Drbul:]

Just one question for me is on the membership fee income stream, with the initiatives that you have underway, do you think you will be able to reaccelerate growth with what you are seeing over the last several quarters?

[Richard A. Galanti:]

I look at it as even though it was lower by six basis points, you know, it’s 10.5% member growth or dollar growth, and on 6% square footage growth, I think we’re doing pretty well. Again, when we first looked at it, I said what the -- because it’s usually flat or something. If you just take out gasoline inflation, and that’s a simple mathematic equation, it’s minus two or three basis points, not six. But again, if you take out cost of sales, we’re a lot more profitable too, so you can’t just take out things. I think our marketing, our membership department feels very good about the initiatives we have underway. I think we’ve seen it in frequency, we’ve seen it with even some of the things that our partner, American Express, has done. You know, 3% on top of the 1% you get on all other Costco things at Costco gas stations, is -- and it’s nothing we’re paying for, it’s getting more people to get that piece of plastic in their wallet, that’s working. And anything that we can do to drive business, I think we are doing a pretty good job of doing that. What we are not doing is TV advertising or crazy stuff that’s not on our list, and I think we are going to be focusing on the value proposition. So I think that we are doing fine there.

[Robert Drbul:]

Okay. Thank you very much.

[Operator:]

Your next question comes from the line of Sandra Baker from [Mortez] & Caldwell.

[Sandra Baker:]

I have just a couple of questions, just on the member question that Bob asked; can you talk a little bit about what kind of trend you would expect going forward, now that we are two years out from the fee increase? And then, just any comments you have generally about the competitive environment?

[Richard A. Galanti:]

On the first question, way back when when we had no price increases, on a good year you’ll see membership fees and percent of sales go down two to four basis points. There’s a little mitigation from the conversion to executive member. That helps you a little bit there offset that, not completely. We don’t anticipate any price increase in the next year or so, so again I’d probably see it down slightly as a percent of sales. And the second question was?

[Sandra Baker:]

Competitive environment.

[Richard A. Galanti:]

I think we and Sam’s continue to be fiercely competitive. When we look at our most competitive markets that we define as our new markets, where in the last six or eight years we’ve gone for the first time and they had been there for 15 years, like Texas, like the Midwest, on a market basket of 100 commodity items, there’s very -- you know, there’s less than a half-a-percentage point different sometimes, and we are both in each other’s warehouses more than once a week club shopping key items. And so they continue to be competitive, and [it’s not getting any worse]. I think that BJ’s has gotten more competitive since some of their management changes of late. It seemed like for a couple of years, we were not club shopping them nearly as often because margins were so different. They are still not as tight as us versus Sam’s but we club shop to them more regularly. And so there’s no rush to improve profits by being less competitive. I mean, it’s still fierce out there.

[Operator:]

(Operator Instructions) You have a follow-up question from the line of Lisa Warner with Bernstein.

[Lisa Warner:]

I had a question related to the merchandise margins and the pass-through on the food cost inflation. I seem to remember that you said you are not going to feel it this year because, and you mentioned electronics credit, but if we were just to look at food items and staple items in household categories, for example, does it mean vendors are not trying to pass through food cost inflation to you, or does it mean you are passing it through to the consumer, or only partially and therefore you have to offset it in some ways with margin improvements in other categories? I’m just confused I think how the whole pass through is working out.

[Richard A. Galanti:]

I’m confused a little too, but I’ll give it a shot. I think first of all, as a good retailer should be, we push hard not to get price increases from our manufacturers. Ultimately we recognize that when such an increase does come through, it’s only after we’ve delayed it as long as possible and mitigated the size of it. At such point that it comes through, we are going to buy in as much as we can at the low price. Typically manufacturers will allow you to buy in a certain number of weeks of your average prior week sales, purchases from them. And then we are going to typically hold the low price longer than our competitors. But ultimately, we are not in the business to lose money. Are we in the business to make a little less, if necessary? Yes, but I’d say it’s not 100% efficient but 80% efficient in terms of the timing of when we can pass through things. But we don’t just look at something, well, it cost us 3% more from the manufacturer so we’ve got to raise the price 3% tomorrow. I think where we can offset some of it to the extent that it [inaudible] sometimes in that, is on those other initiatives, whether it’s private label penetration or identify those items where we can add, if you will, a little margin because of the value of our depot operation in our import department. We can talk offline and try to better explain it but there’s not a whole lot to explain there beyond what I think I just said.

[Lisa Warner:]

No, that’s what I needed to hear. Thanks, Richard.

[Operator:]

(Operator Instructions)

[Richard A. Galanti:]

Okay, well, thank you, everyone.

[Operator:]

There are no further questions at this time.

[Richard A. Galanti:]

Thank you, everyone.