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Costco Wholesale Corporation (COST)

F2Q07 Earnings Call

March 8, 2007 11:00 am ET

Executives

Richard A. Galanti - Chief Financial Officer, Executive Vice President

Analysts

Deborah Weinswig - Citigroup

Mark Warren

Chuck Grom - J.P. Morgan

Adrianne Shapira - Goldman Sachs

David Strasser - Banc of America Securities

Christine Augustine - Bear, Stearns & Co.

Bob Drbul - Lehman Brothers

Mark Miller - William Blair & Company

Peter Benedict - CIBC World Markets

Dan Geiman - McAdams, Wright & Ragen

Dan Binder - Buckingham Research

Presentation

Operator

Good morning. My name is Katora and I will be your conference operator today. At this time, I would like to welcome everyone to Costco's February sales and Q2 earnings conference call. (Operator Instructions)

I would now like to turn the conference over to Mr. Richard Galanti, Costco's Chief Financial Officer. Please go ahead, sir.

Richard A. Galanti

Thank you, Katora, and good morning to everyone. As with every conference call, let me start by stating that the discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and that these statements involve risks and uncertainties that may cause actual events, results and/or performance to differ materially from those indicated by such statements. The risks and uncertainties include, but are not limited to, those outlined in today's call as well as other risks identified from time to time in the company’s public statements and reports filed with the SEC.

To begin with, our 12-week second quarter fiscal ’07 operating results; for the quarter, we came in at a reported $0.54 a share compared to last year’s second quarter $0.62 per share. As outlined in this morning’s press release, excluding the three non-recurring items recorded in Q2, what I will term normalized earnings per share would have been $0.66 per share, and of course this normalized $0.66 result compares to our December 14th guidance of $0.62 to $0.66 and current first call of $0.66.

In terms of sales for the quarter, as previously reported, our 12-week comparable sales figure showed an increase of 5%. We are also of course reporting this morning our four-week February comp sales results, which came in at 4%. I will shed some light on those numbers in a minute.

Other topics of interest that I will review with you this morning, our opening activities and plans, we opened four new locations during the second quarter, which ended this past February 18th -- three new in the U.S. and one new in the U.K. Such that fiscal year to date, we have opened 16 net new locations in the first 24 weeks of fiscal 2007.

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I will also review with you this morning our ancillary business results, our online results, our membership trends, I will talk about our new returns policy for consumer electronics, update you on recent stock purchases, talk a minute about the $2 billion debt offering that we completed a couple of weeks ago, give you some balance sheet numbers, and lastly provide you with some updated direction guidance for the third quarter.

As I review with you our quarterly results, I will discuss not only the reported figures but also the Q2 year-over-year comparisons on what I will call a normalized basis, i.e. without the three non-recurring items. Stay with me as it gets a little confusing, not only as we exclude those three non-recurring items in trying to compare apples to apples but also because of the sales adjustment, many of the percentages on a normalized basis, of course, we would add back the $224 million sales figures, so you have an apples-to-apples comparison to last year. So we will go through this.

Reported sales again for the quarter, the 12 weeks ended February 18th, were $14.8 billion, up 7% from last year’s $13.8 billion. Excluding the $224 million sales adjustment to the returns reserve, again what I would call a normalized sales number, excluding that would be $15.03 billion in sales, representing a 9% total sales increase on a quarter-over-quarter basis, excluding that one-time true-up.

On a comp basis, Q2 comps were up 5% for the quarter, and that is an apples-to-apples number. The 5% second quarter comp was comprised of a 9 in December, really this 9 in December was a 6 adjusted for the extra day in December, year over year. In January, we reported a 2 which again, you lost a day, so that 2 really is a normalized 5, and a 4 in February, as I mentioned. Again, I will speak more to the four-week 4% comp figure in a few moments.

For the quarter, our 5% reported comp results were a combination of an average transaction increase of around 3%, an average frequency increase of about 1.5%. Included in the 3% average transaction increase, about a half-a-point from FX, so a declining level of importance to that is the dollar relative to the currency has not been as weak as it has been the last couple of years. And gas inflation frankly had a very nominal impact on comps of only about 13 basis points.

In terms of cannibalization, we pretty much ramped up our expansion over the last year-and-a-half, two years and given that, it impacted our comps by about 150 basis points to the negative in the quarter.

For the four-week month of February, our reported 4% comp results were a combination of an average transaction increase of 3.5%, and again that compares to the whole quarter, which was a 3%. Also, as I mentioned, the 3% included a benefit from FX of 50 basis points. The 3.5% for the month of February represented only a 20 basis point improvement due to FX. The dollar compared to other currencies is getting pretty close here. And average frequency increase, a little under 1%, over about 0.75% for the month.

Cannibalization was a little higher year over year at 160 basis points, again in that mid-150 range. Also included in the average transaction of 3.5, again very nominal impact of gasoline, and gasoline inflation year over year was only 10 basis points.

Also, similar to January’s Canadian comp, at the end of the January numbers that I think the last week or two being significantly impacted on the negative side by tobacco in Canada, during the month of February, in Canada tobacco comps were down nearly 50%. This is an impact of two things; one, reduced availability of the largest manufacturer over there in terms of using people like us as a wholesaler, as well as a price increase a year ago that we are comparing against. That impact to the month of February represented for the whole company a little over 100 basis points, so that is baked into that 4% number as well. It would have been higher had we not had that impact of tobacco.

Finally, regarding February comps, the first two weeks were low single digits with the second two weeks averaging a little over 6%, so kind of an improvement, an improving trend throughout the month and into this week as well.

So the first couple of weeks of the third quarter are looking a little better than February, although it is only two-and-a-half weeks of a 12-week quarter.

In terms of geographic sales, again relative to the 5% comp for the second quarter, Northwest was pretty close to that number, as was the Northeast, as was the Midwest. California, a little less than that, still positive, as well as the Southeast, a little less than that. Recognizing in California we had the biggest impact of cannibalization.

International, Canada, pretty consistent with what we have seen the last couple of quarters. Probably the strongest area, both in local currencies and using U.S. dollars are the other internationals, notably Asia and the U.K.

In terms of merchandise categories, hard lines and fresh foods, the main four categories, food and sundries, hard line, soft line and fresh foods, hard lines and fresh foods still tend to be a little stronger than the average, with food and sundries and soft lines being a little under the average. Ancillary, of course, still in the low double-digits, even without gas. Nothing really surprising here. Our strong serious hard lines, of course, continues to be consumer electronics, although that rate of increase has come down somewhat. I think our comp was in the mid-teens instead of the high-teens in the month of February.

In terms of fresh foods, the standout department was produce.

In terms of moving down the line items of the income statement, I will start with membership fees. Membership fees were up in dollars 14% and in basis points, 12 basis points and $37 million year over year. Again, in the interest of fairness, this is based on reported sales, which of course includes the $224 million sales adjustment. If you normalize the sales to show the higher sales figure, if you will, that would still be a very strong eight basis point increase year over year on a normalized sales basis, again reflecting the increasing benefits associated with last summer’s $5 increase in our basic membership fee in the U.S. and Canada, as well as the ongoing conversion of members to the $100 executive membership.

As I had mentioned last quarter, I would expect to continue to see a nice pop in the membership fee increase as a percent of sales on a quarter-over-quarter basis, on a year-over-year quarterly basis as we continue to get the first year positive impact of the $5 increase. That is how deferred accounting works.

In terms of the number of members at the end of the quarter, gold star members were 18 million, up about 300,000 from the end of the first quarter. The primary business remains around 5.3 million; business add-ons, around 3.4 million. Recognizing there is a little skew there, because if somebody converts to an executive, they become a gold star in their business add-ons, so my guess is the 300,000 increase in gold star is a little less and a little bit of that offset is an increase in the add-on.

All told, we ended the quarter with 26.7 million member households, up 1.2 million from the end of the first quarter -- I’m sorry, up 200,000 from the end of the first quarter, and with spouse guard’s 49 million, up a little under 0.5 million for the quarter.

At Q2 end, we had 5.7 million paid executive members, adding about 177,000 during the quarter, so that continues to be nice increases, recognizing that these roughly 21% of our membership base generate a little over 50% of our U.S. and Canadian sales.

In terms of our membership renewal rates, they continue strong at the all-time high percentage, rounding up to 87%. Again, as I think I mentioned on last quarter’s call, as we continue to go through the first year of the $5 increase, you usually have anywhere from a point to a point-and-a-half reduction in your membership fees for that year. So far, we continue as a company to average up to the 87, but as we ticked down a tenth in the last quarter from an 86.7 to an 86.6, so we may be looking at an 86 renewal rate and see it pop back up right after the anniversarying of the $5 increase. Nonetheless, a strong number.

Now going down to the gross margin line, reported gross margin in the second quarter, again which included two of the three non-recurring items impacting this year’s second quarter results, on a reported basis we were lower year over year by 28 basis points, coming in at a 10.49% versus a 10.77%. As you will see in a moment, again what I will refer to as the normalized impact excluding these two items, showed year-over-year gross margin in Q2 lower by 17 basis points. I will give you a little chart in a minute.

Before I ask you to jot down a few numbers, let me give you an explanation of the one-time items that impact reported gross margin. The first is the $10 million refund we are booking in this quarter related to a decision that a previously imposed federal excise tax charged on phone cards should not have allowed. This does not just impact us -- it impacts any company and any individual that was charged these excise taxes. This refund covered several years and is non-recurring, of course.

Of the $10 million pretax benefit to our income statement, a little under $9 million is a benefit to gross margin. The rest may be booked to interest income, a little over $1 million.

The second item relates to improved assumptions used to estimate anticipated sales returns and associated reserves. Let me stop for a minute and walk through that with you. In connection with our review and recent changes to our consumer electronics returns policy, over the last several months we have performed a much more detailed analysis of our return patterns than we had ever done in the past. Frankly, for a number of years, historically we have used principally a frequency of shop method. Once this detailed operational data became available over the last several weeks, we determined that it should also be considered in estimating our reserves for sales returns.

Previously, our estimate of the reserve for sales returns was largely based on information that recorded returns as a percentage of sales. However, we do not have detailed information that specified the exact lag time between when the items were sold and when they were returned.

Historically, again, we estimated this timeframe considering a variety of statistics, including the frequency in which the members visit our warehouse. However, our recent analysis provided us with new information that indicated that lag time for certain returns was longer than previously estimated. Therefore, a revised estimate contemplates a longer average lag time over which returns were expected to occur, notwithstanding the fact that our average frequency of shop is higher than most retailers.

With our new study indicating a need for an increase in the amount of sales comprised in returns reserve, we also reviewed our assumptions as to the estimated realization rate on the value of the merchandise expected to be returned. The overall net impact of the sales return reserve of course is a function of the proportion of the return merchandise that can be resold, returned to our vendors for credit, sold at mark-down prices, or scrapped. Reviewing information on recent experience, we have also revised downward our estimated overall recovery rates on the returned merchandise. This of course exacerbated the issue by significantly increasing returns of electronics over the last few years, which have consistently lower realization rates than returned merchandise in other categories.

Ultimately, after revisiting the assumptions used to estimate our reserve for sales returns, we increased the reserve balance and recorded an adjustment to sales of $224.4 million, and a pretax charge to gross margin of approximately $48.1 million in the second quarter.

Remember, these reserve adjustments represent a cumulative impact of many years of sales and margin results, again using our new methodology, improved methodology.

Now, if you jot down the following, I think I will shed some light on how we get from the reported year-over-year difference of 28 basis points to the 17 basis points on a normalized basis and then I will spend a minute talking about the 17.

If you jot down several line items and three columns of numbers, the three columns of numbers will be ’06, all of fiscal ’06, Q107 and Q207. The seven line items will be merchandising, core merchandising business. The second line item would be 2% reward, third line item would be LIFO; fourth, fifth, and sixth line items represent the three non-recurring items, IRS federal excise tax claim, the fifth item would be returns, the returns reserve gross margin adjustment. The next item would be returns sales adjustment, recognizing the sales as an area that impact us, and the last of course would be total.

Now, going across merchandising in ’06, year over year core merchandising business was lower by four basis points; in Q107, higher by eight; and in Q207, lower by 11.

Our 2% reward in all of ’06 had a detriment to reported gross margin of minus 10 basis points. Similarly, in Q107, a minus 10 and a little improvement in the detriment, if you will, in Q207, minus 6.

LIFO, plus 3 year over year for all of ’06 and then zero and zero.

The next three line items have zeros in the first and second columns, so the excise tax refund was going across the three columns would be 0, 0, plus 6 basis points. The returns gross margin adjustment, 0, 0, minus 33 basis points. The returns reserve sales adjustment, 0, 0, plus 16 basis points. If you add up those three columns, year over year in all of ’06, our reported gross margin was lower by 11 basis points; in Q107, lower by 2; and in Q207, lower by a reported 28.

Now, very simply looking at that chart, you can see the two things that are normalized the are minus 11 and minus 6. I think we have gone through the others. Let me just spend a minute on the returns sales adjustment, plus 16. That is simply saying that our reported margin is based on a sales denominator which includes the reduction of sales by the $224 million. If you looked at it simply by changing the denominator to the normalized sales number before that adjustment, that was a 16 basis point difference in the margin percentage. That is simply who I am getting to these numbers.

So looking beyond the non-recurring items, again year-over-year change in gross margin was 17 to the negative, 11 in merchandising, and 62% reward.

Now, in terms of our overall merchandising gross margin being lower year over year in Q2, our core merchandising businesses, and again that is the 80% of sales, the food and sundries hard line, soft line and fresh foods, as a group was down year over year by about 20 basis points. Within these four major departments, food and sundries, which is a little over half of that group, was actually up. Hard lines and fresh foods were down, and that was the principal reason we saw the whole group there being down 20. Hard lines of course is impacted by our higher cost of dealing with returned items, which is a recurring subject here, and of course with a change in the returns policy. Sometime in the future we should see some of these numbers hopefully go down.

Our year-over-year gross margin in the retail gas business was actually up slightly in the quarter, but given the -- it is not a real big impact either way. Also in Q2, gross margin was negatively impacted by the 6 basis points that I mentioned from the higher sales penetration of the executive membership program, recognizing we are starting to see the net negative impact dwindle as the rate of growth in the sales penetration from those members, while increasing is increasing in a slightly slower rate, as you would expect.

Lastly, a component of ancillary businesses, which is helping, is pharmacy. Certainly there have been a lot of questions over the last year-and-a-half, first with Medicare Part D and how that impacts margins, as well as some of our competitors, what was done with generic pricing, which we have dealt with we felt pretty effectively.

Our pharmacy gross margin in Q2 was actually strong, up a little over 50 basis points and growing nicely, so that was again I think a view that that has not been an issue for us. So overall gross margin again for pharmacy was a positive.

Let me take a minute now and talk about the returns policy. Many of you have read or heard about it. I just want to make sure we are all on the same page. Basically, it is a program that we are rolling out throughout the United States over about a six-week period, which commenced a week ago Monday on February 26th in California. On the 12th of March, next Monday, I believe, it is rolled out to all the other western states -- Colorado, New Mexico, Arizona, Washington, Alaska, Hawaii and what have you -- and then over the next few weeks, on the 19th, the 26th, and lastly on the 2nd of April, the remainder of Midwest Texas, northeast, southeast and Puerto Rico. We will continue to look at what we want to do, if anything, in Canada.

In terms of the policy itself, basically we will be implementing a 90-day return policy for the following electronics categories: televisions, computers -- and of course, those two are the big two. Computers for the last five years have had a six-month return policy. Again, that is going to 90. The remaining areas, televisions, computers, cameras, camcorders, iPods and MP3 players, and cellular phones will all now be on a 90-day return policy.

During those 90 days, it would be like always. You bring it back, we’d like you to bring the box, we’d like you to bring the receipt, but it is not necessary and we will gladly give you a full refund for whatever reason. There have never been any restocking charges and there will not be any restocking charges.

We think even so, that 90 days is still significantly better than most of the mass retailers out there, and electronics retailers as well.

In addition, a couple of things that we are adding to this process are two-fold. One is a free technical support 1-800 number for all those items I mentioned, other than cell phones. Cell phones are through a third party and they provide their own technical support. This will basically be what we are calling a Costco concierge type of support. We have been testing it in southern California for the past several months. Basically it is a way for that customer who has bought this item at Costco to call in, not sit on hold for 20 minutes but get through relatively quickly and also talk to what contracting for is a higher level and higher quality response, such that a much higher percentage hopefully of calls with technical questions can be answered, not only the phone answered more quickly but the response more likely to be handled by that first point of contact.

We also have back door numbers to all the major manufacturers where those people can quickly get somebody on if they are unable to answer the questions and provide that support to the customer.

This is something we are paying for and it is something that has we believe solved some of the issue of returns, not just for TVs but other products as well.

In addition, as it relates to televisions and computers, again this is the far largest part of the consumer electronics area, whatever the warranty is on these items will be extended such that the manufacturer’s warranty will be in place for two years. Again, this is something we are contracting with the manufacturers to do, but it will be subject to their warranty. If it is broken, you do not bring it back to Costco. You follow the rules. You call us and we will help you do it, but you follow the rules of the manufacturer’s warranty. There is a cost associated with that, of course, for us and needless to say, we will reserve for that conservatively, I hope.

The one added feature is as relates to the two-year warranties on these items that any televisions greater than 32 inches, such warranty service will be provided in-home at no additional cost to the customer.

So we think that while we have gone from a policy on most of these items of essentially infinity, bring it back any time, you don’t need the receipt, you don’t need anything, there is no restocking charges -- certainly 90 days is not infinity but it is significantly better than most out there. In addition, there is no restocking charge. There is the concierge technical support line, as well as the extension in computers and TVs to two years.

While we have had a few nay-say letters, what we tend to find is many of these letters are being written by people that have been fairly aggressive in their returns personally, so we really have seen not a big negative from it. In fact, on many of the blogs out there, there have been a lot of positives from our customers defending us on the policy.

In terms of our -- I will mention, by the way -- well, let me continue. In terms of our gross margin outlook going forward, reported gross margins will probably continue to be challenging, particularly in hard lines over the next several months, recognizing even with this policy change, anything bought prior to the implementation of it is under the old rules. We are not changing the rules on something that was bought the day before. So we would expect over the next many months to not see a real impact, a positive impact in terms of the real significant disposition costs of some of these items that we have seen over the last few years.

The impact, as I mentioned, from increasing executive member business should still be a hit to reported gross margin but a little less as we continue to move through the quarters. I think we saw a good sign of that in Q2.

LIFO, not a heck of a lot going on there. It is ever so slightly deflationary and we are not booking any charges right now, as we did not either last year, so it is really no impact year over year so far.

Again, our core merchandising groups, notwithstanding electronics, have been pretty good. I think a little of the fall-off in this past quarter in fresh foods again was a slightly weaker sales assumption, and irrespective of what you do when you have slightly weaker sales, you have a little extra spoilage, which can certainly add to the detriment to the margin on a short-term basis.

Again, in terms of the impact of the current policy change, I think that is still several months out.

We are working on other initiatives. I am not trying to be cute or coy, but Jim with the senior merchants on working on initiatives of how to show some improvement in margin as we go forth over the next couple of years. I think what we have shown is that notwithstanding a little weakness this past year, and if you take out the weakness related to the executive membership improvement, we have actually had some decent margins and we think we continue to grow that going forward.

Ancillary businesses, we added three pharmacies to be at 416 at the end of the quarter. In the quarter, we added three. We added four food courts, four mini-labs, four optical labs, 10 hearing aid centers, to be at 220 hearing aid centers, and seven gas stations, to be at 268 gas stations.

In total for Q2, our ancillary business sales comps were 10% and again, there was really not a big delta in gasoline inflation, so with and without gasoline, it was a 10% comp in ancillary. In the four-week February month, it was actually a little better than that.

Moving forward to SG&A, again I will start with our reported SG&A percentages in Q2 over Q2, were significantly impacted by the stock options related charge of $46.4 million taken in the quarter. Including this charge on a reported basis, SG&A year over year was higher or worse by 49 basis points, coming in at a 10.05 reported versus last year’s number of a 9.56. Again, as you will see, this year’s Q2 SG&A figure of 10.05 is negatively impacted by that options-related charge, as well as the sales adjustment of $224 million for the sales return reserve.

So again, jot down a few simple numbers and I think we can look at this pictorially and you will see what I am talking about.

Three columns again, all of ’06, Q107 and Q207. The seven line items would be operations, central, stock options -- and this stock options is the normal, ongoing charge of stock options year over year. As you know, we started voluntarily expensing options in fiscal year 2003 and this will be the culmination of getting all the vesting in and a few other things, and we shouldn’t see any big change in this number going forward. The fourth line item would be the stock options related charge of the $46.4 million. The fifth line item is sales return, the adjustment to the sales based on the returns assumptions, and actually those are the line items and then the total.

Going across operations, and plus means good or lower SG&A percent year over year, operations is plus 5 basis points in all of ’06, plus 4 in Q107, and plus 3 in Q207.

Central, plus 4 in ’06, minus 2 in Q107, and minus 1 in Q207.

Stock options, and this is just the regular, ongoing stock options, minus 5 in ’06, minus 8 in Q107, and minus 5 basis points in Q207.

The one-time charge we are taking here, the non-recurring charge, 0, 0, and minus 31 basis points.

Sales return reserve, 0, 0, and minus 15 basis points, not unlike the plus 16 basis points we had in the margin because of the sales.

And then I will mention quarterly adjustments, so add a line item, please, and that would be 0 in ’06, plus 6 in Q107, and 0 in Q207.

So all told, through all of ’06, SG&A year over year was lower or plus four basis points, better by four basis points. Q107 was flat year over year and Q207 was again reported 49 basis points higher, or a negative 49.

Now, let me get the little ones out of the way. The quarterly adjustment of plus 6 is simply the hit to SG&A in Q106 a year earlier related to the hurricanes, so that plus 6 is just the fact that we did not have one-time charge this time versus last year.

In terms of a little on these SG&A figures, again let me point out, operations showed an improvement of 3 basis points year over year. Our payroll percentages were up slightly, very slightly, but various expense accruals continue to be lower or better year over year.

Our stock option expense again was higher, minus 5 basis points in Q2 but in line with what we expected. Again, I think as we progress beyond ’07, that number will vary plus or minus a basis point, probably around a zero delta year over year.

The stock-option related charge of $46.2 million, as you’ll recall in our 8-K filing on December 14th, we described the company’s intention to protect the more than 1,000 employees who face possible adverse income tax consequences in connection with the review of stock options announced by the company last October 12th. As noted in that release, we estimated that Q2, we would take a charge growing out of the previously disclosed investigation and this charge related to protecting our employees against these adverse tax consequences for events beyond their control. There were a few of us that were not protected for that, as you might expect.

The protection largely entails repricing upward the options with compensating payments to the employees for the difference.

At that time last quarter, we estimated that we would record a charge of up to $70 million pretax. The actual charge we are recording, the $46.2 million, is lower mainly because certain components of the $70 million estimate do not flow through the income statement. Rather, they are recorded as a reduction to equity. I think we mentioned even when we felt the charge might be up to $70 million that the actual cash impact was significantly less than that. That really has not changed. In all, this is the 31 basis point hit to SG&A.

Next, reported sales are lower by $224 million due to the increase in the estimated sales return reserve. This quarter’s SG&A as a percent of sales therefore is higher by 15 basis points more than it would be using the normalized sales figures as a denominator instead of the actual reported sales figure.

Lastly, in terms of SG&A impact from the revision to our method allocating certain payroll and related expenses, again I will ask you to put your pencil down for a minute. I am really re-explaining this next comment, not that there is as much of an impact to Q2, but it did benefit greatly Q1 SG&A. As we mentioned back then, it will hurt by up to $0.02 a share, we estimate, Q3’s number.

As I mentioned in the first quarter of ’07, we revised our method allocating certain payroll related expenses in order to more accurately reflect the costs for a given quarter. This basically has to do with FICA taxes and other payroll related taxes. Again, because our fiscal year is on August year-end, and during that first quarter, we had typically done it kind of regularly over the course of the fiscal year, what you have happen is as people max out on certain of these payroll taxes midway through the calendar year, we typically had recorded something in the first quarter when in fact the cash impact was negated because many people had maxed out or some people had maxed out already individually.

So what that did is it benefited or reduced SG&A in Q2. It has an offsetting detriment to Q3 and a slight positive, plus or minus a little, in Q2 and Q4, such that for the year there is no impact at all, but again it was a -- we believe the correct way to account for it.

I only bring it up again to simply remind everyone that in Q3, we estimate that it will have a negative impact on an apples-to-apples comparison with the prior year of a little over $0.02 a share.

In terms of SG&A outlook for the remainder of ’07, payroll probably will be a little bit of a challenge, effective this month. Every three years we review our pay scales, or our whole employee agreement. As you would expect, we always look at top of scale and on an annual basis, increase that ever so slightly. But in addition, this time we are also changing the -- we are upping the bottom of the scale. For the last I believe six years we have been at $10 and $10.50 an hour, as entry level wages. There are some locations, like L.A. or some aspects of New York, sometimes a warehouse manager may have some discretion to start someone at a little higher rate if it is required to get good people.

That being said, effective this month, we are going from starting wages of $10 and $10.50 to $11 and $11.50. We estimate that this will cost us -- just the $1 increase is probably about $3 million a month pretax. Again, probably not the full impact of that but a lot of it related to the fact that some locations sometimes in some markets have to start people a little higher already.

We should get some offset with this with the continued improvements in benefits and working comp, but again the best question is going to be sales. Every extra percentage point in comps helps that, and as I have mentioned, we have gotten off to a decent start, at least in the first two-and-a-half weeks of this quarter.

Next on the income statement is pre-opening expense. Pre-opening expense this year was about $3 million higher, coming in at $7.5 million versus $4.6 million in the quarter. There are not any big surprises there. We are working on a few more things this year than last year. In the quarter itself, we opened four this year versus two last year.

In terms of provision for impaired assets and closing costs, again no big surprises. They were higher this year. Last year in the quarter, $1.4 million; this year, $3.5 million.

So all told, reported operating income was down year over year, of course, with the one-time items from $431.3 million last year to $361.3 million. However, on what I will term a normalized basis, i.e. excluding these non-recurring charge items, operating income year over year in Q2 would have been $446.8 million, higher by $15 million or 3.5%.

I think given the little weaker sales and the tremendous impact that we have seen in majors with margins, not a bad showing there.

Below the operating income line, reported interest expense was higher year over year by about $700,000. The biggest delta there is simply capitalized interest, which is an offset interest expense being a shade lower.

Interest income, $36.5 million in Q2 this year versus about $1.3 million higher than the $35.2 million a year ago, and then no big surprises.

Let me now spend a minute talking about the $2 billion debt offering that we completed a couple of weeks ago. Basically, the $2 billion debt offering is a five-year debt, a $900 million five-year debt with an all-in fixed rate of 536, and $1.1 billion of ten-year debt with an all-in fixed rate of 557.

The debt will be reflected on our balance sheet in Q3 as the transaction was funded just after the end of the second quarter.

A few of you have called and asked why so much? You have, looking back at the second quarter, at the first quarter balance sheet on November 26th, you guys have $2.5 billion in cash and equivalents on your balance sheet already. What do you need to do this for?

Let me very simply show you our thought process, and I think it is pretty straightforward. If you think about the basic cash-in items, net income and use whatever estimate you have, $1.0 billion for the year, we have depreciation of about $600 million and we also have, on a regular basis right now over the last couple of years, and anticipate in the next couple of years, $200 million to $300 million a year in proceeds from exercise of existing stock options.

Now, a year ago, we went to RSUs, restricted stock units, but we still have close to 40 million options outstanding, about 37 million options outstanding that are all in the money and we would expect to see that nearly $1.5 billion aggregation of all the exercise prices of those flow into the company over the next several years.

So again, if you start with a net income of $1.0 billion, depreciation of 600, exercises of 200 to 300, round it to the nearest billion dollars, you have $2 billion coming in. You have CapEx of a shade under $1.5 billion this year, dividends of around 260 and a debt payment of $300 million, which will be next week on a five-year debt note. So again, in very rounded terms, you have $2 billion in and $2 billion out.

Now, the only thing I have excluded from this little simple analysis is stock buy-backs. In the first-half of this fiscal year, we have spent a little over $900 million on buy-backs, which, if you annualize those 24 weeks to the whole year, you are talking about kind of a current trend of about $2 billion. So adding that to the equation, you have $2 billion in and $4 billion out.

Again, many of you ask, well, what about the balance sheet cash? You have $2.5 billion on there. Well, you look at our $2.5 billion of cash, equivalents, and short-term investments, about a little over half of that is what I will call not readily useable. It is monetize-able, but it is not readily useable. Examples would be weekend debit credit card receivables to the tune of $600 million, international cash of $200 million, which we typically repatriate on a regular basis to the U.S. from particularly Canada, but that is on a formula basis, so there is a little lag there, if you will. But we do not see that coming back. As it comes back, more has been generated there.

There is a little in foreign accounts as well, other foreign accounts, and as well as just over the weekend cash in transit. So when you look at all that cash, while we are earning interest on a lot of it, it is not all necessarily useable to go out and buy stock.

So with that, the other question would be why so much right now? Why not a little bit later? We basically looked at the yield curve and as many of you know, it is inverted and the feeling was that with us not being out there in the debt markets in a long time and being a relatively good name, and having a lot of appetite out there and having an inverted yield curve, we basically do this and take advantage of the fact that we can invest very short-term and have a very, very small negative carry versus what we are earning on this money while we are holding it and what we are going to pay long-term for it.

So we thought it was good timing and we are pleased to have gotten it done quickly and we think cost-effectively. So that’s that part.

Overall, reported pretax earnings was down year over year to $394 million. Again, on a normalized basis, pretax income was up 3.5%, up from $463 million to $478 million.

Our tax rate was a shade higher, still better than average for the year but a shade higher this year in the second quarter versus last year, coming in at 36.72% versus a 36.11% a year ago. No big surprises there.

The balance sheet will be part of the Q&A that we will have posted shortly on our website. I think that it may be a day or two before we have a finalized cash flow statement, and that will be put up accordingly as well. But in terms of preliminary balance sheet numbers here, and this is always subject to a couple of minor reclasses, but I do not see any big changes here.

Cash and equivalents at the end of Q2, which was February 18th, of $2.233 billion. Inventories of $4.931 billion. Other current assets of $1.112 billion. Total current assets of 82.76. Net TP&E of 89.17. Other assets of 7.32, for total assets of 17.925.

Short-term debt of 461, and that includes the current portion of the $300 million of long-term debt that will be paid off next week. Accounts payable of $4.962 billion. Other current liabilities of $3.242 billion, for total current liabilities of 8.665. Long-term debt of 1.68, deferred and other of 2.38. Total liabilities of 9.071.

Minority interests of 66. Stockholders equity of 8.788, and total of 17.925.

Let me point a couple of things out on the balance sheet. Basically, again a very strong balance sheet, even adjusting for the $2 billion, no issues or concerns there, plenty of financial strength. Accounts payable as a percent of inventories at Q2 end is down slightly from a year ago. Again, that is indicative if you think again of a little lower sales and a little higher inventory. The inventories, I might add, while they are higher, I will mention that in a minute, they are clean. We had our best ever physical inventories at mid-year just this past few months and as Jim said at the last budget meeting, he wants to plan to reduce the inventories by anywhere from $0.5 million to $800,000 of warehouse. Basically, if you look at our inventories, and I think again this is more a reflection of sales than anything, being a point or two weaker in the last few months, there is no one department. There is a little here and a little there.

The average inventory per warehouse last year at Q2 end was $9.656 million. At the end of this quarter a year later it was $10.403 million, so an 8% increase. Again, we think that over the next several months, we can bring that down a little bit.

Again, it is all over the board hard lines, about 70,000 or 80,000 in warehouse -- hardware, rather. Majors is about 70, which is electronics, Jewelry is 40,000, even though jewelry has been a positive comp. Pharmacy again I think this has to do with being a little more aggressive on what we are offering, not only the pricing but on generics but adding a little there, it was up about $100,000 in warehouse.

Again, I want to reiterate, no inventory concerns at all. It was our best year ever and we still think we can improve our inventory levels.

In terms of CapEx, in fiscal ’06 we spent $1.2 billion. Year-to-date, we have spent a shade under $700 million, pretty much in line with our budget. Again, I would estimate that CapEx for the whole year will be in the $1.4 billion to $1.5 billion range.

Our dividend is currently annualized at $0.52 a share, which again on an annualized basis would be the $260 million I mentioned.

In terms of Costco online, it has continued to do well. While its level of increase has come down a little in Q2 versus Q1, it is still very strong. In Q2, sales were up 34%, including our year-to-date number at 43% up. That of course is on top of a 61% increase in all of ’06.

In terms of expansion, as I mentioned for the first half of the year, we opened 16 total new units. We opened another one a couple of weeks ago in Colorado and we are opening one I think this morning in Pittsburgh, and in total, in addition to those two we expect the total in Q3 of six net new units. In Q4, we expect to open 10 or 11, including one relo, so 9 or 10. So that will put us at 31 to 32 for the year.

Again, following I think one or two from what we have estimated pretty much going -- it is simply timing. When I looked at our fiscal ’08 list and what we affectionately call around here, what has been green inked since Jim uses green ink to okay things, and I think we have currently on that list of green-inked items for next year, 38 units with only five or six of them being in month 12 of next year, so we are again a little delay in a few this year, but ahead of the curve next year at this point, at least. I would expect in ’08 to easily do in the 35 to 40 range.

If you just look -- I said 31 to 32. If you just use the 31 number on last year’s ending base, consolidated of 458, that excludes the Mexico units, unit growth would be 6.7% this year and square footage growth about 7.2%.

I know Jeff Elliott here gets lots of call right afterwards about what is your quarter ending square footage, at the end of the quarter, we ended up with 66.6 million square feet.

Lastly, let me talk about stock repurchases. Since June of ’05, we have repurchased approximately 55.5 million shares at an aggregate purchase price of a little over $2.8 billion, or about $50.81 a share. So we still have repurchase authorization under our current programs of approximately $1.7 billion, which authorization expires in a couple of tranches in calendar 2009. I would expect that to be done before than and we will worry about what else we need going forward.

In Q107, as you know, we purchased $425 million of stock, representing an annualized run-rate of about $1.8 billion. In Q2, we purchased $481 million of stock, representing an annualized run-rate of $2.1 billion. Well, any number going forward is subject to change, as we have shown I think since June or July of ’05, when we commenced buying back stock. We have generally done so on a regular basis, perhaps increasing the run-rate this year from the $1.4 billion run-rate in all of ’06.

Finally, before I turn it back to Katora for Q&A, a little direction for Q3. First call is currently at $0.57. My guess is that some of you include that assumption of a $0.02 hit related to the payroll-related thing and some of you don’t. So we will assume the $0.57 probably includes at least $0.01 for that, so on a normalized basis it would be $0.56. My guess is I would look at a range that has that at the high-end, and at the lower-end probably in the $0.52 or $0.53 range.

The fact of the matter is we are going to have to wait and see. Sales have picked up a little bit. That is good. I do not anticipate any changes in returns over the next few months, as again anything prior to the return change is grandfathered in, and we will see.

But given where we are now, I think it is better to be a little conservative and hopefully we can continue to come in at the high-end of your ranges out there.

Q4 is currently at $0.84. That is certainly within the range that we think and for the year, first call is at $2.58, which again I would say is at the higher end of the range of what we would like to conservatively assume at this time. But even at the end of Q2, we said $2.50 to $2.60, which would represent a 9% to 13% increase in a year which has one less week than last year’s 53-week year. Again, these are normalized numbers excluding the non-recurring items in this quarter.

With that, let me turn it back to Katora for Q&A. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Deborah Weinswig.

Deborah Weinswig - Citigroup

Good morning, Richard. You touched on the change in your generics pricing in the gross margin this quarter. Can you also please provide some additional color on the program launch during the quarter and how it compares to the $4 generic program that you had previously?

Richard A. Galanti

Sure, well, we matched what our competitor did out of the box on the $4 for 30 days. Historically on generics, our sense is it costs at least more than $4 to fill any prescription, and so we might have three tranches on a generic that might be making this up, but $7.99 for 30 days, $9.99 for 60 days, and $10.99 for 90 days, recognizing the cost of pills is very little on these generics, but you are still having only one cost of filling a prescription, whether it is 30, 60, or 90 days out.

But that being said, we wanted to match the competition while we came up with our own plan. We since have our own list of generics which I think again numbers in the 200 to 300 range in terms of how many generics. Our is pretty flat, just 100 pills for $10, as compared to 30 pills for $4, 100 pills under that program would cost you I think $13.33. We are at $10.

In some cases, it is 100 pills for less than $10 because we were less than $10 to begin with, and so we are not interested in selling 30 pills for $4. We lose money on it and so we think we are giving our customer the best value and protecting ourselves as well.

Deborah Weinswig - Citigroup

Then, with regard to the inventory reduction that you talked about, is there a new technology that Costco has put in place? Or are you just installing greater discipline?

Richard A. Galanti

Jim just raised the decibel level a little. The fact of the matter is when you are talking about doing $1.2 billion or $1.3 billion a week in sales here and every percentage point is $12 million of sales. While we turn our inventory fast, again when I looked at it, usually the concern is you look at it and say “oh my god, you are $700,000 more in inventory” and you expect $300,000 or $400,000 just because sales are growing at twice that level, but where is the other $400,000?

Where your concern is in one category that is not doing well. The 100, the 50 or the 70 in electronics, no big deal. That is still comping in the mid-teens. But when you looked at it, it was throughout. It was 20,000 in this department and 15,000 in that department and 42,000 in that department, including the primers like paper goods and stuff. That is again simply a fact that sales in February, at least certainly through the first part of February and the last part of January had softened a little bit. They have come back a little bit. I think that will take care of some of it.

But again, I think just a reminder from the boss reminding them if they would not like to do it, he would be happy to do it in about 30 minutes. It is really that simple. I am not trying to be cute about it. We are -- this is not complete science. This is also the art of merchandising and mashing out merchandise.

Deborah Weinswig - Citigroup

Last question, can you talk about what you are seeing with regard to executive membership trends, both traffic and ticket? I think most recently, you had talked about them representing about 50% of sales. Are we still in that ballpark?

Richard A. Galanti

Yes, I think I mentioned that the 21% of the members represent in the U.S. and Canada 53% of sales. Now, about 10 percentage points less, about 43% I believe is reward-able sales because we do not provide an executive member reward on tobacco, gas and alcohol.

So it is still increasing, but it is increasing at a really low rate. If you look at the hit to gross margin of 6 basis points, if you reverse-engineer that, that would imply at a 2% reward about a 3% increase year-over-year in sales penetration of executive members getting the reward. Again, it is still growing but growing at a lesser rate, as we now have so many of those higher-volume people wanting to do it.

But once they are there, they end up buying more because affinity programs do work and they are our most important customers. Their renewal rates, which is part of the 87% renewal rate, is in the low 90s.

Operator

Your next question comes from the line of Mark Warren.

Mark Warren

The reserves that you are taking, I understand it is a one-time charge but given the fact that your returns are costing you more than you thought it was, what is it going to be costing on an ongoing basis? Does the change in the policy on the electronics more than offset that?

Richard A. Galanti

It took Jim easily two years to get to the point where he was even willing to approve this change that we are doing. Certainly we are doing it recognizing that we had to do something and we think that it will offset a big chunk of what we are being impacted by but again, that is several months from now, because everything that was bought prior to the day of the change is grandfathered into the old policy. Certainly during fiscal '08, you should start to see some of that improvement.

I'm sorry, the first part of that question?

Mark Warren

Are you starting to reserve at a higher rate now going forward as well?

Richard A. Galanti

Yes, we are. If you look at that $48 million, recognizing in a way it is from inception to date in the company because it is a change in the methodology of what we are using. It is a cumulative impact.

Certainly these are not auditable numbers, but when we have done some back-of-the-envelope estimates of if we had you this methodology three or four years from now, during which time the sales of these electronics items has gone through the roof and the returns issues have been exacerbated, how much of that $48 million relates to the last several years? A true ballpark number might be $0.01 a share for the last couple of years. You would not spread $48 million evenly over 20 years but you would not also say that it went from 14 to 60 or 12 to 60 or whatever in just the last year or two.

Mark Warren

If you look at all of your TV returns, or -- I guess TV is probably the best product to look at since it is such a big-ticket item -- if you look at all the TV returns, are a big percentage of them returned after 90 days?

Richard A. Galanti

No, a majority are returned within 90 days but when you are doing $2.5 billion a year in TVs and even a small percentage, which has a low realization when you dispose of the item, is still going to impact you greater than you thought it would. How is that going to impact it once the change in return policy goes into effect? We have our fingers crossed. We think we have done it a good way both for our members and ourselves.

Mark Warren

Okay, one other question; on the new clubs that you are opening, as far as new club members, not the ones that are being cannibalized from current clubs but new club members, are the trends that you are seeing similar to what you have experienced in the past or are there any differences there?

Richard A. Galanti

I do not think we have seen any major differences at all.

Operator

Your next question comes from the line of Charles Grom.

Chuck Grom - J.P. Morgan

Richard, in your prepared marks you mentioned that Jim was working with the merchants to drive better margins. I am sure he has been doing this for the past 15 or 20 years. Could you elaborate on the potential opportunities that he is looking at on this front?

Richard A. Galanti

I cannot elaborate specifically on them but I can tell you that as I sort out examples over the last few years, like when we took the allowable maximum markup on goods for private label from, whereas everything used to be at 14 and now it is 15.

When we looked at our depot operations and demanded a higher return on those assets, which in effect raised the cost of goods a little bit and arguably, without cheating, allowed us to improve a little in margins.

There are different kinds of things. I cannot go into them and I do not want to be cute or coy and suggest it is overnight where you can get X dollars per week, but there are real things that we can do to allow us and our buyers to still maintain, in our view, the integrity of limiting our mark-ups but still allowing us to earn a little bit more where we are very competitive.

Chuck Grom - J.P. Morgan

Then, just kind of a similar follow-up question; in your annual report, you outlined a private label mix of about 25%, which was higher than your former guidance. When you look at the store, what product areas do you see the most opportunity going forward?

Richard A. Galanti

Well, it really is everywhere. Certainly there is more in general consumer products, whether it is supermarket products and domestics. We just put our name on these very high-end 520-count Egyptian cotton bedding, so there are really a lot of different items. Certainly the big ones typically, like when we do a private label diaper and it is $100 million a year in sales out of the box, but there are not many of those left.

Chuck Grom - J.P. Morgan

Just one last question on international; how much longer do you expect Canada to be weak because of the tobacco issues up there?

Richard A. Galanti

I am looking at Bob here. I think it happened in the summer. Bob thinks it happened in August, so we will assume July or August.

Chuck Grom - J.P. Morgan

Okay, so we would expect to see international comps in this mid-single digit range until then?

Richard A. Galanti

I think we are getting a double whammy because there was a $0.01 price increase up there, so the detriment should improve a little but then be at that lower level of detriment for the rest, from now until summer.

Operator

Your next question is from Adrianne Shapira.

Adrianne Shapira - Goldman Sachs

Thank you. Richard, I just wanted to go back to the guidance for the third quarter. The last conference call, the $0.57, it sounded like that was not at the high-end and it sounds like the early trends on sales are pretty encouraging. I am just wondering, where does the -- understanding the payroll impact, but where does the further conservatism come in?

Richard A. Galanti

Well, keep in mind that the payroll impact is maybe up to $0.01, a little less because it starts in mid-March and that is a month into the quarter already, so it is a little less than a full $0.01. Again, there is a little offset to that to some markets already. Normalized, the lower-end is up close to 10%. I do not think there is a big change here.

Arguably, I am allowing myself in this economy to be a little more conservative. I remember when we gave guidance for Q2 of $0.62 to $0.66, which was honest guidance. We also recognized that the impacts from returns are still going to impact us for the next few quarters even if we change the policy, as we are changing the policy now.

So certainly there is a little conservatism built into the number. Again, as I mentioned, I would hope that like we gave with our range of $0.62 to $0.66 and we came in at a normalized $0.66, we can do the same here.

Adrianne Shapira - Goldman Sachs

Okay, that is helpful. I am just wondering, as you say, in this economy, is the economy the macro? Or is there something else on the competitive landscape that you see that has --

Richard A. Galanti

Absolutely nothing else on the competitive landscape. I mean, competition is not easy but it is not any tougher than it was a month ago or a quarter ago. Again, arguably I think we have taken the viewpoint, we want to be a little conservative in our outlook because you never know what is going to happen tomorrow. I even was not sure if I wanted to share with you the last couple of weeks of sales were a little better than planned. They are a little better than planned, but who knows what tomorrow brings?

Adrianne Shapira - Goldman Sachs

You had mentioned pharmacy as a standout. Are you seeing any sort of lift really as B.J.'s gets out of that business in overlapping markets?

Richard A. Galanti

At the last budget meeting from the east coast regions, I guess by definition you will see there is a small amount of lift but I doubt if it is that meaningful to the whole company.

Adrianne Shapira - Goldman Sachs

Then just lastly, you had mentioned traffic seemed to have softened a little bit in February, down 1%. Anything to read across in terms of the success of the wallets program? Anything there to call out?

Richard A. Galanti

First of all, it was 0.75% versus 1.5%, so still up, traffic was still up in the quarter.

I think the fact that those things work, certainly the strength last week I think is important, the last couple weeks is in part due to some of the mailers we have done. My guess is, at least for the first partial week of this year, of this month, I do not have a daily traffic number but our traffic is probably up a little bit from the 0.75%.

Richard A. Galanti

Bob is mentioning to me, and again we have been pretty good at not mentioning weather, but certainly the craziness with snow from the Midwest to the east coast has not helped.

Operator

Your next question comes from the line of David Strasser.

David Strasser - Banc of America Securities

Thank you. When Wal-mart announced their fourth quarter, they talked about gross margins of Sam's being up. I guess the question is A, do you notice that? And B, do you take that into your consideration from a pricing standpoint, from a strategy standpoint, when you see their gross margins going up there?

Richard A. Galanti

Literally every location with nearby competition, Sam's or B.J.'s and in some cases others but principally those two, we are out there weekly and sometimes more than weekly comp shopping them, and react to whatever the competition is doing and try to stay ahead of them.

I think part of their argument for improving margins is some of the greater level of global sourcing and collaborative buying with their parent that they have done over the last couple of years.

One of the things that we have seen when we do -- we do also comp shops of like Sam's units where we are not competing with them in markets where they are by themselves and we have seen the spread of Sam's versus Sam's, competitive and non-competitive, expand a little bit over the last couple of years.

Now, perhaps that is because we have hit them in a lot of markets where we were not before. We really do not use their comment that their margins are improving a little as giving us confidence that we can improve margins at all. We are very paranoid out there and we are out there every day and week comp shopping them.

David Strasser - Banc of America Securities

One other question; you talked about the entry-level wages and you talked how you are always trying to raise the high-end of the wage. What about in the middle of the scale? As you raise your low-end, do you ultimately bring up the whole hourly wage structure?

Richard A. Galanti

In the old structure, it took an hourly full-time employee about a year, maybe a shade under a year, to get from $10 to $11 or $10.50 to $11.50, so there are a handful of new hires that will automatically go to the $11 and $11.50. They have been here six months and they went from $10 to $10.25 to $10.50. They might get that free six-month ride to $11, and so there is a little bit of that built into it as well.

The top of the scale, somebody who has been at the top of the scale, we basically every year have increased that somewhere in the low two’s as a percentage of their hourly rate. We have done that every, essentially every three years we re-up it for three more years with that kind of 2% increase each year for the next three years, so we have always been able to do that.

Operator

Your next question comes from the line of Christine Augustine.

Christine Augustine - Bear, Stearns & Co.

What are you hearing, if anything, about supermarket negotiations in southern California?

Richard A. Galanti

The only thing I have heard is what I have read, which says that there are some stumbling blocks, but I cannot imagine that the unions or the companies would allow to happen what happened last time, because it was not only short-term detrimental, it was a couple of years detrimental. But logic sometimes is not a word used in those negotiations.

My guess is that even though you have heard some rumblings that there are some issues that are not surmountable, I have to believe they will figure it out.

Christine Augustine - Bear, Stearns & Co.

What about workers' compensation in California? Is there still that talk about some people really got penalized and maybe it went too far and it needs to get reversed?

Richard A. Galanti

There is always an example of a person that can come in front of a regulatory presentation and talk about their particular case that was impacted negatively and unfairly by it.

Again, I would assume -- we are not out there lobbying, but I would assume there are lots of lobbying activities going on on both sides. Again, we have not seen -- like anything in California, they are going to be proactive as a state in providing additional benefits to their citizens and being more fair, whether it is paid FMLA or you name it.

My guess is over time, it slips a little bit, but we do not go back in that abyss.

Christine Augustine - Bear, Stearns & Co.

But you are anticipating that benefits and workers' comp, in terms of how you are accruing for it, that that actually should continue to help you on the SG&A this year?

Richard A. Galanti

Yes, but the workers' comp is a much smaller piece, in fairness.

Christine Augustine - Bear, Stearns & Co.

Okay, and then, how about on utilities or just overall energy costs this year versus last year? Are you still seeing increases? Have you been able to offset anything?

Richard A. Galanti

Well, if I look at total warehouses for year-to-date, which would be 24 weeks -- this is just our internal warehouse P&Ls -- utilities as a percent of sales are essentially flat year over year, so we must be doing something because the yields, the costs per hour are certainly a little higher.

Christine Augustine - Bear, Stearns & Co.

How about international expansion? What is happening with Australia? Is there something going on there?

Richard A. Galanti

Well, like a couple of other countries that we are not in yet also, there has been something going on for many years, off and on. We have not made any announcements.

We have, over the last several years, like six, seven years, we have had somebody there for a while and then they come back, so there is really nothing to say yet. That again is one of probably two or three countries that you could have used as an example.

We constantly are looking at a few other countries. There is nothing on the horizon over the next 12 months but it does not mean that tomorrow that can change. I can assure you things have changed before, like when it is a done deal, we are going into a given country and then three months later, we are not going, so who knows?

That would certainly be one of three countries that is a possibility over the next few years.

Christine Augustine - Bear, Stearns & Co.

The last question I had was on Smart & Final. Did you guys look at that at all? Do you compete against them? Or do you not consider them competition? If so, do you think anything is going to change under different ownership?

Richard A. Galanti

Didn’t a buyout group buy them?

Christine Augustine - Bear, Stearns & Co.

Yes, Apollo.

Richard A. Galanti

Retailers have only one way to be arrogant; it is when Harvard-educated buy-out people buy stuff. My guess is we are not terribly concerned about any changes there in their newest capacity.

They have always been a competitor. Certainly they are a competitor for all the food service people that we serve, the food service customers that we serve. I do not think this is a real big deal.

We are 0 for whatever when it comes to acquisitions, other than the merger of Price and Costco back in 1993. The only time we have ever looked at it is on the half-a-dozen times a year when it is a tab in an unsolicited presentation from an investment banker

Operator

Your next question comes from the line of Robert Drbul.

Bob Drbul - Lehman Brothers

The question I have is, can you just elaborate a little bit more on the trends in the fresh business?

Richard A. Galanti

Well, they were generally positive. They were positive comps but produce was the standout. Maybe a little of that is pricing. There is nothing terribly unusual. I think again, if you look at some of the weather factors, if you look at commodity pricing was a little up in some of those areas, I am sure that hurts you a little bit. We do not really see anything that alarms us at this point.

Bob Drbul - Lehman Brothers

Then, just sort of bigger picture, Richard; do you have any insights you would care to share with us around the consumer or the economy as you are seeing it from a business standpoint?

Richard A. Galanti

Not a whole lot that would I do, other than make some stuff up here. One of the things I think is continually gratifying when I look at our numbers is whether our comps were 4 or 12, the frequency has never -- in the last I bet you 60 months, the last five years, the last 10 years probably, the frequency other than a change of a number of days or something, but the daily frequency has never been below one. It has not been below 1% or above 2%. Probably three-quarters of those data points are within the zero to plus one.

Whether sales are a little stronger or a little weaker, we generally are still getting an ever-so-slight positive frequency and that is good. That means we are doing our jobs as merchants, whether it is through coupons or mailers or diverting merchandise that people want, or having great pizzas, or whatever out there.

From that standpoint, when I go to the budget meetings every month, I am still comforted by the fact that the merchants have a lot of things up their sleeves as it relates to new stuff that is coming in, whether it is new manufacturers, brands that historically outsell us, new fresh food items.

I think merchandising-wise, we are still at the top of our game in a lot of that stuff. That did not really answer your question but at least it made me feel better.

Bob Drbul - Lehman Brothers

The other question I have is I guess when you look near-term or the next couple of quarters, do you think gross margins can continue to improve or will start to improve, be a little bit higher? Can you just talk about your thoughts around gross margin a little bit more?

Richard A. Galanti

What I can say is as tough as competition out there, and it is ever so tough, it is not any tougher or less tougher, but it is ongoing and all the time. Arguably, when people say who is your toughest competitor, I sincerely say Jim. We already have that issue.

I cannot tell you with confidence it is going to improve over the next year. I can tell you with some cautious optimism that the hit from executive membership will be less and start to be closer to zero than 10. I can tell you that Jim and the merchants are working on some initiatives that are real and it is not just willy-nilly raising the price of a few items. It is looking at some of the thing that we do that, you know, how do you improve margins? And it sometimes it includes effectively raising the cost and therefore getting a little more on something. But it is doing it without cheating while maintaining that philosophy.

Jim is still committed to having pretax earnings, notwithstanding this year and last year, committed to trying to get pretax earnings to grow faster than top line sales. Again, all things being equal, I know that the rate of annual expansion will not be skyrocketing like it has from 15 to 25 to 31 or 32. It will be more in line with top-line growth. So even though those are existing market units, which are better than new market units out of the box, they are still much lower than average units, the average of all our units. So it is a higher level of tempering that will slow down. That is a positive.

When you ask me how comfortable I am in Q3, give me more quarters and I will be more comfortable, more fiscal quarters. Clearly if I look just at electronics, which is what, 5% or 6% of sales, year over year you are talking a 100-plus basis points detriment in that department. That alone should help you a little bit.

I think a combination of things out there. Unless competitors get crazy out there, but we are all crazy already, and we are all logical though, level-headed. There is fierce competition out there. I think we have been able to show we can do it.

I mentioned to many of you before, let's not lose sight of the fact that on a cumulative basis since we started the 2% reward back five years ago, that has hit margin for 84 or 85 basis points. So even though reported margin the last year or two have been flat or down a little bit, our margins over the last five years have been up slightly, even with higher competition, stronger competition, and an 84 basis point hit from that.

I am encouraged that we have the ability to do it. It sometimes does not come as smoothly and as quickly as we all like.

Operator

Your next question comes from the line of Mark Miller.

Mark Miller - William Blair & Company

Just trying to understand a little bit better the gross margin trend and specifically talking about the merchandise margins down 11 basis points, where they were up 8 basis points last quarter. Were you saying that the change in that trend has been exacerbated by more returns in the second quarter, because presumably that was hurting you last quarter as well? Or is it more that there has been more deceleration in fresh food? Or is it something else?

Richard A. Galanti

I think it is both. First of all, we have our new methodology, which again, while most of it is cumulative, some of it is the quarter. In addition, we have even a percentage point or two of comps lower than you had planned originally. That hurts you a little bit, and a little deceleration in fresh foods hurts you a little bit. None of those are insurmountable, though. That is what we do for a living.

Mark Miller - William Blair & Company

When you look at the comp trend over the last few months, any observations when you look at the business customer versus the individual customer?

Richard A. Galanti

Interestingly, the two customers have been pretty darn consistent, so we have not seen any dramatic change in trend between the two.

Mark Miller - William Blair & Company

Last question would be on the traffic; how much do you think the in-store traffic has been impacted by the stabilization of gas prices year-on-year? My understanding is that half the people that go to get gas also come into the store, and as we lap higher oil and gas prices in the summer, should we think of that as a tougher comparison, or is that not material?

Richard A. Galanti

I do not know if we have ever looked at it that way. I think something that helps our comp a little bit, interestingly, is the in-fills. If we are now a 15-minute drive instead of a 30-minute drive from you, you are more likely to come a little more often.

I think that as gas prices went from the high ones to the high twos, probably we saw some benefit from that. I am not so sure that it is discernible with all the other factors as it goes up or down $0.30.

Operator

Your next question comes from the line of Peter Benedict.

Peter Benedict - CIBC World Markets

On the membership fee income, can you talk a little bit about what we should be expecting in terms of the growth rate in the back-half of the year? It looks like things grew about 14% in the first-half.

Richard A. Galanti

Again, without giving away the hat here, I would think that once the $5 increase was initiated, while it was initiated May 1st for new sign-ups, the bulk of people are existing members and that commenced July 1st. So from July 1st to June 30th, it should be a slightly ever-increasing benefit. That rate of growth should continue, if not improve a shade over the next quarter-and-a-half to two quarters.

Peter Benedict - CIBC World Markets

Can you talk a little bit about maybe what you have seen consumers do with respect to spring product in markets where you have had a break in weather? Have you seen a meaningful pickup there?

Richard A. Galanti

Honestly, I have not looked at it. It is almost too early. I mean, the Florida’s and the Arizona’s and the southern California’s, they are used to it. I have not looked at it, I'm sorry.

Operator

Your next question comes from the line of Dan Geiman.

Dan Geiman - McAdams, Wright & Ragen

Good morning. Regarding the wage increase, what was the methodology behind it? Is there anything you can add there, recognizing that obviously you are pretty generous with your employees? Also, when was the last increase that you took, and would you expect a similar interval going forward?

Richard A. Galanti

The methodology is clearly not as scientific as you might think or hope. Basically it is the ongoing discussions that we have every month with our operations people, with the challenges, one of the observations that in some markets, notably California or parts of New York, in some locations, over the last couple of years, last year-and-a-half, we have had to raise the starting wage in given locations just based on the ability to hire the right people. The fact that others have raised theirs, so the spread has come down some.

I think it has been six years since we changed the bottom of the scale. You mitigate it a little bit by changing the hurdles. If your tranche is to get from bottom to top, 6 years ago was a full-timer, 3.5 years, and then it was 4 and it is maybe a little more. We have mitigated it a little bit that way, too but I cannot tell you when are we going to do it next.

We like to have a good spread. We are more based on the observations that we see in some of our markets and we are not prepared to have different wage structures in different markets in the U.S.

Operator

Your final question comes from the line of Daniel Binder.

Dan Binder - Buckingham Research

Just on your last comment about not having different wage structures across the country, just out of curiosity, what is the logic behind that? It would seem like in some of the lower cost of living markets, that would maybe be an opportunity to optimize it a bit.

Richard A. Galanti

Well, one would think. You will to have ask Jim that. It has always been that way from our inception. It is simple, it is easy to understand. We do have people transferring among locations and a lot of people, particularly when we have gone into new markets, some of which are smaller markets.

The view of the operators and Jim has always been is that it is easy to -- maybe it is expensive, but it is easy to do. It eliminates any riffs that are sometimes caused when somebody is being transferred.

Dan Binder - Buckingham Research

On the tobacco issue in Canada, in the past when we have seen price increases, whether it was in the U.S. or in Canada, typically it has been this one-month hit and then you go back to normal. This time around, it sounds like January and February were hit. Was that just because the price increase somehow straddled the month or were there two price increases?

Richard A. Galanti

It was the last week of January and the first week of February, so it did straddle it. That is the biggest reason.

Dan Binder - Buckingham Research

So then next month it goes back to a more normal, I mean -- ?

Richard A. Galanti

I would think so, except for the Imperial piece, where the largest manufacturer of the most popular brands.

Dan Binder - Buckingham Research

That was like a 25% hit before in prior months. Is that roughly what would you expect going forward?

Richard A. Galanti

Maybe there is a little piece that you catch up because people bought more before the price increase a year ago.

Dan Binder - Buckingham Research

I know the Chinese New Year shift hurt you last month. How did that benefit the international and overall comps this month?

Richard A. Galanti

Wasn’t it the last week of January that helped us, Bob? Or was it this year? It was in February, hold on. I have it here. If I look at Korea and Taiwan, good example. In local currencies, Taiwan for the first two weeks of February, or the calendar February, were comping over 100%, and I think they were comping negative teens the two weeks prior to that, or negative 30%.

Korea, same thing. Not over 100%, but between 50% and 80% in those first two weeks of the month. Interestingly, Canada -- remember Taiwan and Korea are nine locations. Canada is 70. Canada in local currency was ever so slightly negative, as it has been for a number -- it is actually much less negative than it had been in local currency. Then, actually the U.S. dollar, at least in the month of February, strengthened relative to it, so Canada in Canadian dollars in February was at minus 1 and in U.S. dollars was a minus 3. That more than offsets that plus 100% for those two weeks in Taiwan in four locations. Canada, of course, tobacco in Canada is hurting it too.

Dan Binder - Buckingham Research

So if you isolate the Chinese New Year shift itself -- I guess I am just trying to get an understanding of what the run-rate is for international, if you take out some of these issues.

Richard A. Galanti

Year-to-date in local currencies, ex-Canada, international is at 11, in local currency. In U.S. currency, it is 17, because the dollar has been weaker.

Dan Binder - Buckingham Research

Then, last question is related to the TV return policy. I think the conventional wisdom has been that there was about a $0.07 to $0.09 hit on earnings last year as a result of the excessive portion of the returns, I guess what you consider beyond normal. As that policy starts to kick in and gives you benefit, when we take into consideration that there are some costs associated with extending the warranty to two years and the concierge service, how much of that would you ultimately expect you could recoup over time?

Richard A. Galanti

Let me start by saying I think the $0.07 and $0.09, there has been a few of the analysts out there that have put out some numbers. We have not blessed any numbers, although we have not said they are out of sight or major wrong, either.

Our view when we went into it was that the cost associated with making some of the changes like the extra warranty and the concierge 1-800 number, and maybe you still get 70%, 80% of the benefit back, but that again is not going to even start for several months.

Dan Binder - Buckingham Research

Should we start to see some sort of benefit by Q4?

Richard A. Galanti

My guess, it would be no earlier than Q1. If you think about the fact that if a good chunk of your stuff is returned in the quarter, but then the other chunk is returned over the next six months, if I had to say give me your best single-point guess, and this is just a guess, it is easily six to nine months after you put the policy in place, which would imply the beginning or the end of Q1 of our fiscal year next year.

Well, thank you, everyone, and we will be here. Good-bye.

Operator

This concludes today's Costco's February sales and Quarter 2 earnings conference call. You may now disconnect.

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