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Costco Wholesale Corporation (COST)

Q3 2006 Earnings Conference Call

May 31st, 2006 11.00 am EST

Executives:

Richard Galanti, Chief Financial Officer

Analysts:

Debra Weinswig, Citigroup

Charles Grom, JP Morgan

Christine Augustine, Bear Stearns

Adrianne Shapira, Goldman Sachs

Mark Husson, HSBC Investment Bank

Daniel Binder, Buckingham Research Group

Dan Geiman, McAdams Wright Ragen

Robert Toomey, EK Riley Investments

Neil Currie, UBS Warburg

Bob Drbul, Lehman Brothers

Presentation

Operator

Good morning. My name is Crystal and I will be your conference operator today. At this time, I would like to welcome everyone to the Costco Wholesale Corporation's conference call to discuss Q3 earnings and May sales results. Operator instructions. I will now turn the conference over to Mr. Richard Galanti, Chief Financial Officer. Please go ahead, sir.

Richard Galanti, Chief Financial Officer

Thank you, Crystal. Good morning to everyone. As with every conference call, I’ll 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 press release as well as other risks identified from time to time in the Company’s public statements, and reports filed with the SEC.

This morning as usual, I would like to review with you several items. To begin with, our 12-week Q3 FY2006 operating results. Briefly, we came in at $0.49 per share for the 12 weeks ended May 7th, 2006, up 14% or $0.06 per share over last year's Q3 EPS figure $0.43. These results were 1% below the top end of the range of EPS guidance I provided you in March and of course First Call throughout the quarter remained at $0.50, so $0.01 below that figure. As I will discuss with you in a few moments, a pretty good result given weak gasoline profitability and a higher than estimated tax rate. In terms of sales for the quarter, our 12-week comp sales figures showed an increase of 7%. In terms of the three retail reporting months most closely aligned with the quarter - February, March and April - our reporting comps were 8%, 7% and 7% respectively. Which brings me of course to the strong 4-week May comp sales figures we reported this morning of 10%. I will speak more to that figure in a few minutes.

Other topics of interest that I'll review this morning are recent openings - we've opened a total of 17 locations since the beginning of the fiscal year, last August 29th. 13 of these are in the US, including one relo, so 12 net new openings in the US to date. Four new locations in Canada, including one relo, so net of three in Canada. We now have 68 in Canada. One new location in the UK, our 17th, one new location in Mexico, our 28th. The latter in Mexico of course, we account for on an equity basis. For the remaining 14 weeks of this fiscal year, we expect to open 12 more locations, including one relo and one in Mexico. All told, this would put us at net new locations excluding the two in Mexico, of 26 for the fiscal year, plus those two, of course, in Mexico. The 26, by the way, reflects two openings planned for August that have slipped into early September, the first month of FY2007. I will also discuss this morning our ancillary business results, our online results, membership trends, our balance sheet, update on recent stock repurchases, and lastly provide you with a little updated direction and guidance both for Q4 and FY2006 overall as well as our expansion plans for 2007, which should be in the mid-30s.

So with that said, sales for the year, as I mentioned: total sales were up 11% from $11.7 billion last year in Q3 to $13 billion this year. On a 12-week to 12-week comp basis, Q3 comp sales were up 7% for the quarter. For the quarter, our 7% reported comp sales results with a combination of average transaction increase of a little under 6%, about half a percentage point of that was due to FX and an average frequency increase of about 1%, up for the quarter. Cannibalization, as you know we've continued to infill more than new markets, and that continues to increase. On cannibalization, the impact in Q3 was a 135bps hit to the quarter. That compares to about 120bps YTD and something I believe in the high double digitbps for the last fiscal year. Again, increasing penetration of existing market openings, we would expect to see that (a percentage point?) higher. Also included in the average transaction increase of a little under 6%, is about 90bps due to gasoline inflation YoverY in the quarter. This effect, of course, was even higher in May. I'll talk about that in a minute. For the 4-week month of May, our 10% reported comp sales results resulted from an average transaction increase of a little over 8% for the month. About 175bps of that was due to FX. We've seen a particularly strengthened Canadian dollar relative to the US dollar, which is where about 12-15% of our sales come from.

The difference between the Q3 comp of 7 and the May comp of 10, about one percentage point of that was the relative increase of FX from an impact in the quarter of about half a point, to the impact in this month of 175bps. The average frequency increase was a little under 2% up for the month, and cannibalization, which I mentioned again in the quarter, was 135bps. For the month of May it was 180bps, again a little under a half a point higher impact than in Q3. Also included, the average transaction increase of a little over 8% is about 200bps due to gasoline inflation YoverY in May. As you know, the prices rose pretty dramatically in May. If you take these three items which we have talked about, I thought I'd give you some numbers on each month. FX, cannibalization and gas inflation, these three items represented about half of the delta of the 7% comp in the quarter versus the 10% comp in May. In terms of sales comparisons by geographic region, all regions in the US showed good improvement. In Canada, we had not only the impact of the strong Canadian dollar, but the underlying local currency as well. Canada sales comps in US dollars in the quarter were up in the low double digits, with about 4% of local currency. That improved to about 20% in May and about 7% local currency. So we've seen some nice improvement in Canada, even in local currency.

Other international continues to do well also. Again, total comps for the quarter, 7 and for the month of May, 10. In terms of merchandise categories, basically the three major ones: sundries; hard lines and soft lines were all up nicely. Hard lines are showing the biggest rate of improvement. Fresh foods was in high single digits, pretty much in line with the past, a point or two down from where it had been in the last couple of quarters. Ancillary businesses are continuing to be strong. Within food and sundries, there was one outlier, tobacco. Tobacco is about 6% of our total company sales and about 14% of our food and sundries sales. That was down 4% in these reported numbers, the result of a year ago when there were pending tax increases on tobacco, both in the US and Canada. That drove up sales last year in the month of May, before those price hikes went into effect a year ago. Hard lines, consumer electronics is still the driver, with it coming in, in the mid to high teen comps, notwithstanding the fact that the price points continue to do fine in a lot of products within consumer electronics.

Soft lines, relative strength in house wares, home furnishings and both men's and women's apparel, our gas sales by the way, during the quarter, were 23% comp with about 5% of that being gallonage(?). For May, food sundries again strong, all nine sub-departments positive including tobacco, ranging from 3-13% each. Hard lines: strength in hardware, gardens and majors. Soft lines, strength in house wares, men's and women's apparel, with offsets in the area of media being negative. Moving to the line items in the income statement, I'll start with membership fees. Reported in Q3, membership fees were $276.2 million, or 2.12% of sales. That's up 11% or $26 million from a year ago, down 1bps recognizing the strong comp sales and total sales figures. Again the same story, strong renewal rates, increasing penetration of the $100 a year executive membership and new market openings. As you know, we announced recently a $5 increase in the basic Gold Star and Business memberships, I'll talk about that in a second. In terms of the number of members at Q3 end, Gold Star, 17 million households up from 16 million a quarter ago. Primary business 5.2 million up from 5.1 million. Business add-on, 3.6, up from 3.5, for a total of 25.8 versus 25.4 at Q2 end. Including add-on cards, a total of $47 million up from $46.4 million.

At the May 7th quarter end, paid executive memberships just barely topped 5 million, which is about 20% of our total membership base. During the quarter we saw an increase of 239,000 accounts go to Executive Member. That's a 5% increase since Q2 and about 20,000 new signups a week to Executive Member. YTD that represents a 760,000 increase in that base of 18% in the 36 weeks. So executive membership which increased in terms of total number of members 30% in FY2005 is up another 18% in the first three quarters of this fiscal year. Those 20% of our members of course represent around 50% of our sales, with about four fifths of that 50% being rewardable sales. Of course, we don't reward tobacco, alcohol and gasoline. In terms of membership renewal rates, they continue strong. Exactly the same as each of the last two quarter-ends, 91% on the business side, 84% in Gold Star, averaging 86% overall. As I mentioned to you almost two months ago on April 6th, we announced that we would increase our basic business and Gold Star annual membership fees by $5, from $45 to $50, in both the US and Canada. That went to effect for new sign ups, effective May 1st and July 1st for renewals, which will be the bigger impact of course.

By recognizing no change planned in the $100 Executive Membership, we estimate the $5 will impact about 15 million of our members and make the break even of making the decision between base membership and Executive Membership more favorable to a larger group of people. Going down the gross margin line, in Q3 our gross margin was lowered by 11bps. 10.48 during the quarter versus 10.59 a year ago. As usual, jot down a couple of figures to help the explanation here. There's only four line items; merchandising, 2% reward, LIFO and total. Three columns; Q1, Q2 and Q3 2006, so this would be the variance YoverY in terms of basis points at gross margin and components of it. In terms of merchandising in Q1, YoverY it was 2bps down at minus 2. Q2 minus 9bps, Q3 2006 minus 4bps YoverY in the quarter. 2% reward, minus 9, minus 12 and minus 10. LIFO, zero, plus 2 and plus 3. And total, minus 11 in Q1, so in other words in Q1 2006 YoverY gross margin as reported was down 11bps. In Q2, minus 19 and in Q3, minus 11.

As you can see our overall merchandising gross margin was lower by 4 in the quarter. Again, this compares to the minus 2 in Q1 variants, and the minus 9 variants in the Q2 YoverY. A very similar story to the last couple of quarters. The minus 4bps figure is pretty much in which line with what I discussed with you all the way back in early December. On my December 8th Q1 conference call I said that in terms of our outlook for 2006 gross margin, reported gross margins would probably continue to be a little down due in large part to the gas non-gas sales penetration issue and to some extent increased Executive Membership penetration. That's exactly what you see here. Of the minus 4bps figure, by the way, minus 11bps was gas related. As well, lower YoverY sales penetration of our core merchandise, businesses and food sundries, hard lines, soft lines and fresh foods, these four major categories represent 80% of our total company sales. These, of course, have higher gross margins than our gasoline business. The reduced sales penetration of these businesses hurt us a little. In fact, the aggregate gross margins of food and sundries, hard lines, soft lines and fresh foods were higher YoverY in the quarter by 14bps but were a drag on total company gross margin.

Again, as I mentioned, gasoline gross margins not only was the increase penetration was penetration higher, but with the rapid rise in gas prices we saw a detriment to the gross margin even in gas. Looking beyond the merchandising component, our Q3 gross margin was again negatively impacted by 10bps from higher sales penetration of 2% Executive Member program, again implying that 10 basis point increase YoverY would apply 5% increase in sales penetration of those rewardable sales YoverY in the quarter. In terms of LIFO, note that we took no charge in this year's Q3 versus a $3.5 million charge in last year Q3. This helped reported gross margin by 3bps. Overall gross margins were OK - actually good - in the core businesses. We think that's a very positive sign for us. In terms of our gross margin outlook continuing into Q4, really the same commentary as I indicated both three and six months ago. Reported gross margins will probably continue to be negatively impacted a little due to gas/non-gas penetration issue. We are seeing a little improvement in actual gas margins over the last couple of weeks. But, as we all know, that can be fleeting but we'll hope that it continues for a little bit. As well the impact from increasing Executive Member business should be a continued hit to reported gross margin but should start to trail off a little bit over the next couple years recognizing that now 50% of our sales are to those members.

LIFO, again we had no charge in Q2 and Q3, and we would assume little or no impact from inflation in Q4. Any inflation that we're getting in some general merchandise categories like paper goods and the like is being offset dramatically by consumer electronics deflation. Most importantly, we believe, again, our core merchandise groups are doing well. Once we anniversary the current increases in gas sales penetration and hopefully the increased sales penetration of Executive Membership, not hopefully, but we'd expect that to slow a little bit, we would expect the negative impact to margins for these to be greatly reduced. Gasoline, while volatile to our margin and P&L these past few quarters, we estimated about a $0.02 EPS impact in Q3. It's a great business for us in terms of bringing in the customer, in terms of the customer trust and loyalty and the value to our member and again profitability for any twelve-month period continues to have been pretty good. Before going onto SG&A, in terms of ancillary businesses we added eight pharmacies to be at 392 at Q3 end. We added six food courts to be at 443, six mini labs, one-hour photo labs to be at 440, six optical to be at 432. We actually closed one print center so we have nine instead of 10 now. We added seven hearing aid centers to be at 183 and six gas stations to be at 241.

Again, in Q3 ancillary business comps were up 16%, up 9 without gasoline. Now moving to SG&A, again, I'm happy to report positive trends in SG&A leverage during the quarter. In Q3, as you will see, our SG&A YoverY was lower or better by 12bps coming in at 979 in this year's third quarter versus 9.91% of sales last year in Q3. This is our best QoverQ improvement in the last seven fiscal quarters. Many of you who have known us for a long time during the three years of 2002, 2003 and 2004, know we saw that going in the opposite direction and we've seen some nice trends over the last couple of years here. Again, to jot down a few numbers to give some elaboration to these numbers, the line items would be operations, central, stock options, and total. Again, three columns, Q1, Q2, and Q3. And operations in Q1, plus 9bps, Q2 plus 7, Q3 plus 12. Plus here means good, by the way, or lower SG&A YoverY. Central plus 2, plus 3 and plus 3. Stock options, minus 6, minus 8 and minus 3 for a total of in Q1 YoverY plus 5 or lower by 5bps. Q2, plus 2 or lower by 2bps, and again Q3 plus 12bps or lower YoverY by 12bps in the quarter. In terms of a little editorial on those figures, again, as we were hurt, if you will, a little bit in our gross margin percent from mix changes strong gasoline sales of course helps SG&A a little bit.

We benefited in lower Q3 over Q3 SG&A due to improvement in our largest expense categories. Payroll improved YoverY by 3-4bps. Our worker's comp and benefit expenses are continue to go show improvement as well by a few basis points. The 3bps improvement in SG&A and central is again certainly helped by our strong comp sales results. Finally, our stock option expense, which was higher by 3bps YoverY, a little less of a hit than in prior quarters due actually just to the timing by several weeks of this year's stock grant. Nothing major there. Regarding the expensing of stock options, as you know, we began expensing stock options in 2003. So we now have 3.75 years, if you will, of gradual expensing under our belt. Under prior rules, given our option grants vested ratably over five years, we've seen the expense grow each year such that by 2007 we would include in our income statement five-fifths, or essentially a full-year of stock options grant. One-fifth from each of the prior five years. This past year FAS123 was revised to be FAS123R. We adopted that, of course, from the beginning of this fiscal year. Basically it took years four and five of this expensing procedure into this year. That's why we see a little bit of an impact this year.

By the end of this year we'll have effectively a full amount of grant in there and while it may increase a little over time we wouldn't see that be a big impact to SG&A. In terms of outlook for SG&A, again, we're encouraged with what we're seeing in each month's results. Certainly, we depend on good comps, and hopefully these positive trends will continue. Next on the income statement is pre-opening. It was up $900,000 to 10.4 million in Q3 versus 9.5 a year ago. Same number of basis points: eight. Last year in Q3 we had four openings including two relos, there was also a couple of million dollars of international pre-opening. This year we had six openings, no relos but a little more remodel ancillary activity as well and no big surprises in that number. In terms of provision for impaired assets and closing costs, in Q3 2006 these costs total 1.2 million pre-tax. A year ago they totaled 3 million. Nothing unusual here, as well, simply our ongoing relocation efforts whereby costs associated with closing to be relocated units are expensed up front once the decision to relocate is made. All told, operating income in Q3 was up 12%, or $39 million over last year's Q3 figure, up to 354 million this year from 316 last year. Below the operating income line reported interest expense was substantially down by 5.8 million. Last year in Q3 interest expense was 8.5 million. This year 2.7 million. This reflects both the June 15th payoff last year of $300 million debt amount and lower interest expense on our convert as more of its holders convert into our dividend paying common stock.

As you know, our convert is substantially in the money by a factor of two. Interest income and other was higher YoverY notwithstanding our repurchase since last year, last June of nearly $1.5 billion of common stock in the market. During the quarter, interest income and other was 33.8 million, up about 3.6 million from 30.2 million last year. Virtually all of this increase was due to much higher investment income principally reflecting higher average interest rates, which more than offset a slightly lower cash balance. Overall pretax income was up 14% from 337.8 million last year to 385.5 this year. In terms of our effective tax rate, as you know, last year in Q3 it was 37.9% as compared to 38.93% this year in the quarter. The 38.93% figure this quarter is higher than the 37.5% estimate I gave you on the last conference call. About three quarters of this variance relates to truing up prior estimates for tax benefits related to unremitted earnings as we repatriate a significant amount of money from Canada back to the US You'll recall in end FY2005, three quarters ago, we had a sizable tax benefit that reduced our Q4 tax expense and benefited Q4 earnings by about $0.04 a share. Similarly, we recorded small tax benefits in Q1 and Q2 of this year related to unremitted earnings.

Basically freeing(?) up that now that the final Canadian returns have been filed and impacted again this tax rate, again, about three quarters of the variance versus our direction impact related to that. For the remainder of the year in Q4 we would expect the tax rate to be back in the 37.5 to 38% range. For a quick rundown of other topics let's start with the balance sheet. Cash and equivalents 3.302 billion, inventories 4.416 billion, other current 629, total current 8347. Net PP&E, 8274, other assets 663, total assets 17284. Short-term debt 369 million. I might point out that 309 million of that is the current portion of long-term debt which will be due, I believe, in March, so within the next twelve months. Accounts payable 4.439 billion, other current 2.684 billion, total current 7.492 billion, long-term debt 230, deferred and other 261, liabilities, total liabilities 7.983 billion, minority interest 62, stockholders equity 9.239 billion also totaling 17,284. Later today on our website we'll have our standard quarterly Q&A which highlights things like LIFO, opening schedules, EPS calculations, some of the detail as well as balance sheet and the cash flow statement which we're just finalizing this morning.

Pointing to a couple things on the balance sheet, again, quite a strong balance sheet, plenty of financial strength. In terms of AP percentage, reported this quarter, simply AP divided by inventories was 101% versus 102% a year ago at the end of Q3. A more appropriate number - which is not on the balance sheet - would be merchandise AP'ed inventories. That was 85% in the quarter versus 84% a year ago, so up a percentage point. Average inventory per warehouse, 9.835 million. Last year at Q3 end 9.462 million, that's up $373,000 at warehouse or up 3.9% compared to a 7% quarterly comp and, of course, a 10% May comp. Areas higher, again, the strong FX was about 65,000 of that. Consumer electronics inventories notwithstanding deflation continuing to put out more stuff, $70,000, slightly higher YoverY jewelry inventories about 50,000, and pharmacy about 90,000, a third of it being in RX and two-thirds of it being health and beauty aids. Again, that increase in inventory is below the sales increase in that area. Again, merchandising feel very good about our inventories. Merchandisers, they're clean and of good quality.

In terms of capex, as you know, in 2005 we spent a shade under a billion dollars, 995 million. Our projections for this year were 1.2 to 1.4 billion. This was for - quote unquote - 28 to 30 planned net new openings. YTD for the first 33 weeks we're at 752 million. Of course, Q4 is our longest quarter and we've got a lot of openings planned. My guess is we'll come in right somewhere around the mid-point of that previous projection of 1.2 to 1.4, probably right around 1.3 billion if not a little higher. A big slug of that is openings not only in Q4 but those costs of land and initial construction costs for those associated with a lot of expansion just after fiscal year-end. In terms of Costco online really doing well this year, for the quarter sales, at costco.com were up 62% and up 67% YTD through Q3. Sales in that area should exceed $900 million this year.

Next on the discussion list is expansion. Basically in Q3 we opened seven units which included one relo for a net new of six. The net new in Q1 and Q2 was eight and two respectively, so a total of 16 to date through Q3 end. In Q4 we have 11 new units including one relo, so 10 net new plus one more in Canada. That would give us a total openings of 29 less the three relos of 26 and our consolidated figures plus the two in Mexico. For 2007 we would expect, again, net of probably four or five relos somewhere in the low to mid 30s, and if you talk to our real estate people, they would suggest it's even a little higher than that but knowing how we are in the past, a number in the low to mid 30s would be a nice bump not only from this past year but significant increase from 2005 as well. The two that slipped, by the way, since some of you keep track of this, basically a couple slipped from August to September, La Quinta, California and Raleigh, North Carolina. Nothing magic there, just timing. But if you took the net 26, net new consolidated on a base of 433 that we started the year, that would equate to 6% unit growth and 7% square footage growth.

Lastly, talk about our stock repurchases. As you probably know, we had in place a year ago an existing common stock repurchase program allowing us to repurchase up to $500 million of Costco common stock. Since that time we have had two additional board authorizations that increased the $500 million amount to a billion five, so an increase of a billion. Then another increase of a billion to a total of 2.5 billion. Beginning in June 7th of 2005 near the beginning of our Q4 of 2005, and through the end of FY2005 we repurchased 9.2 million shares at an aggregate purchase price of 413 million, or 44.89 a share. Since that time and through yesterday we have purchased an additional 20.5 million shares at an aggregate price at of 1.42 billion, or $50.79 a share. So all told, since the beginning of Q4 2004 we repurchased a total of 29.7 million shares at an aggregate purchase price of 1.455 billion, or a little under $49 a share. Under these previously approved authorizations, we can repurchase an additional 1.45 billion of stock.

Again, as I mentioned last quarter, you should expect continuing stock purchases and hopefully future increase authorizations in the future. Before I turn it back to Crystal for Q&A, some minor direction for Q4 and FY2006 overall. I believe First Call dated 5/30/06 is at $0.77 and, again, as I said the last couple quarters we're comfortable with that at the high-end of a small range. That would imply First Call for the year at 233 and, again, that being at the high-end of our range, 230 to 232 to 233, up in the low to mid-teens for the year. I would hope we could do that or a little better but we'll keep our expectations where they are and see how the quarter goes. Certainly we're off to a nice start with sales. With that I'll turn it back for Q&A. Crystal?

Questions and Answers

Operator

Operator instructions. Your first question comes from Debra Weinswig.

Q - Debra Weinswig, Citigroup

Good morning, Richard. In terms of the inflationary or deflationary categories in the quarter, can you go through those and also the total impact on the top line?

A - Richard Galanti

When you add it all up, it's basically zero. In terms of anecdotal stuff, the biggest increase is looking down the list of the top 20 increases for the last four weeks. I mean crazy things, gasoline of course is about 20% up both leaded and unleaded. Tuna was up 14%. I'm just going down the list here and give you some of the big ones. A few of the nut categories like walnuts and pine nuts up in the low 20s. Coffee up slightly a few percentage points. You know, really it is all over the board, nothing major. Canned salmon, 20%, olive oil, 35%, pistachios, 31%. So just a potpourri of things. Nothing that stands out big. Again, the biggest impact was clearly gasoline and the two gasoline, leaded and unleaded, regular and premium unleaded gasoline. In terms of deflation, nearly the whole darn list is electronics. You know, things like the little 1Gb media disks, memory disks, you know. In terms of deflation, YoverY down 40%+. TV's, certain specific TV's down 20 to 25%. Again, nothing really earth shattering there other than the big categories are consumer electronics. But again, the overall impact to the company, you look at it even with inflation, despite the fact that you have significant deflation in at lot consumer electronic categories, consumer electronics comps, total sales comps are up in the mid to high teens the last several months. Again, that's a function of more availability and even though the price points on a given item are down, there's more items with higher price points like plasma and LCD TV's, 1Gb memory chips instead of 512Mb or whatever it was.

Q - Debra Weinswig, Citigroup

OK. With regards to, can you update us in terms of where you are on global sourcing right now either percent penetration or where you are from a benefit standpoint and with the opportunities still remains?

A - Richard Galanti

You know, I don't have an exact number, Debra, to give you. We're doing a lot of it. I am not trying to be vague or cute. I don't have an exact number for you. We're doing some of these I've mentioned in the past several quarters, certainly we've seen big impact in things like produce. We've seen impact in things like certain branded items in Japan that we got certain Japanese manufacturers attention. I am not talking about electronics, I'm talking even some food, basic food items when we indicated we'd be interested in selling some of those items in key west coast markets in the US so it greatly expanded the availability of those.

Operator

Your next question is from the line of Charles Grom.

Q - Charles Grom, JP Morgan

Good morning, Richard. On gross profit margins for Q4, assuming gas stays where it is today, which I realize is a big leap of faith, would you expect the merchandise component of your GPM to improve YoverY, given the easy compare you have from last year?

A - Richard Galanti

Given those assumptions, yes, but we've got that built into our numbers with a little cautious optimism. Hopefully we can do a little better. But yeah, given what you just said, sure.

Q - Charles Grom, JP Morgan

OK. Second question is on pricing. We haven't seen a lot of material price investment from either BJ's or Sam's. Is this consistent with what you guys have seen and are you anticipating more competitive pressures in the near-term?

A - Richard Galanti

Well, you know, it's hard and I know you and others as well do pricing studies and certainly we do pricing studies every week in every market. A couple three years ago particularly with respect to Sam's, with their changes over there in management and strategies, you know, we all seen a higher level of competitor pricing. Its remained at a high level. I think what we've shown is we can do both. We can improve margins while being very competitive. What I've said and, of course, what Jim Sinegal has said for twenty years is we're never going to be anything to compromise our competitiveness. I stand by that, and I don't think we've seen any big changes either way. You know, the fact that we're opening more units in existing markets clearly existing markets have a little better margin versus the Company average than new markets. That helps you a little. More of my view comes from buying better and perhaps a little bit from private label as well. I've given a couple of examples in the past of even things like taking half of our diaper business, disposable diaper business and going to private label or Gatorade a couple years ago. The athletic drinks, not Gatorade, but the private label athletic drink, the increase in health and beauty aids and things like vitamins and analgesics and things. So all those things help, and certainly, in our view distinguishing what we do versus our competition in terms of higher end items and new and exciting items. The one thing I don't lose a lot of sleep over at night is there are merchants continue to be out there on the offensive.

Q - Charles Grom, JP Morgan

And then just one last one to clarify, the 10 openings in Q4, that's going to be 10 that you're going to actually open, those do not include the two that are going to roll into September, correct?

A - Richard Galanti

That's correct.

Operator

Your next question comes from the line of Bob Drbul.

Q - Bob Drbul, Lehman Brothers

Good morning, Richard. Can you talk on the May sales, can you talk a little bit about any trends that you saw sort of week-to-week? I was wondering if you could just elaborate in terms of utility costs and how that's playing into your business at all right now?

A - Richard Galanti

We try to get away from giving daily and weekly numbers because it drives us crazy and it drives you guys more crazy. Week one was the weakest of the three with all the other three weeks being quite strong, and talking to the head of merchandising, Craig Jelnick, he pointed out two things. There was a little bit of timing of a couple of mailers that we had done. He felt the bigger impact also was from a switch in Mother's Day, just in terms of how that fell from one week to the next YoverY, again, not a big difference but, clearly, pretty good numbers for the quarter, for the month rather. I'm sorry, what was the second question?

Q - Bob Drbul, Lehman Brothers

Utility costs like how you're managing utility costs and how it's impacting your business overall right now?

A - Richard Galanti

For the quarter it hit us, the core warehouse businesses, utilities and telephone which is mostly utilities, was higher YoverY by 2bps, so that was an impact negatively to SG&A.

Q - Bob Drbul, Lehman Brothers

Can you talk a little bit about the profitability levels of your Canadian business?

A - Richard Galanti

Well, that's actually something that is in our segment analysis, our segmentation footnote because Canada is big enough that it's a separate entity. I think we have US, Canada, other international. It's pretty much in line as percent of sales with the US. I don't think there's any big dramatic difference. Canada just I think might be just ever so slightly lower percentage, but it's to minimize(?) that difference.

Operator

Your next question comes from the line of Christine Augustine. Christine, your line is open.

Q - Christine Augustine, Bear Stearns

Can you please talk about private label penetration, where you think that might go kind of 2007, 2008, and are you able at all to discuss some of the new markets that you might be targeting for club openings? Thank you.

A - Richard Galanti

In terms of private label, it's kind of the same old story for the last 10 years. Today it's about 16-17%. We think it will continue to grow gradually as a natural progression. Five, eight years ago when it was at 8%, we said over the next five or ten years it probably will grow into the mid teens. Now that it is in the mid, or slightly high teens we're saying it will grow probably to 20 or a little over 20. We still want to be a supplier of branded goods where our customers can see and compare and compete on those items. Certainly there's some items that we're not going to do, but I think what we have found even on something as loyal as a branded high quality disposable diaper that we think there's a market where we can find it. So we'll continue to expand it. Again, I am not trying to be cute, but the tea leaves would say that a number that's currently in the mid to slightly high teens will probably have a two in front over it, I don't know whether it is two years or four or five years from now, but over the next few years. In terms of new markets, really, what we're, if I had to look at the list over the next 50 locations over the next year-and-a-half, my guess is there's probably less than two or three that are in a brand new market. Probably another half a dozen that are in kind of new markets whereas we're opening a second unit in a mid-west city where we already have one. Not a lot there. In terms of international, my hope would be that two years from now we'll be looking at a couple countries right now and my hope would be that we might can have something open, but it's probably two or three years away given how things take over there.

Operator

Your next question comes from the line of Adrianne Shapira.

Q - Adrianne Shapira, Goldman Sachs

Richard, can you just touch on cannibalization? It seems like it's inching higher and given the ramped up expansion plans, where would you expect it to maybe level off and what level would you be comfortable with?

A - Richard Galanti

As you know, we're comfortable with wherever it is. My best guess a year ago when it was in the mid-50bps range, that we thought it might get up towards 100, maybe a little over 100. We're certainly doing more of it. It could get to - I'm pulling a number out of the air - but if you get to 150, 200, and that would be just fine with us. 250 would be fine if it means that we're expanding the market. The net benefit of doing it in terms of return on, incremental return on investment is still quite positive for us even though it impacts that number. We asked ourselves that same question yesterday, and we kind of look at it as yet it as yes, it's up significantly from a year ago, but even net of that comps are up and net of cannibalization and net of FX and everything else our comps are showing improvement. We're completely comfortable wherever it lands. When we look at every new opening, even net of the impact to nearby locations, it's a net positive. We view it as a net positive.

Q - Adrianne Shapira, Goldman Sachs

OK. You're clearly growing through so it makes sense. Just maybe talk about the mailers. We've noticed kind of ramped-up mailings in between the wallet programs. Talk about how important they are and are you noticing they're getting a little bit more important in the current environment?

A - Richard Galanti

You know, it's been an ongoing effort probably since we did our first summer passport, gosh, eight, ten years ago, seven, eight, nine years ago, whenever it was. I think more of it is a reflection of the vendors like it as well, and sometimes mailers, you may see different mailers in different regions. Some of it's based on regional items, some of it is based on the pool of money that's available for a given program. I think probably we've gotten better and smarter over the years as well a understanding, while ideally we would want everything to be, every day low price at netted(?) landed cost, take everything out, co-op dollars, slotting allowances, volume and term discounts, you name it, there are different pools of monies that different vendors have, and sometimes you don't get it unless you use it in the way that they want as well. But it's all over the board both ways and so I think it has improved. It has helped us gradually. I don't think it's that big of a deal on a YoverY incremental basis. In the quarter, certainly, I think it helped a little as I mentioned in weeks two, three and four versus one, but so did Mother's Day.

Operator

Your next question comes from the line of Mark Husson.

Q - Mark Husson, HSBC Investment Bank

I just wanted to follow-up on that cannibalization question. You said that you get an incremental return on capital. Are you talking about incremental dollars in the market or incremental percentages?

A - Richard Galanti

We look at it two ways. One is, of course, what that unit's going to do in terms of a cash-on-cash ROI but also, what is the impact of it net of cannibalization. So as an example, in an existing market if we do a new unit and it does 110 million in its first 52 weeks, that's great and wonderful and it's an existing market, and we probably have a little higher than average gross margin versus the company. It opens up pretty healthy. Take that 110 million and subtract 20 to 30, you know, of cannibalization out of it so maybe it's net of 80. That net of 80 is still quite a good return compared to a new market unit that might do a net of 55 or 60 in the first 52 weeks arguably with a little lower than average margin on average.

Q - Mark Husson, HSBC Investment Bank

And is it the lower return on capital which means that the new markets are such a small part of your opening program?

A - Richard Galanti

I think it's more the fact that, first of all, some of what we used to call new markets or existing markets, you know, if you just put out a dart board out there with a map of North America on it if you will, we're in a lot of the markets that we're in, and over the last, starting in late '96 to probably '04, we went from I think 23 or 4 states in the US to 37 states. Chicago for a few years was a new market. Now Chicago, probably the oldest unit in Chicago is four plus years old and we have, I think, 12 or 13 units. It's no longer a new market. I think it's more the fact of there is that as well as the fact that we see, we continue to see more - we continue to appreciate the ability that in-fill's work and that there's more opportunity.

Many of you have known us for awhile, you know, a powerpoint slide that I used to have a few years ago was the example of the greater Los Angeles market where Costco and Price Company merged in late 1993, combined we had 31 units in that larger, greater LA area. At the time of the merger we felt there was probably two or three locations we were going to close because there was a Price Club and a Costco within a mile or two of each other. That wasn't first order of business the day after the merger, a year later they're all growing. They all have a couple hundred plus employees, and keep them open. Today we have 42-43 locations there, and we think there's another 10-15 to go over the next five plus years. I'm hoping five plus years from now we've done 10-12 and we think there's another 10 then. So I think just the market penetration of our concept, not just for us but for our industry, is still positive.

Q - Mark Husson, HSBC Investment Bank

OK. Just one quick sort of follow-up then. If you look at the next 50 stores in your pipeline, do you think you can open them all without hurting overall group return on invested capital?

A - Richard Galanti

Given that we're probably hurting it a little this year because of the ramp-up from 16 net units to 26.

Q - Mark Husson, HSBC Investment Bank

It's going to hurt a bit.

A - Richard Galanti

That's 26 to next year 33 or whatever, maybe it hurts a little bit, but I think we got a lot of good things going on now. I don't know yet. We're just starting a few weeks ago we just started the detailed bottoms up six or seven iteration process. At the end of the day I'd be cautious and say it's going to hurt a little bit.

Operator

Your next question comes from the line of Daniel Binder.

Q - Daniel Binder, Buckingham Research Group

Good morning. Just had a couple of questions. First, I guess just on the gas business historically one other retailers have seen softer traffic trends because of rising gas prices. I suspect you have benefited because you're offering a compelling offer. I'm just wondering, are you still seeing sort of that customer reaction at the gas pump in terms of the traffic as the prices shoots up or are you primarily just getting the benefit in gas from the inflation? That's the first question. Second question was related to consumer electronics. Just wondering, I think in prior calls you've talked about how that business has impacted the gross margin negatively because of a lot of open box returns that you get and the no hassle return policy. Just curious if you're doing anything on that front by holidays to mitigate that impact? And then the last question was maybe if you could just give us an update on some of your other formats, what you're doing with them, Home Store I think you have the Pro Store, too, as well. Just kind of directionally where you see those businesses going.

A - Richard Galanti

The gas business, first of all, anecdotally absolutely we continue to see a positive there. It comes in different levels. If you go back to September with the hurricanes last year when prices spiked nationwide dramatically, we were in the news every day and every market it seemed like. That certainly helped. Over the last several weeks and, again, anecdotally, I've heard the same thing from the operators, not to that extreme but to the fact that Costco's the place to buy gas when in virtually every news account about it. I know anecdotally I hear that all the time from people telling me the lines are so big but they're still standing in them. That helps, but it helps not just there as you're standing in line and you call home and you go in and pick up dinner and you buy a few other things on the way out the door. In terms of electronics, you're right. I did mention both in Q1 and Q2 recognizing Q1 ends in late November, so you've got the first four, six weeks of the Christmas season, selling season, and then Q2, of course, is late November through mid February so you've got the first four or five weeks of Q2 is the last four or five weeks prior to Christmas and during that Christmas selling season.

We did see an impact because of our favorable return policy, and again that has been mitigated somewhat. The things we have done, first in our business we put signage out saying warning this picture may not look as good as home if you don't have the right hook-up and the right availability with HD. So our success in TV is both availability from suppliers as well as a much better quality picture being fed into our locations through HD satellite feeds created our own problem in that way, if you will, recognizing that it's not just bringing home the TV and screwing in the little cable thing. It's making sure have you the right box in the basement and making sure you know how to use it. The second thing we did, which I believe is now rolled out, we have a, on all the screens in our locations a, basically a 60-minute feed which is really 20 three-minute feeds and every three minutes, for about one of each of those three minutes, the TV screen splits in half and it shows you, again, compares this with what it will look like if you're HD ready. One half shows what HD compatible TV will look like and the other shows what it will look like if you're not. It shows the customer the difference, and again, to remind them that they need to have proper installation and call their service provider to make sure they have the right box, if you will, in the basement.

The third thing we're doing, and I'm not sure where and when, I know it's in the next few months, it may be tested already in one market on a small basis. We're testing with some outside service providers on installation ability as well which we part of one of the offerings that we have that at Costco. We already have that at costco.com where it's essentially a white glove installed service. We think, again, we've seen improvement in the markdowns related to returns from just what we've done so far, and we'll keep working it. It's a great business for us mitigated by returns, not nearly as extreme as the impact that we saw like on computers a few years ago when we had a change of return policy. At this juncture we have no plans to change our return policy. That could be different a year or two from now, but at this point the answer is a clear and concise no. The other formats, I think we have five Costco business centers and four Costco business centers and two Costco homes.

We plan to open a third home this calendar year, and it may be a couple months later, but in the next twelve months for sure, and we, I think have plans to open, Bob, do we have one more home, one more business center next year? I'll call it zero to one at this point. I think they're working on one. Again, they're good concepts. We take things slow, as you know. Our primary focus is figuring out even with these two concepts they are profitable with regard to Costco Home even though we've been open as long as about two years in the first one a little over a year in the second one, we want to make sure it has legs a couple three years out. Secondly, again, the primary focus on both of them is see what we can learn from it to bring into our 477 Costco's worldwide. We did open, by the way, our first car wash last month here in Seattle. But no plans yet. We'll see how it goes.

Operator

Your next question comes from the line of Dan Geiman.

Q - Dan Geiman, McAdams Wright Ragan

Good morning. Can you talk a little bit more about our Hillsborough, Oregon store, some of the things you're doing there and also some of the things you might be applying to the rest of the stores in your chain?

A - Richard Galanti

The Hillsborough, Oregon is a 205 or 6,000-foot unit so it's a 55,000 feet bigger than the current prototype. We did that purposely. It's near home, here in Seattle, about 20,000 feet is devoted to increased presence of furniture and home furnishings. Another 10,000+ is devoted to expanded fresh foods, expanded floral, both consumer and commercial floral, so as an example a caterer, or a hotel or a wedding planner can come in and buy a box of, I don't know how they come, three dozen uncut roses in a waxed refrigerator box, if you will, ready to process themselves. And so we're just testing new stuff. Certainly, the thing that has been exciting from the late 80s has been fresh foods. We've got a lot of, we've got expanded whole meal replacement items, expanded pastries, expanded cooked items so it's, if you will, kind of the R&D kitchen for us as well for some expansion there. It's going fine. Again, it's one unit. We'll see how it goes. Don't expect us to start opening 205,000-foot units any time soon. Just doing what we thought.

Operator

Your next question comes from the line of Mark Husson.

Q - Mark Husson, HSBC Investment Bank

Just a quick follow-up. In so far as you can tell in the US, is there any difference between the velocity of sales growth for people who are buying primarily for themselves and their families relative to your people buying primarily for businesses? Is one healthier than the other right now?

A - Richard Galanti

Just looking at the daily sales sheet of mix, not a big delta there lately. Clearly, Executive Membership tends to be more business occupied, if you will, and when people do convert to Executive Member, we see a spike in their sales growth, their purchasing growth. My guess is that benefit is over, though, because we're now into year five of the Executive Membership program so probably more of the Executive sign-ups today, I mean I'm guessing here, are Gold Star versus Business a little bit. So the answer probably would be no.

Operator

Your next question comes from the line of Robert Toomey.

Q - Robert Toomey, EK Riley Investments

Good morning. A question, Richard, regarding industry retail square footage trends, one large retailer I think has recently indicated it may be slowing its retail square footage growth. Yours, you've been running 6 to 7% a year, seems pretty stable and moderate. I just wondered if you could talk about your view right now on retail square footage growth and how that might impact your business?

A - Richard Galanti

You know, not to sound sharps here or have blinders on, but we feel kind of very strong about our business and the ramp up that we're doing in it. It took a couple years here to get off the ground with changes arguably out there in terms of availability of large sites, zoning, traffic mitigation issues and building up our own pipeline and expansion of our real estate efforts. If you think about from 16 net new in 2005 to 26 this year to clearly something in the low to mid 30s next year, if Jim were sitting here, I'm sure he would say 40 in 2008. So clearly, and I would then temper it a little bit. But clearly, that trend would be that percentage might grow a little, but certainly in that six to seven range, and I don't know if it averages up to seven and eight. Certainly we feel good about our growth over the next few years. And we've got a lot more in the pipeline to do so.

Q - Robert Toomey, EK Riley Investments

What about the industry trends, though, Richard? Is there anything going on there that when you look out at your competition, you know, some of the large big box retailers, is there anything going on there that is worrisome or positive for you?

A - Richard Galanti

You know, with respect to Sam's, I think, as you know, Wal-Mart of all probably a year ago publicly indicated that they're ramping up all their expansion, again, for concerns of what's going on in communities around the country as it relates to traffic mitigation and zoning. We see some of that, too. My guess is we see a little less of it than they do for other reasons, but again, I hate to sound like I have blinders on. We're more focused on looking at our own growth and feeling that we've got a lot of market potential still. To the extent that doesn't bode well for other retailers outside of the warehouse club business or even our competitors, so be it. And again, I'm not trying to be cute, we are singularly focused on ramping up our own growth and we do have a lot in the pipeline.

Q - Robert Toomey, EK Riley Investments

OK. One other question I have relates to, I think you mentioned earlier in the call that there was a question pertaining to gross margin, and you felt that ex the impact of gasoline that there could be some increase in gross margin in 2007. Do you think most of that would come from an anniversarying of the gasoline or would there be other factors that might have an impact on that?

A - Richard Galanti

Well, clearly, again, I can answer this a few weeks ago to someone. Over the last year starting with the hurricanes back in the fall and more recently the last couple months, we've seen these unprecedented increases in gas prices. Who knows. A year from now we might be talking about hopefully gas will come back below $4. You really don't know what's going to happen. Over the next several years we may have two or three more unprecedented moves in gas. Certainly each time that happens it causes a little consternation with our gas P&L numbers. I'm hopeful that if there's at least a little slow down in it, recognizing that it has impacted us negatively now for three quarters because of this continuing rise in gas prices, that a little slowdown of that will help us. And certainly the increased sales penetration of private label, the global sourcing that we talked about a minute ago, just our buying power out there and the constant aggressiveness on innovative new items where you get a little higher margin because it's a more unique item, are all things that are net positive. So that's a very vague way of saying I'm cautiously optimistic.

Operator

Your next question comes from the line of Neil Currie.

Q - Neil Currie, UBS Warburg

Sorry to beat on the drum about gas prices but within your comments about fourth quarter and your comfort with First Call number out there or that being the high-end of your range, does that include an assumption on rising gas continued rising in gas prices or what assumptions have you made about gas prices over the summer?

A - Richard Galanti

Basically, it assumes that they weren't going to fall, and again, I don't want to be cute here, but doing a very bottom up approach, and recognizing every four weeks we do a rolling update for the next three, four-week periods, this is where the numbers fall out. My guess is it includes an assumption that they're going to remain high, but relatively speaking not go up another $0.20-0.30 a gallon. They've actually gone up a little in the last couple of weeks until yesterday I think a little bit, but, so again, we'll just have to see. I would say that there's a little caution in the numbers but not a lot.

Operator

At this time, there are no further questions.

A - Richard Galanti

Thank you, everyone, and Jeff, Bob and I are here to answer any questions. By the way, the Q&A will be out later today which will include the cash flow as well, about 11:00 our time. Thank you.

Operator

This concludes today's Costco Wholesale Corporation's conference call to discussion third quarter earnings and May sales results. You may now disconnect.

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Source: Costco Wholesale Corporation, Q3 2006 Earnings Conference Call Transcript (COST)
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