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Executives

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

Analysts

Chuck Grom - J.P. Morgan

Susan Anders - Citigroup

Christine Augustine - Bear Stearns

Adrianne Shapira - Goldman Sachs

Mitchell Kaiser - Piper Jaffray

Uta Werner - Sanford C. Bernstein

Mark Husson - HSBC Securities

Bob Drbul - Lehman Brothers

Dan Binder - Buckingham Research

Gregory Melich - Morgan Stanley

Thomas Fort

Peter Benedict - Wachovia

Todd Slater - Lazard Capital Markets

Theresa Donahue

Costco Wholesale Corporation (COST) F1Q08 Earnings Call December 13, 2007 11:00 AM ET

Operator

Good morning and thank you for holding. My name is Bernice and I will be your conference operator today. At this time, I would like to welcome everyone to the fiscal year 2008 first quarter conference call. (Operator Instructions) Mr. Richard Galanti -- he is the Chief Financial Officer -- you may begin your conference.

Richard A. Galanti

Thank you, Bernice and good morning. This morning’s press release reviews our first quarter fiscal 2008 operating results for the 12 weeks ended November 25th. As with every call, let me start by stating that the discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and that these statements involve risks and uncertainties that may cause actual events, results, and/or performance to differ materially from those indicated by such statements.

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

To begin with, our 12-week first quarter of fiscal ’08 results, for the quarter we came in at a reported $0.59 a share. This compares to my guidance back on October 10th of something in the mid to high 50s and I indicated that $0.59 actually may be a shade high but we got there. First Call was at $0.59 at the time. It actually I think went to $0.58 and recently has been bumped back by you guys to $0.59, so pretty much in line with First Call.

In last year’s fourth quarter, we came in as you know at $0.51 a share, so EPS was up 16%, helped in part by share repurchases.

There were three items that particularly impacted our $0.59 EPS figure that I would like to point out. Number one, a little over a penny a share -- actually about $8.9 million pretax -- represented increased SG&A expense related to a planned sharing with our U.S. employees for their help in controlling healthcare costs. As you know, four years ago we made some changes to healthcare and we told them that with those changes, they would bear a little bit more of the burden but we would expect them to pay about a certain amount. We actually did better than that and we are choosing to give a little bit back to them.

Our income tax rate also benefited in the quarter, so the first one hurt the quarter by a penny. Our income tax rate included a couple of discrete tax positives. Usually those things tend to offset one another. There’s usually three or four of them, pretty small items. In this case, they all went the same way. That added about $7.7 million of reduced taxes, so that’s an after tax $7.7 million, or about $0.02 a share to the positive.

And lastly, the third point, as I mentioned to you on our October 10th call, the fiscal year ender, on the fiscal year end earnings call that we would be negatively impacted this year in Q1 as compared to last year’s Q1 for a large profit swing that we would anticipate in gas operations. As you know, with prices continuing to go up until very recently, the last couple of weeks, we’ve seen a change there, but on a comparison basis, we had unusually strong profits last year.

This last item represented about $30 million pretax or $0.04 a share year over year swing to our EPS and certainly had a big impact on our margin. Frankly, a little bit more than I actually anticipated at the time I mentioned it to you back in October.

So I think you’ll see our earnings for Q1 were pretty good. The underlying results came in actually in our view a little better than we had expected, a pretty good showing.

In terms of sales for the quarter, total sales were up 12% and our 12-week comp sales figure showed an increase of 8%, certainly benefiting gas inflation and the strong FX, or a weak U.S. dollar.

Our other topics of interest, I’ll talk to you about our opening activities. We opened a total of 15 locations since the beginning of this fiscal year on September 3rd, 11 new plus four relos, so a net of 11. Of the 11 new locations, six were in the U.S., four were in Canada, and one was in Taiwan, such that now we operate worldwide 529 locations and of course that includes the 30 in Mexico, which we don’t consolidate those figures into our financial results.

I’ll also review with you today our ancillary business results, our online results, our membership trends, the impact for changes we made back in February -- the impact from the changes we made back in February and March to our electronics returns policy, an update on recent stock purchases, our balance sheet, and lastly provide you some updated direction for the second quarter and the year.

In terms of back to the discussion here, sales again came in for the quarter at $15.5 billion, up 12% from last year’s Q1 of 13.9. As I mentioned, comps for the quarter were eight. The eight was essentially comprised of a six in September, a nine in October, and a nine in November, so essentially a six, nine, and nine equaled the eight for the quarter.

As I mentioned, the 8% reported comp benefit from gas inflation, that was a little under 150 basis points and from the weak U.S. dollar, which represented about plus 250 basis points.

So for the quarter -- so basically that eight is on a total company basis is closer to a four plus. For the quarter, our 8% reported comp was a combination of average transaction increase of about 5.5% for the quarter and average frequency of about 2%.

In terms of cannibalization, which we will always have cannibalization, given our ramp-up and expansion, basically that negatively impacted comps by about 110 basis points to the negative, so you can add that back in if you choose.

In terms of comps by geographic region, of all the high volume mature markets like the West Coast of the United States principally -- actually, the Northwest came in the strongest relative to where it has been tracking, California a little weaker than it’s been tracking and the further south you go in California, the little weaker it’s gotten, particularly the L.A. market. The Northeast was fine. The Midwest was actually the strongest region but of course, it has the most new units. It actually was in the low double-digits. And as I mentioned, international was quite strong. International -- Canada, while a mid single digit number on a local basis was in the high teens given the tremendous strength of the Canadian dollar year over year.

Another international, not as extreme as Canada but mid to high single digit comp on a local currency basis and low double-digit on a U.S. dollar basis.

In terms of merchandising categories, food and sundries and ancillary businesses were the standouts, as was fresh foods, frankly. Hard lines was certainly positive but coming down a little bit from ’07 and soft lines was in the mid to low single digits, nothing -- and I think that’s partly a reflection of the economy and partly why we see our food and fresh foods continue to be strong.

Within food and sundries, by the way, I mentioned it was strong despite the fact that we still have a little bit of a negative swing, a negative comp in tobacco. Tobacco is about 6% of our total company business and about 11% or 12% of our food and sundries sales. If you recall back in Q4, because of the big swing in Canada as we were just in the process of anniversarying the reduction in tobacco sales in Canada when Imperial Tobacco, about half of the tobacco sales up there, decided not to sell through large distributors like ourselves.

And if you’ll recall in Q4, tobacco comps along were minus 14%, whereas in Q1 this year, they are minus five. It has nothing to do with -- very little to do with Canada. The big thing there is there was a price increase a year ago in the U.S. Obviously that come back a little in the next month as that anniversaries and so beyond that, not a whole lot to say about that.

Within the hard lines comp, electronics comps were in the high single digits with sporting goods up in the high teens. Hardware, a slight negative comp, although not a big dollar category at this point, at this part of the season.

Electronics continue to do very well, probably a little lower. It’s come down from the craziness over the last couple of years. An example would be televisions, which still are showing price point declines per television in the 20% range, but still having high single digit comps.

Within soft lines, nothing terribly thrilling either way. Women’s apparel was one of the stronger departments in the high single digits. Jewelry, while positive, not as positive as previously and coming in the low single digits and actually weakening throughout the quarter. So again, bigger ticket discretionary items having a little bit of impact there.

Fresh foods, 9% -- basically all departments were positive. Standouts were deli, produce, and fresh fish, actually.

In terms of going down the income statement, membership fees were up 13% in dollars, up $38 million to $338 million and up three basis points as a percent of sales. The continued benefit from the remnants of the $5 membership fee increase we did about 16 months ago because of the way deferred accounting works continue to have good renewal rates and also while slowing down a little bit, still increasing sales penetration of the executive membership conversion to the $100 executive membership fee.

In terms of membership base, we had 18.9 million Gold Star members, up about 300,000 from the end of the year; 5.5 million primary business, up about 100,000; and 3.4 million business add on, rounding to flat with a 3.4 million at year end. All told, 27.8 million member households, which is about 400,000 above the end of the year 12 weeks earlier and including spouse cards, right around 51 million cardholders out there.

If you looked at the 27.8 million member households and just simply divided by the number of warehouses we operate, the average warehouse has about 52,500 member households per location. That represents average locations that do our company average $130 million in sales and are probably 15-plus years old.

One of the things that was a standout of late was we had an opening in Asia recently that had paid sign-ups equaling that number as of opening day, recognizing we usually allow people to come in and sign up during the eight or so weeks prior to opening when we have people on premise.

In terms of executive memberships, we had 6.69 million at quarter end and that was actually a fairly big increase from 12 weeks earlier, an increase of 360,000 or about 30,000 a week. Probably that whole number jumped quite a bit. I should point out that these roughly 24% of our membership base, they generate now over 50% of our sales.

In terms of renewal rates, as I’ve talked to you I think in the last two or three quarters, it teeters at 86.5 -- one month it’s 86.4, the next month it’s 86.6, so it rounds to 86 or 87. As of quarter end, it was 86.4, so essentially though for the last I think three quarters, it’s been right there at 86.5-ish.

In terms of gross margin, we were up by nine basis points and in reading some of the calls out there this morning, reading some of the things that were put out some sell side, some concern about that. I think -- let me ask you to jot down a few numbers and then we can talk through it.

We’re going to have about seven line items here. Going down the left-hand side, we’ll have core merchandising margin, and what this chart is, for those of you who are new, is simply a year-over-year basis point variance and how do we get to the nine basis points where the margin was higher year over year by nine. So the first line item would be core merchandising, the second line item would be a new one, ancillary businesses, and I’m -- were separating that out simply because gas was such a big swing. The third line item would be 2% reward. Fourth line item, LIFO. The fifth line item would be the federal excise tax claim and the IRS assessed it to and a benefit we had in ’07, but just bear with me here. And the last two would be related to the sales returns adjustments that we did last year in Q2 and Q3, and we try to help you understand we are getting a little benefit from the change in electronics returns policy, not only in the fact that returns in absolute dollars are coming down but also the accrued amount of the sales returns reserve and the associated margin reserve adjustment to that is improving slightly as we go forth. So it will be returns, gross margin adjustment would be the next line item, and the last one will be sales, returns sales adjustment and that again had to do last year with the adjustments, and then the total.

I’ll let you write down basically three columns. All of fiscal ’07 would be column one, the fourth quarter of ’07 would be column two, and the first quarter of ’08 would be column three.

Now going across core merchandising, it was plus six basis points for all of ’07; it was plus 34 basis points for just the fourth quarter; it was plus 41 basis points for fiscal ’08.

Ancillary businesses, plus one for all of ’07; plus one for the quarter; and minus 30 for the first quarter of ’08.

Two percent reward, minus 7, minus 4, and minus 5. LIFO, zero, zero, zero. The federal excise tax claim we received on telephones, in ’07 it was a basis point to the positive and of course zero and zero for the next two columns.

The sales returns adjustment, again if you recall in ’07, we had charges and increases in that number, both in Q2 and Q3. On a total year basis, that was minus 12 basis points to the total year margin. In Q4, as you’ll recall from my last call, it was plus seven basis points and in Q1, it’s plus three.

And then the returned sales adjustment and again, this had to do with the fact that when we reduced sales to adjust our sales returns reserve, it had the effect of on a reported basis reducing sales a little bit so the percentages were higher. That was a plus eight in ’07 and then zero in each of the next two columns.

So if you add all that up, and bear with me here, all of ’07 margins year over year versus ’06 were down three basis points. In the fourth quarter of ’07, they were up 38 basis points, and in the first quarter that we are just reporting, they were up nine.

So let me go through this. I think the first thing that this clearly -- I can clearly point out is that our overall merchandising gross margin, while the whole quarter was higher by nine, the core merchandise, the four major departments, food and sundries, hard line, soft lines and fresh foods, was higher year over year by 41 basis points.

All of these four major departments were higher year over year, ranging from 22 to 69 basis points better. Hard lines, of course, was the top one there and that had the added positive impact by the reduction in returned items and electronics. This is both an improvement in the returns reserve, which is that three basis point number I gave you, as well as just in terms of getting returns back each day and what goes into the current quarter results as more prior sales are passing -- more previous sales are passing the 90-day returns threshold.

Our year-over-year gross margin in the retail business, as I mentioned on our fourth quarter conference call back in early October would be down and again, it was down this year but as important, it was very strong last year so it was a combination of that being whipsawed. And most of that, nearly all of that 30 basis points is in the gas with a small amount being in a couple of other departments that are ancillary businesses. But when you look at gas, you had significantly lower margins on something that’s 8% sales penetration.

In terms of our gross margin outlook going forward, I think it’s positive at this point. We shouldn’t see the big negative gross margin variance from gas as we did in Q1. We shouldn’t see that in Q2. Gas has actually turned the corner for now. As well, last year in Q2, we had a big slowdown in profitability in gas as well, so we’ll be comparing against a pretty normal number last year and actually starting off, although we’re only two-and-a-half weeks into the quarter, pretty well.

General merchandise is doing fine. We’re coming out of our seasonal stuff cleanly and we don’t expect any big markdowns and again, we’ll still see a small negative impact to margin from the increasing executive member business but that’s getting to be, as you see, a smaller and smaller hit and of course, it’s positive to the company in other ways, such as sales, membership, and common member loyalty.

LIFO, we assume very little, if not zero impact from inflation. I know we hear about things going on every year. Through the first quarter, there’s -- of course, what’s driving the inflation in our case is electronics but we’re not seeing a heck of a lot elsewhere either, even in the first three months. So that seems to be not a concern this year from a reported standpoint.

Before going into SG&A, in terms of ancillary businesses, in the quarter we opened five pharmacies to be at 434. We opened six food courts to be at 488; six one-hour mini-labs, to be at 486; six optical optometry shops to be at 478. We remain at eight print and copy centers. We added eight hearing aid centers to be at 245 and we added nine gas stations to be at 288.

Not a whole lot to say -- these are all good businesses and we continue to open them where we can in most cases.

As I mentioned earlier, ancillary business sales comps were up 16%, up 6% without gas, and again that was gas inflation, principally.

Moving on to SG&A, our SG&A percentages Q1 over Q1 were higher by 17 basis points, coming in at 10.15% of sales this year compared to 9.98 last year. Again, if you’ll bear with me a second and last table that I’ll ask you to jot down, the line items will be as follows: operations; the second line item will be central; the third line item will be stock or equity compensation; the fourth line item will be -- I’ll just call it 409A -- this has to do with the stock option issues from last year and some remnant expense there; sales return, which again is an impact to ’07 is the next one; and lastly, quarterly adjustment and finally, total.

And again, three columns, all of ’07, Q407 and Q108.

If you look at operations, and this chart, by the way, for those of you who are new, minus means bad or higher. So these are basis points year over year, so going across the top, operations was minus four in all of ’07, or four basis points higher for the entire year; in Q407, minus 23; and in Q108, minus nine.

Central, minus two, minus two, and plus two, so in ’08 we actually did a little better year over year as a percentage; stock compensation for all of ’07 was minus four, for Q4 it was plus two, and for Q108 was minus one.

409A was minus six in ’07 -- that’s when we took a big reserve or charge for that, what we were doing to protect our employees; Q407, zero; and Q108, minus three and I’ll talk about that in a second.

Sales return, minus seven in ’07 and then zero and zero. And lastly, quarterly adjustments, plus one in ’07, zero in Q4 and minus 6 in Q1 and I’ll talk about that in a second.

So the total of those are for all of ’07, SG&A was higher year over year by 22 basis points; in Q4, it was higher by 23; and in Q108, it was higher or negative 17.

A little editorial; as you can see, first of all operations was higher by nine year over year. Recall first and foremost that the dollar an hour bottom of scale pay increase that we did back in March, including benefits, that’s about six basis points of the nine. That, as I mentioned to you before, will pretty much anniversary after the second quarter. I think it anniversaries about three weeks into the third quarter, so the little remnant effect of that to the negative in Q3 but essentially that is an anomaly that should anniversary shortly.

Our central expense improved by two basis points -- nothing big to say there. In terms of stock compensation expense of minus three -- I’m sorry, minus one, as I mentioned before we now are -- there’s a full amount of vesting or five years of one-fifth vesting in this number, a combination of previous stock option grants plus in the last two years, RSI grants, restricted stock units. That’s going to fluctuate up or down a basis point, nothing big. The big reason I think it was higher year over year by a basis point is the stock as you know had moved nicely upward and so on the date of grant on this year’s -- we do our big annual grant back in October, so that had the impact of just picking that up a little bit. Not a terrible issue there.

And lastly, the next, the 409A, this is to increase the accrual to cover adverse tax consequences for options held by our employees. These relate to the employees outside the U.S. While the U.S. Government has come out with what is called the 409A issues, some of the other governments where we have employees who have received options, not all the rules are finalized and basically, there’s a small impact there. It’s essentially non-recurring. We might still get little remnants of it over the next few quarters as that’s resolved but we don’t expect that to be a big issue.

The next one, and I mentioned to it in my first part of the call here, was a sharing of some of the savings with employees and benefits. Basically, as you know for those of you who have followed us for a long time, in late calendar ’03 and effectively the beginning of calendar ’04, we changed our healthcare benefits such that after nine or 10 years of not charging our employees, not passing on any of the healthcare increases, we went to them at the end of calendar ’03 and said we do have to pass some of it on to you and rest assured, we will do everything to mitigate it and really it’s been a combination of some of the changes we made but more importantly, our employees being better consumers of healthcare and as you might expect, we felt that given the performance in ’07 of that healthcare, looking at it after the fact, of course, that we felt that part of that should be shared with them.

That’s about $9 million, just a shade under, like $8.9 million or about six basis points. There’s no guarantees in the future but that’s certainly an anomaly in this quarter.

So if you look at the 17 overall -- and by the way, that last comment was related to that quarterly adjustment component of my little chart of minus six -- if you look at it overall, you’ve got the dollar an hour pay increase of roughly six basis points of this number, you’ve got the 409A of three, and you’ve got the benefit sharing of six, which arguably even if you thought we do it in the future and there’s no guarantees, if this is a whole year’s worth of that in one quarter so it would be a lot lower. But you know, the six and the three and six is 15 of that 17, so certainly we did a lot better than we did in Q4, relatively speaking and that’s quite encouraging.

Next, going down the income statement line, pre-opening expense was about $1.2 million lower, or two basis points better coming in at $21.5 million, no surprises there. Last year in the first quarter, we opened 12 units. This year we opened 10, six plus four relos, but they all have pre-opening. And we also, of course, in those numbers are some small expenses related to upcoming openings after quarter end as we incur those as we do prior to opening.

In terms of the provision for impaired assets closing costs for Q1, last year we had a $4.3 million charge. This year, it was essentially flat, $79,000, the cost. Roughly about $3 million of closing costs expenses are things like that, impaired assets, offset by a nearly like amount related to a couple of real estate gains we had on some dispositions or closings.

All told, operating income in Q1 was up 12% year over year from $353 million last year to $394.9 this year, or an increase of about $41 million. And again, if you look at the benefit sharing and the $1 an hour increase as part of that, I feel that’s a pretty good number.

Below the operating income line, interest expense was substantially higher, of course, for the $2 billion debt offering we did back in February. In Q108, it came in at $23 million versus only $2.1 million last year and again, that’s virtually all the interest expense on $2 billion of debt.

Interest income and other was better, higher year over year by $6 million coming in at 33.3 versus 27.1 last year. Most of that -- nearly all of it, not all of it, though, is higher interest income. This is the other component of that title of this line item is an increase in earnings from our 50% interest in our Mexico operation since we don’t account for that on a consolidated basis but rather on an equity basis and any change in our half of those earnings goes to this interest income and other line.

So overall, pretax income was up 7% versus last year’s Q1, from $378 million to $405 million and again, that number includes the impacts of the healthcare cost sharing with our employees, as well as the other things I mentioned.

In terms of the tax rate, again I mentioned that was a little bit of an anomaly to our benefit in Q1. The tax rate came in at 35.3 versus 37.4 last year. I think frankly the 37.4 would be what I would budget for the year, recognizing you are always going to have discrete items in a quarter based on solving or completing audits with various state, federal, and country taxing authorities. Usually they all go -- a few go one way and a few go the other and it’s not a big issue. In this case, we benefited from two or three of them, the two or three that occurred all going in the right direction.

In terms of the balance sheet, and of course this will be out shortly on our website but I’ll give it to you now. Cash and equivalents of $3.210 billion; inventories of $5.773 billion; other current assets of $1.319 billion; total current assets of $10.302 billion; net PP&E, $9.920 billion; other assets, 7.82; for a total left hand side of the balance sheet of $21.004 billion.

On the right hand side, short-term debt of 37; accounts payable of $6.168 billion; other current liabilities of $3.489 billion; for total current liabilities of $9.694 billion. Long term debt of $2.182 billion and of course the $2 billion related to what I mentioned earlier about a debt offering we did back in February. Deferred and other, 2.95, such that total liabilities are $12.171 billion; minority interest, 70; stockholders equity, $8.763 billion, for a like total of $21.004 billion.

Let me point out a couple of things on our balance sheet. I haven’t actually talked about a debt-to-cap ratio in a while but now that we have a -- the debt-to-cap ratio at quarter end was 20%. Not bad given that we’ve in the last two-and-a-half years have bought back over $4 billion of stock and added $2 billion to our debt side, so certainly a little bit different complexion, as planned, to the balance sheet over the last two-and-a-half years. Still plenty of financial strength.

In terms of -- a number that we always look at is accounts payable as a percent of inventory. On a reported basis, it improved from last year’s Q1 end at 103 to this year’s first quarter end at 107%, recognizing that the payables -- the denominator in this calculation is merchandise inventories. The numerator is a combination of merchandise payables as well as other accounts payable, most notably construction related payables. And so backing out construction related payables, we still showed improvement. Last year, first quarter ran 86%. This year, first quarter ran 88%.

Average inventory per warehouse at last year’s quarter end, it was $11.401 million. This year at quarter end, it was $11.687 million, or up about 2.5% or $286,000. Nearly all of it, $260,000, is the simple calculation of assuming that your currencies were flat rather than -- your foreign currencies were flat rather than strong relative to the dollar.

Other things of note within inventories, electronics was about a little over $100,000 higher; tobacco was about $67,000 per warehouse lower -- a big chunk of that relates to Canada and some of it relates to a couple of locations where we’ve reduced our tobacco, given we weren’t seeing a lot of ancillary benefit from it. And hardware, down about $42,000 but those were nothing meaningful to most of those numbers, other than the FX.

And as I mentioned earlier, we feel good about coming out of Christmas clean as it relates to inventory, so we don’t see any issues there at this point.

In terms of CapEx, in ’07 as you know we spent $1.4 billion and my guess is this year will be in the 1.7 to 1.8 range. In the first quarter of the 1.7 to 1.8 anticipation, we spent $436 million.

Dividends, not a whole lot to say. You’ve seen it but we increased -- this past May we increased our quarterly dividend from $0.13 a share per quarter to $0.145. This $0.58 per share annualized dividend represents a cost of the company just right at $250 million.

Costco Online actually did better than we had planned and its continued to do very well. During the first quarter, on top of a 40% or 41% increase for all of ’07 versus all of ’06, Costco.com in Q1 was up 45%. We should well exceed $1.5 billion in sales this year, which is better than our plan.

In terms of expansion, as I mentioned in the first quarter we opened 10 locations, four of which were relos. Currently, we expect to open seven in Q2, a few of which have already opened, of course. I think five of those have already opened or will have by the end of this week. No relos, so net of seven for Q2 compared to a net of six for Q1. In Q3, we anticipate opening seven, including two relos, so a net of five. In Q4, we plan to open 15 less three relos or a net of 12, which would put us 39, including nine relos or a net of 30.

As with any of these estimates, particularly looking out to Q4, there’s always a few that slips but it looks like now that our best guess is the 30. In addition, we anticipate opening one additional unit in Mexico this year.

If you look at the 30 on our beginning base of 458, now the 458, this is consolidated numbers so the 458 does not include Canada -- does not include Mexico but 30 on a base of 458 would be about 6.5% unit growth and a shade over that in square footage growth, recognizing that new units tend to be a little bigger on average and the relocations, of course, always are bigger because you are relocating from a smaller unit.

In ’08 -- that was ’07, by the way -- in ’08, we are also adding 30, so now 30 on a base of 488 is about 6% unit growth and then a slight increase on that per square footage.

In terms of stock repurchases, since June of ’05, we have repurchased about 78.4 million shares at an aggregate purchase price of $4.125 billion, or about $52.62 per share. We currently -- for those of you who have been keeping count, we’ve had total board authorizations under a few different authorizations of $5.8 billion. We had 4.5 and then we got another $300 million and then more recently, $1 billion. So of the 5.8, we’ve expended $4.125 billion, so we have about $1.7 billion left.

Notwithstanding the stock price being up, we are buying but at a lower amount, usually on a regularly daily basis. We haven’t in the last couple of weeks, simply because we buy through blackouts using the 10D51 filings. Those of course have to be put in place a few weeks before quarter end and three or four weeks ago, the stock was substantially lower than it was yesterday and so there have been a few days here where we haven’t bought any. But I would say on an annualized basis, for the first quarter, we are clipping more at $1 billion or a shade over $1 billion on an annual basis.

And in terms of -- before I turn it back over to Bernice for Q&A, a little direction for Q2 and ’08 overall. I think First Call today is at 74. You’ve heard this like a broken record. That sounds good. Probably at the high end of a small range and hopefully, we’ll do better than that. In Q3, we’ve at least gotten off to a good start on the gas but we think that the 74 is a good number.

Q3 -- I don’t talk about Q3. The whole year, I think First Call is at 2.99. Again, I think that’s a fair number. Again, I’ll be a little cautious, given the craziness out there in the world. That’s at the high end of a reasonable range.

Lastly, supplemental information will be posted on our investor relations site later this morning. Just go to Costco.com and in the bottom corner, where it says investor relations, click on that and you’ll be able to see that.

With that, I will open it up to questions and I will turn it back over to you, Bernice.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Chuck Grom. Your line is open, sir.

Chuck Grom - J.P. Morgan

Good morning, everybody. On the TV returns over the past couple of years, could you speak to at what points during the calendar year you experienced the greatest spikes in those TV returns and particularly over the next few months, that that was a high period. And if you also could speak to how this has trended since the policy change went into effect, and if you could essentially speak to July going forward, obviously the 90 days from the April 1st change.

Richard A. Galanti

In terms of calendar issues, it generally -- I think we ourselves exacerbated the issue over the last few years with the two coupon booklets that we do, the 12-week summer passport and the 12-week winter wallet. As prices continued to go down, my old storyline was a year earlier when a customer bought a flat screen TV when they had finally gotten down to $2200. He came in, bought if for $2200. A year later, he gets a passport or a winter wallet and not only has our normal price gone down -- I’m making this up, but say $1900 but there’s a $250 or $300 coupon, and so that’s effectively $1650 or $1600. That individual is coming back and returning a TV for $2200 and walking out with a new one for $1600 and guess what? We had a big write-down on that, the one that we had originally sold for $2200.

In terms of the trends, it should be incrementally a little better. Recognizing that the sales -- most of the improvement that we see should be in the core number because that’s just the returns we get in the quarter. They are actual, physical returns and how we account for them based on does it go back to the shelf, which in electronics is rare. Does it -- is it disposed of via salvage at $0.60 on the dollar or $0.20 on the dollar or $0.80 on the dollar? And of course, electronics, given the ongoing obsolescence issue, that was always an issue.

The reserve piece is I think reflective, Chuck, with the second part of that question of that’s based on the lag. And what happens now is here we are in September, October, November sales for Q1, we now have a chunk of sales from roughly mid-March to now that every day, a higher percentage of future anticipated returns relate to more recent sales, that that should keep clicking up. It’s hard to mode what it’s going to be.

Frankly, if you’ll recall back in Q4, there was a seven basis point improvement and in Q1, it was what, a three?

Chuck Grom - J.P. Morgan

It was a three, yeah.

Richard A. Galanti

And frankly, I’m surprised at the seven and I think a little bit has to do with just how our estimate model works. It is still based on daily lags of historical stuff.

All I can tell you is -- I probably go back to what I said to anybody that would talk to me about this six to nine months ago. If you took roughly $4 billion in departmental sales and looking back over a five-year period, we saw our realized margin in that area go down over 400 basis points, or $160 million plus, and even though we still have 90 days, which is longer than most, or mostly all, and we had more than -- and we installed a concierge service, which has a cost, and we added a second year warranty to TVs and computers, which has a cost. The way I kind of dialoged it to anybody who had called was if we are talking about a number that’s $160 million plus, even if we get half of it back and it takes two or three years, that’s 10 to 12 cumulative basis points, maybe three or four a year. I guess that’s still my best guess and I’m sticking to it but it’s hard to know, exactly.

But again, the bigger piece I think is in the core number and if I just look at dollars, the dollars -- in the first quarter, if I look at total sales dollars in electronics and total dollars of returns of electronics, irrespective of its to go back to the shelf or disposed of or salvaged, in absolute numbers as a percent of -- electronic returns dollars as a percent of sales dollars in the first quarter year over year is down by almost -- down by about 20%.

Chuck Grom - J.P. Morgan

Okay, and how did that compare to the fourth quarter then?

Richard A. Galanti

I don’t have it in front of me but I would bet it’s less. It would have been less impactful.

Chuck Grom - J.P. Morgan

So the benefit is getting bigger then.

Richard A. Galanti

Yeah.

Chuck Grom - J.P. Morgan

And then just switching gears on the pricing side, Sam’s Club has said publicly that they are not interest in fighting the penny war with you going forward. What sort of opportunities can this open up for the company on the margin front down the road?

Richard A. Galanti

Tell them thank you. But clearly, you have to recognize that we are both fierce competitors and given that we both overlap in many markets, we are both good at -- there’s so many -- probably half or more of our sales are what I would call commodity. Maybe not half anymore but roughly half are commodity items, whether it’s snickers bars or paper towels or milk or butter. And while I’m glad to hear that but we’ll see. I mean we still, as I’m sure they do us, we still shop them every week in every market, if not more frequently and I think we will always play that fierce -- we’ll always be very competitive.

Whether to the extent that they’ve chosen not to go down by a penny, great. Then we won’t have to do that either but who knows. I don’t think we’ve really ever done that a lot but we’ve always -- we and them have always been very competitive on the half of your sales that are those branded, core commodity items.

Chuck Grom - J.P. Morgan

Thanks very much.

Operator

Your next question comes from Deborah Weinswig.

Susan Anders - Citigroup

This is actually Susan Anders in for Deborah Weinswig. Can you talk a little bit about what you are doing from a promotional perspective and also how the Black Friday handout went? And then maybe if you can just provide some additional color on the membership revenues. It seems the growth is a little bit slower this quarter.

Richard A. Galanti

I’m sorry, ask the first part?

Susan Anders - Citigroup

The promotional perspective, if you can just talk about it a little bit and how the Black Friday handout went. And then secondly, if you can provide some additional color on the membership revenues.

Richard A. Galanti

Well, Black Friday of course is the week after -- was it the week after? No, no, it was the last week. I’m sorry. It was. We started doing a handout, a coupon handout in-store the week prior to Thanksgiving about three or four years ago. It did as expected. It was good but there was not -- in terms of a year-over-year change, nothing positive or negative.

In terms of membership fees, again I know -- I heard that again at the Wal-Mart analyst meeting, they had indicated they saw some challenges with member sign-ups. Thankfully we have not seen it. We are still growing our mature warehouses slightly, slightly more than covering the renewal -- the non-renewers and again, our renewal rates have held frighteningly steady right, you know, plus or minus a tenth or two of a percent from 86.5.

I think that will continue. The fact that we had a little bit more executive membership conversions in Q1 than we have had on an increase year over year, that helped it a little. Each month now going forward through July when we’ll be at the second anniversary of the $5 price increase and because deferred accounting takes it all the way out there in terms of how you see incremental benefits from it.

My guess is if you look into ’09, one, executive membership penetration, while it will still increase a little but it will increase less, and as you’ve seen historically, if you just took our historical track record, we don’t raise the basic membership fee every year. In fact, on average it’s been about every five years, so if you assume in ’09 we did no increase, and I’m just making observations here. We haven’t made any decisions or even discussed it, but if you assume there was no increase there and you assume there is increasing penetration of executive member but less increasing penetration, then you probably see membership as a percent of sales start to flatten out, if not go down a basis point or two.

If you go back 15 years ago when there was no executive membership, so the only thing that analysts counted on to see that number change as a percent of sales was the $5 increase to that every five years, and what you see is there would be a big jump there as a percentage of sales membership fees and then it would dwindle back to where it was because in theory, the fee stays the same but the customer buys more each year.

My guess is that we’ve enjoyed, because of executive membership rollout over the last five years, the fee increase two years ago, or a year-and-a-half ago, we’ve enjoyed an increasing -- membership fees as a percentage of sales continue to show improvement. My guess that number on the income statement as a percent of sales is up this year, is up or flat or close to flatten out in ’09 and who knows beyond that.

Susan Anders - Citigroup

Thank you very much. That was very helpful.

Operator

Your next question comes from Christine Augustine.

Christine Augustine - Bear Stearns

Good morning. Richard, on the core merchandise margin expansion of 41 basis points, I just wanted to clarify something -- did you say the majority of that was because of the change in the return policy, so it was reflected through the hard lines margins?

Richard A. Galanti

No, I said of those three core components, of those four core -- food and sundries, hard lines, soft lines, and fresh foods, and I said the range, each of those departments were up year over year and in fact, the range was anywhere from 22 to 69. Normal deduction would say the hard lines is 69 because of the benefit in electronics but hard lines is what, 15% of total sales or 17% of total -- something in the mid to high teens as a percent of total sales. So that is not the driver of the whole number at all.

Christine Augustine - Bear Stearns

So what are the drivers? Is it price increases? Is it better sourcing? Is it a higher penetration of private brands?

Richard A. Galanti

Yes.

Christine Augustine - Bear Stearns

All of the above?

Richard A. Galanti

Yeah, and you know, I guess what I want to -- and I think we’ve tried to be pretty open with people over the last nine months as we talked about initiatives. We’re not going back and raising prices on anything. As new things come in and we feel we can make a fair margin, and fair is -- our definition of fair as you will expect is lower than many of your definitions of fair out there. We’re still going to be fiercely competitive and penny game or not, 50% of your items are fiercely competitive to start with.

Private label does help. Getting a fair rate of return on our [crossed off] operations, which means a slightly higher cost or a profit center for certain items which allows the buyer to mark the good up such that it covers that return on that value to us.

I’m not trying to be cute but that’s how it works, so we are not looking for margin by saying let’s take up the can of corn $0.10 and let’s raise this a nickel. But going forward, particularly with seasonal stuff where you don’t compete on a lot of items directly because they are all different brand names, all different sizes, they are not commodities, our savings are so stellar relative to traditional retailers that we can make a fair margin and show improvement to the company.

Christine Augustine - Bear Stearns

And on the $9 million roughly that was that quarterly adjustment for the healthcare benefits, is that effectively some sort of rebate that you give to the employees that runs through your SG&A? How does the employee see the benefit?

Richard A. Galanti

It was an after-the-fact thought and that’s why we didn’t charge last year, frankly, but once we decided last month in reviewing ’07 and looking at our healthcare plans into ’08 and ’09 and not only what are we doing for the employees, how can we improve the existing benefits? There was a little extra, extra cost that we used to improve other aspects of the plan that will cost us a little money but this is -- we haven’t said to the employees how we are doing it yet. It will be something that will get to them in February, March but since it relates to how we all, including them, performed on healthcare during the ’07 year, it’s an appropriate to accrue for it.

Christine Augustine - Bear Stearns

Thank you.

Operator

Your next question comes from Adrianne Shapira.

Adrianne Shapira - Goldman Sachs

Thank you. Just getting back to the core merchandise margins, last quarter when you reported the 38 basis points, you cautioned us not to expect that pace of improvement. Obviously you’ve exceeded that this quarter and I’m just thinking as you head into the second quarter and as you point out, gas should be less of a drag, why -- what is a reasonable run-rate? Shouldn’t we expect that continued opportunity at least at these levels?

Richard A. Galanti

Well, I hope so. I guess in the fourth quarter, it was frankly my goodness, that’s a lot. And that’s how I think each month we saw it improving, we just kind of looked at it and human nature is that how can we get there so fast. And the fact that Q1 is -- I agree with your question. I would still probably temper it. Maybe not temper it as much as I did in Q4 -- temper my comments because what I told somebody recently on a phone call and using their model, and I’ll make the example up here, but let’s say they assumed that over the next three years, margins are going to be up X basis points a year. And I said fine. The only thing I can tell you that’s going to happen is that on a quarterly basis year over year, to achieve X there will be quarters on a year-over-year variance where it will be X minus 10 or 15 and there will be quarters where it’s X plus 10 or 15.

I certainly agree with you that we now have two quarters of very strong core margin improvement and certainly I agree we should do better -- we should continue to do quite well. Again, I would probably still temper it but temper it less than I did as I looked at Q4 into Q1.

Adrianne Shapira - Goldman Sachs

That’s great to hear because also heading into Q2, given that the mix should also help with general merchandise growing as a percent of the mix. Obviously a holiday quarter and as you point out, the 22 to 69 basis points with hard lines being strengthened, you would expect that mix to grow as well in the coming quarter. That also should probably be a benefit.

Richard A. Galanti

Q2 will be fine. I don’t know if there’s that big of a mix change. First of all, let’s say hard lines penetration will come -- well, let’s see. In hard lines, you’ve got all of Christmas but then you’ve got January and February, so yeah, my guess is without trying to set my foot too far out here, that should give you some comfort. I’m not sure if it necessarily goes a lot in one direction.

Adrianne Shapira - Goldman Sachs

Okay, thanks, Richard. And then just lastly on the -- you talked about bigger ticket and discretionary items perhaps being impacted because of the environment. Can you talk a little bit of the small business customers? Are they sensing any difference or are you seeing any difference in terms of buying patterns and any resistance there in terms of some of the initiatives that you’ve taken on the margin from that customer? Thanks.

Richard A. Galanti

No. The business member -- I would have thought that again, the small restaurant owner might be impacted a little bit but we really haven’t seen a big change to our business penetration.

And the improving pricing structure in certain categories is a non-issue. There’s been nothing that we have seen there that isn’t -- I mean, the biggest impact there is Jim is traveling every day visiting warehouses and calling up and yelling at buyers, saying when did we go up on that, or why are we here and bringing a few of them down and that’s fine. That’s what he’s in charge of.

Adrianne Shapira - Goldman Sachs

Great, thanks. Best of luck.

Operator

Your next question comes from Mitchell Kaiser.

Mitchell Kaiser - Piper Jaffray

I was hoping you’d comment a little bit on the TV pricing declines that you saw, or the deflation in November. What we’ve been hearing is that supply has been pretty tight, both on LCD and plasma, so I was hoping maybe you could decompose the price declines a little bit in terms of LCD versus plasma and maybe small versus large screen TVs, if you would have that.

Richard A. Galanti

Well, as I mentioned, there was about 20% deflation on like items. Those were exact like items, recognizing probably the price point deflation per item is not as big a drop because people are trading up as well to something bigger.

I think some of the pressure on price is not to go down as much because of tight supply in flat screens, mostly the LCDs. That is consistent with what our buyers and GMs told us and told a few of you because you happened to be out here that day, when they had just spent two weeks in Asia. This has got to be six, seven months ago, and -- six months ago, and indicating that despite a great increase in manufacturing capacity, LCDs had picked up strongly and there is so much more demand now coming outside of the United States for this product capacity. That is holding prices.

What our buyers told us at that time was is they pretty much have locked in declining pricing through the end of the calendar year based on commitments we had made back in June and July for this season. The manufacturers -- again, I’m referring back to this conversation six months ago, the manufacturers would like you to believe and had led in discussion with our buyers that they would anticipate in calendar ’08, little if any deflation, if not a little inflation. The buyers’ perspective was that is probably directionally right but a little bit of wishful thinking.

Now throw into that the economy and who the hell knows what is going to happen. But I would say overall, the average price point is coming down but not as much as a like item deflation, because people have traded up.

And again, in electronics, we really -- we’ve seen the slowdown in units but it’s a slowdown -- in other words, not as big of an increase but heck, for two or three years, you were having 30%, 40% unit increases and now it’s 20 or something, or the high teens.

So it’s still pretty healthy. I wonder when it will run out of steam. I already have enough TVs and cameras but at the -- I want to contrast that to jewelry. We have always -- I remember for the last few years, you’d see diamonds sales were up 15 and now they are flat, and we were still up 15 instead of 20. And just in the last few months, we’ve seen a big deterioration in jewelry, more so in non-diamonds, more so in watches and pearls and silver, which I would call maybe a little more discretionary.

Diamonds, people still get married, people still have anniversaries for earrings and whatever else, or upgrades of diamonds and again, it has softened but not as much as other types of jewelry.

Mitchell Kaiser - Piper Jaffray

Okay, that’s fair. And then I was just wondering if you could talk about the MP3 category within electronics. I know you had some outages on the iPod last quarter, I believe it was. Are you feeling pretty good about the stock there and the demand or sell-through on those?

Richard A. Galanti

That was more of a transition, since Apple doesn’t price protect the retailers when they are switching, it’s up to the retailer to basically bear that cost or make sure they are -- in our case, given they are similar margin to begin with, we opted if you recall back in August to just bring down our inventories and forego, I think we estimated about $25 million of iPod sales in August and wait for the new ones to come out. The new ones are doing fine.

Mitchell Kaiser - Piper Jaffray

Okay, good. Thanks and good luck.

Operator

Your next question comes from Uta Werner.

Uta Werner - Sanford C. Bernstein

I was very impressed with the gross margin increases you’ve just reported and I was wondering whether you see further gross margin increases or something of a step change this year with the flattening out over following years or whether you think we are going to see similar improvements happening year over year.

Richard A. Galanti

It’s so hard to know, Uta. I think the -- again, if I had a crystal ball, I would have guessed that we wouldn’t have gotten as much as quickly. Clearly we are not going to get incrementally this much more next year and the following year but it would lead me to believe that whatever my original thoughts were for a couple of years, two-and-a-half years out, we’ll be better than that just because we started off so strongly.

Now, I’ll be the first person also to caveat that and say that’s based on not compromising our competitiveness and not having a major recession where all of us are impacted, perhaps us a little less than traditional retailers but nonetheless impacted. But we’re not -- we still have a focus on being the best value and driving down prices where we can as well, so it’s a balance act.

I think the good news for us as I’ve shared with some of you is that we are -- when people have always asked over the years who is our toughest competitor and my answer is us -- it’s us and I think that does give us a little movement and a little room for movement here but we are going to still look to see how -- make sure we are wowing you every day.

So my guess is that based on what you guys collectively thought and what I thought, recognizing we only go one year out anyway but if you looked at two or three years, getting off to a good start makes me feel it a little better but certainly not take this year’s X and multiply it by two or three.

Uta Werner - Sanford C. Bernstein

When you were looking at these gross margin opportunities, were you trading that off against some increment on comps?

Richard A. Galanti

No. I mean, honestly and many of you guys know us, we’re not that analytical and smart. I would say that if we felt that if any price change would hurt a comp, we would not change it and you never know exactly what it is but you’re not talking about big numbers here also. You’re talking about new items, improving your margin a little bit on new items, seasonal items, so -- so much of this is not discernible. It is not a big change in perception because if it were, you would see a change in comps.

Uta Werner - Sanford C. Bernstein

Great. One more question related to the Internet business; what’s the sales mix that you are observing there? Are there any shifts? And also, what’s the gross margin or operating margin of the Internet business relative to your store business, if you can talk about that?

Richard A. Galanti

On the first question, clearly electronics dominates and it’s -- or anything electrical, whether it’s electronic games or game consoles or -- as you know, we have about similarly about 4,000 items online but only 10% or 15% overlap with the warehouse, so it’s clearly more heavily skewed to non-foods and some bigger ticket items.

I would say that given that there are some manufacturers that are willing to sell us online that aren’t prepared to sell us in-store, that has helped that grow as well.

In terms of margin, we don’t disclose exactly what it is. It is a lower gross margin overall than our company, than the warehouses, and a higher pretax, as you might expect because there is not a lot of major overhead.

Uta Werner - Sanford C. Bernstein

Thank you.

Operator

Your next question comes from Mark Husson.

Mark Husson - HSBC Securities

Could you just talk a little bit about the impact of currency on earnings and if you were to look at the gross margin metrics and the SG&A metrics that you’ve given us in remarkable detail, thank you, would currency be a meaningful impact on the way that the gross margin or SG&A has mixed? And does it impact the overall EBIT number?

Richard A. Galanti

I would have to -- I don’t have that in front of -- I haven’t done that in front of me. Certainly it’s a positive, given that all foreign countries I believe are positive now. A couple of the new countries are slightly positive but given that and the fact that the currencies, particularly in Canada, are going the right way, I think it would clearly help EBIT. I think it is not as discernible to the percentages because all your percentages are impacted -- your sales percentage, your sales dollars for Canadian dollars are higher expressed in U.S. dollars than they would have been with a flat currency, as are your expense dollars up there, as are your earnings dollars.

Probably you guys could do as easily an example as I can. If you look in the 10-K, it has the segment reporting in the back. I think it has four columns -- U.S., Canada, Other International, and Total. And so you could take Canada and Other International and shave it by the average currency over the last -- what is it -- Canada, for us it’s predominantly Canada because Canada is about 12% of our company and other foreign countries are an incremental 4% or 5%, so total non-U.S. is in the high teens.

So you take that, those numbers and if the currencies are up 15% or whatever, or on average for all of last year they weren’t up that much but let’s say they were up 10% -- I’m guessing here, by the way. You could look at it that way.

Mark Husson - HSBC Securities

So it helped sales by a couple of percent overall and it probably helped EBIT by something like the same amount, maybe a little bit less?

Richard A. Galanti

Without analyzing it, I’d say the same amount but I’d have to look at it.

Mark Husson - HSBC Securities

Great. Thanks very much for your help.

Operator

Your next question comes from Bob from Lehman Brothers.

Bob Drbul - Lehman Brothers

Two questions for you; can you elaborate a little bit more on the comments you made around California and any trends that you really do see discernible in that state for you?

And then the second question is did you do any hedging in gas during this quarter? And are you still dabbling in the hedging side of it?

Richard A. Galanti

Let me answer the second one first; no. A couple of things happened over the last few years since Jim allowed us to try it. Most importantly is it’s still a low margin business and the cost of hedging has probably gone up some because of the volatility in gas prices. And so all things being equal, at the end of the year you’ll make on average the same but you’ll spread out your P&L a little bit better instead of having these ups and downs, and that was never a big concern of ours but if we could do it, fine, without a big cost but given that the cost of hedging is higher and the margins to start with are lower, it didn’t make sense.

In terms of -- if I look at the L.A. region, if you go back over the last couple of years, generally speaking -- and I’m making these numbers up, but if the U.S. was let’s say a six, within that U.S. California, which is 38% I believe of the U.S., or 40% of the U.S., was probably a 2.5, so call it -- or three, I’m sorry, a three versus a six. No, three, three-and-a-half, so 250 to 300 basis points lower, if you will, just looking at that metric, that gap.

And it’s not other U.S. versus L.A. or California or versus L.A. -- it’s L.A. versus the total which includes L.A. And that 250 to 300 basis point gap over the last several months has gotten up to maybe 450, so another couple of hundred.

And so relatively speaking, while everything has come down a little bit from a couple of years ago, L.A. has come down a little bit more. Now, as Jeff Elliot here pointed out, cannibalization is probably half of that delta because we certainly have done a disproportionate amount of our cannibalization in California over the last two years.

But even with that out, maybe it’s 100 basis points but I don’t know why. I mean, it’s all the reasons that we all suspect. First of all, traveling is a hassle in some markets like that. Gas is more expensive. The housing market arguably has been hit harder there than in some markets but the housing market has been hit in other markets that haven’t been as impacted.

So that’s what we know.

Bob Drbul - Lehman Brothers

Thank you very much.

Operator

Your next question comes from Dan Binder.

Dan Binder - Buckingham Research

Just a follow-up on the California question; did you see -- you said about half of the gap is maybe macro related, half of the delta change. Is that something that was getting worse through the quarter or is that fairly stable?

Richard A. Galanti

I think it was -- I’m looking as we talk here -- I think it was pretty stable. California comp, if I look at September, October, or November, there is actually -- the lowest number was in September. Now, it was probably lower in August because if you’ll recall, as a company we had a pretty crappy number in August. But basically, California comp was almost flat in September and both in October and November, up 2%-plus, so it’s coming back.

Dan Binder - Buckingham Research

Okay. And then, there’s about 12 to 15 basis points with the SG&A increase that we could point to as being perhaps one-time in the quarter and I know in the normal course of business, there’s all kinds of one-time things that come up from one quarter to the next but if you just sort of -- let’s just say for the benefit, you have to strip that out right now and look at the SG&A on a fairly strong comp, I guess I’m a little bit surprised there isn’t more leverage on an 8% comp, or even if you wanted to look at it on a 4% comp at the core. Is there any sense that we would be able to get more leverage going forward on those kind of comps?

Richard A. Galanti

It’s hard to predict. I would say it’s difficult, given that energy costs are going up and again, taking out the anomalies, even the ones that we cause ourselves, like the bottom of scale or the sharing of healthcare savings, it’s -- as I’ve said before, there are not a lot of silver bullets out there. It’s not like we’re very inefficient and we can improve efficiencies greatly, so we do need some comp.

You’d like to think that on a relative -- you know, as I’ve also said, a little inflation wouldn’t hurt and I hope it’s not a lot and although when you read the news every day, there is certainly some inflation coming and arguably, that helps this lag.

I would say for the last few years, I’ve always felt that is -- as I look back to last year when I’ll say consensus analyst estimates out there, given margin initiatives and given other things, was is that hey, the Costco story out there was if I had to again summarize consensus, was that the company can get 9% or 10% top line growth, it can get 4% or 5% or 6% from EPS accretion and on top of that, if they can get 10 or 15 basis points of anything, recognizing 10 basis points is about 3.5% to 4% earnings growth, earnings per share growth, that 10 to 15 gets this to be a story that’s in the mid to high teens.

I always kind of looked at that consensus as acknowledging that expenses are hard, that aren’t going to necessarily improve but aren’t going to go up a lot if we do our job right, and that we can improve margins of that amount.

As you’ll recall in Q4, we beat one and got hurt by the other, so we still ended up with about the same number of basis points. I think if you take out the tobacco anomaly here and again take out a few of the things that you see that are not completely one-time but a little bit one-time, that the net of the two should be a little better than that consensus 10 or 15 but with most of it, if not more than all of it, coming from margin at least over the next year.

Other than that, that’s the general storyline that we look at.

Dan Binder - Buckingham Research

I guess if we look out over the course of the year, gas may not continue to be a huge contributor, depending on what happens with prices. Obviously it’s hard to predict but let’s say the comps come down either because gas or currency isn’t an issue or as much of a contributor, or if the core business slows a little bit, what’s the ability to adjust the expenses down? I guess I’m just trying to get a sense -- if we’re not going to be able to see a lot of SG&A leverage on a mid to high single digit comp, is there some protection on the way down to adjust?

Richard A. Galanti

I don’t think there’s a lot of protection. I think the FX thing helps and/or hurts all lines of the income statement, so that really shouldn’t be an impact. Gas should, to the extent -- gas is not falling out of bed overnight, by the way, but finally it’s not increasing. It’s decreasing a little but even flat will be okay on a year-over-year basis.

I think that’s our toughest number.

Dan Binder - Buckingham Research

And last question on the discretionary side, you talked about jewelry, TVs -- are there any other areas of the club that you would sort of throw on the discretionary area that is showing any kind of marked change in trend?

Richard A. Galanti

Well, some things like small electrics, I didn’t mention it earlier but small electrics are actually in the mid to high single digits and I’m not talking about entertainment electrics. I’m talking about clock radios and hair dryers and the like. Housewares are okay, so -- furniture this past summer was okay, where we bring in big ticket furniture items during the seasonally slow June, July and before back to school. I would say for the most part it’s those two.

Dan Binder - Buckingham Research

Okay, great. Thanks.

Operator

Your next question comes from Gregory Melich.

Gregory Melich - Morgan Stanley

Thanks. Two questions, really, I think they’re part of one; I wanted to get into the basket a little bit bout the inflation and what portion of that ticket increase is inflation versus other stuff. So stop me if I’m wrong here -- if it’s 5.5% ticket and 2% traffic, once you take out the FX and the gas, you are probably -- that 4% comp was half ticket and half traffic. Is that fair?

Richard A. Galanti

Yes.

Gregory Melich - Morgan Stanley

Okay, so then that 2%, how much of it is just regular pass sort of inflation? Now you guys raising prices but basically passing through increased costs on those commodity type items that as you described I think before, are not new items where you are getting a little extra margin but the 70% or 80% of the items that are just existing items where you are seeing some pass-through.

Richard A. Galanti

Well, I’ll look at it two ways with you; one again through the first quarter, our LIFO index is a few basis points below 1.00, so that would indicate there is no inflation, recognizing you’ve got electronics, which is down and everything else, which is up a shade. That’s only on inventory, of course.

If you look at -- if I look at specific items within inflation, I’m just looking down the list here; cheese, cashews, blueberries, grapes, coffee, and some of these items are on the 10% to 20% range.

Now, on the deflationary side, let me see something that is not electronics -- pistachios, I think we bought in well. That’s down in the mid teens. And of the top 30 LIFO items, that’s the only one that’s not in the electronics department. So we are seeing a little bit but then things that aren’t in LIFO are taking market away from a branded item into a private label. Something as basic as an item that we had, we introduced I think three or four months ago, which is kind of like the vitamin waters. It’s called -- there’s a regional bottler out here that does a water called Talking Rain and now they do Vita-Rain, Kirkland Signature Vita-Rain by Talking Rain. And let’s say the 18-pack of the vitamin water is $20. The 18-pack, the exact same bottles, the exact same colors, the exact same sizes, it says Kirkland Signature on it and again it’s a slightly different -- it’s a different manufacturer, is more than a third to 40% lower price point.

And by definition, if we only sold the first one and now all of a sudden, I’m not sure what the penetration is but even if it’s as low as 30% of the unit sales, that had a deflationary impact.

So I would guess that net net, we haven’t seen a lot. We are starting to see some more in basic food items, whether it’s -- or basic what I’ll call supermarket items, whether it’s sundries or paper towels or canned goods or what have you.

Gregory Melich - Morgan Stanley

So it sounds like of the 2% ticket increase, you’d say the bulk of it is stuff that you are doing.

Richard A. Galanti

I would bet it’s stuff that we are doing to -- you know, we are always trying to increase the pack size. In fact, my guess is that 18-pack is now a 24-pack or -- I know toilet tissue which sequentially over four or five years I think has gone from a 24-pack to a 30 to a 36 now. I think so, but again, there are several examples out there. We still try to increase the price points.

Gregory Melich - Morgan Stanley

And then second, I guess related, you talked about the margin as sort of longer term progression and Jim going around the clubs and calling back with things that need to roll back, effectively. How do you guys, or how does Jim look at the comp deceleration at 4%? Do you look at it on an absolute basis? In other words, we don’t -- if that got to two for you guys, you might pull back stronger. That would be evidence that it was impacting comps. Or do you look at it on a purely relative basis versus the market and competition?

Richard A. Galanti

Without knowing exactly what he would say, my guess, my strong guess would be it would be the latter. If the underlying normalized comp for us was a 6 when the world, when U.S. retail overall was a 3 and U.S. overall went to a minus 5, I think if we were zero, we’d be thrilled, but -- or Wall Street would be less unhappy with us than others.

I would say that’s the way he would look at it more. But he would also look at it, what he does not want to see is the weekly comp shops we do with our direct competitors and on those -- but recognize those are the items that are -- what we are looking at are like items and like competitive items that the customer has at top of mind, whether it’s a consumer customer or business customers. It’s milk, it’s paper towels, it’s copy paper, it’s Coca-Cola and Pepsi Cola. It’s Advil and Tide and those are quite competitive.

Again, I remember after talking about some initiatives and then we came in with an August comp of 2%, I know shortly thereafter we were on -- Jim and I were in New York at a speech and the question of the day was well, does this change your mind about pricing, about margin initiatives? And the answer was no.

That’s more of a competitive reaction. If we felt that competition was changing comps is one thing, but we think we’re doing just fine right now.

Gregory Melich - Morgan Stanley

Great. Thanks.

Operator

[Thomas Fort].

Thomas Fort

I have two questions; the first one is when we think of gas sales, you talk a lot about the gross margin impact but I wanted to know to what extent you can leverage them on the SG&A front?

Richard A. Galanti

What we can do on SG&A?

Thomas Fort

To what extent when we think about margins overall, operating margins on gas sales, so you’ve talked about the negative impact and how that can drag the gross margin down, but is there a certain level of gas sales where the comp can actually benefit the SG&A, where you can leverage the SG&A on the higher comp sales due to gas sales?

Richard A. Galanti

Clearly I think we -- our SG&A, notwithstanding that it’s higher year over year, all things being equal it would have been even a little higher if gas wasn’t inflationary right now. But that’s a small driver of that number, either way.

Thomas Fort

And the second question was I wanted to know if you were seeing anything different on the competitive landscape.

Richard A. Galanti

No, I don’t think things have gotten tougher at all. I mean, it’s been tough for a long time. We were always competitive and again, when you are talking about competition, certainly our biggest competitor is Sam’s, in terms of number of locations we compete with somebody on and we’re both warehouse clubs.

They got a lot tougher about five years ago when they had a management change. They have remained tough. Again, I am happy to hear that they commented that they are not going to play the penny game but at the same token, neither of us are going to let, are going to fall asleep at the wheel here and we are both in each other’s locations weekly, if not more frequently. And I don’t see a big difference there.

I don’t see it getting any worse but it’s not like it’s looking to get any better.

Thomas Fort

Great. Thank you very much.

Operator

Peter Benedict.

Peter Benedict - Wachovia

Thanks. First, on the fee structure, you noted that you increased fees on the base members every four to five years and with that in mind and considering that you didn’t move the executive fee last summer and I don’t think you’ve ever increased that fee, how should we think about strategy with respect to the executive fee going forward?

Richard A. Galanti

Well, I think -- we don’t know. When we talk about it, we look at the menu of what we could do. I remember even when we went from 45 to 50, we looked at various alternatives -- keep it at 100, because it’s a nice round number; go up 5, which is kind of an odd number; go up more than 5 but then try to figure out what else you could give back to implicitly say it’s 5 and feel it’s 5 and at the end of the day, we looked at it and said if we kept it the same, break-even on the 2% reward would go from $2750 to $2500 -- in other words, 2% of the $50 difference instead of the $55 difference. And by doing so, we would -- there would be about 2.5 million members that in theory are now above the break-even threshold on executive member. Not to say we are going to get a lot of them but even if we can get 10% of them, that’s another quarter of a million people that we can switch that will spend more and buy more and will be more loyal. So that was the motivation for doing that.

It really has not been a topic of discussion for the last year, nor do I expect to see it as a topic in the next several months. Beyond that, who knows? I think at some point we will look to increase it, assuming it continues to be successful but I don’t anticipate that in the next year at least, if not longer.

Peter Benedict - Wachovia

Okay, fair enough and understanding that you said your renewal rates overall have held up pretty well, is there any regional variance though that you’ve been seeing there? Is there any pockets of the country where you are seeing some pressure?

Richard A. Galanti

Not really. The only thing that we ever see regionally, each warehouse has a certain amount of payroll that we call marketing. Marketing is a lot of things. It’s the membership desk when you walk in to get signed up. It’s the employees that go out and canvas to small businesses or to large employer groups for their employees. It’s the people that have the RF handheld device that go up to you and scan your card while you are waiting in line and let you know that based on your last year’s purchases, you would have made out well on the executive membership.

And what you’ll see sometimes on a month-to-month basis, a given region might be weaker in executive member conversions but stronger in Gold Star sign-ups. Well, they spent that month focusing on that or they might be just weaker in general in sign-ups -- well, that month included two weeks of AMEX co-branded membership cards, membership credit cards doing two weeks of tabling activities for that.

So overall, I would say the answer is no. You’ll see some regional differences sometimes just because of the actions in a given region, the regional marketing manager in a given region is taking.

Peter Benedict - Wachovia

All right, great. That’s encouraging and then just last, quickly some clarification on the buy-back -- did you say that we should expect you to buy back just over $1 billion worth of stock this year, or just that your current pace of buying is at that rate?

Richard A. Galanti

I said our current pace of buying -- I just took the 12 weeks of Q1, the dollars expended and multiplied by 52 and divided by 12. And again, keep in mind that given the run-up in stock and the fact that I think for about three-and-a-half, four weeks now we’ve been in blackout, so we had to file a 10D51 in advance of that when “there is no material knowledge that we have” and that was done when the stock was in the 65 to 67 range I think. So the matrix didn’t go much above 67 or 68, I think. So we’ll have to revisit that next week when we’re out of blackout.

My guess would be is we would continue to buy but not go crazy and see what happens with the economy too.

Peter Benedict - Wachovia

Great. Thanks so much.

Operator

Todd Slater.

Todd Slater - Lazard Capital Markets

Well, this call has gone on a long time, so I will just speak to you guys offline.

Richard A. Galanti

Okay. Why don’t we take one last call?

Operator

Theresa Donahue.

Theresa Donahue

My question was answered. Thank you.

Operator

There are no more questions in queue, sir.

Richard A. Galanti

Okay. Thank you, everyone. We’ll be around.

Operator

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

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Source: Costco F1Q08 (Qtr End 11/25/07) Earnings Call Transcript
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