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

Dec.13.07 | About: Costco Wholesale (COST)

Costco Wholesale Corporation (NASDAQ:COST)

F1Q08 Earnings Call

December 13, 2007 11:00 am ET

Executives

Richard A. Galanti - Chief Financial Officer, Executive VicePresident, 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

Operator

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

Richard A. Galanti

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

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

To begin with, our 12-week first quarter of fiscal ’08results, for the quarter we came in at a reported $0.59 a share. This comparesto my guidance back on October 10th of something in the mid to high 50s and Iindicated that $0.59 actually may be a shade high but we got there. First Callwas at $0.59 at the time. It actually I think went to $0.58 and recently hasbeen 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 $0.59EPS figure that I would like to point out. Number one, a little over a penny ashare -- actually about $8.9 million pretax -- represented increased SG&Aexpense related to a planned sharing with our U.S. employees for their help incontrolling healthcare costs. As you know, four years ago we made some changesto healthcare and we told them that with those changes, they would bear a littlebit 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 backto them.

Our income tax rate also benefited in the quarter, so thefirst one hurt the quarter by a penny. Our income tax rate included a couple ofdiscrete tax positives. Usually those things tend to offset one another.There’s usually three or four of them, pretty small items. In this case, theyall went the same way. That added about $7.7 million of reduced taxes, sothat’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 ourOctober 10th call, the fiscal year ender, on the fiscal year end earnings callthat we would be negatively impacted this year in Q1 as compared to last year’sQ1 for a large profit swing that we would anticipate in gas operations. As youknow, with prices continuing to go up until very recently, the last couple ofweeks, we’ve seen a change there, but on a comparison basis, we had unusuallystrong profits last year.

This last item represented about $30 million pretax or $0.04a share year over year swing to our EPS and certainly had a big impact on ourmargin. Frankly, a little bit more than I actually anticipated at the time Imentioned 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 hadexpected, 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%, certainlybenefiting gas inflation and the strong FX, or a weak U.S. dollar.

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

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

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

As I mentioned, the 8% reported comp benefit from gasinflation, 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 totalcompany basis is closer to a four plus. For the quarter, our 8% reported compwas a combination of average transaction increase of about 5.5% for the quarterand average frequency of about 2%.

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

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

Another international, not as extreme as Canada but mid tohigh 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 andancillary businesses were the standouts, as was fresh foods, frankly. Hardlines was certainly positive but coming down a little bit from ’07 and softlines was in the mid to low single digits, nothing -- and I think that’s partlya reflection of the economy and partly why we see our food and fresh foodscontinue to be strong.

Within food and sundries, by the way, I mentioned it wasstrong despite the fact that we still have a little bit of a negative swing, anegative comp in tobacco. Tobacco is about 6% of our total company business andabout 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 ofanniversarying the reduction in tobacco sales in Canada when Imperial Tobacco,about half of the tobacco sales up there, decided not to sell through largedistributors like ourselves.

And if you’ll recall in Q4, tobacco comps along were minus14%, 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 priceincrease a year ago in the U.S. Obviously that come back a little in the nextmonth as that anniversaries and so beyond that, not a whole lot to say aboutthat.

Within the hard lines comp, electronics comps were in the highsingle digits with sporting goods up in the high teens. Hardware, a slightnegative comp, although not a big dollar category at this point, at this partof the season.

Electronics continue to do very well, probably a littlelower. It’s come down from the craziness over the last couple of years. Anexample would be televisions, which still are showing price point declines pertelevision 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 lowsingle digits and actually weakening throughout the quarter. So again, biggerticket 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 feeswere up 13% in dollars, up $38 million to $338 million and up three basispoints as a percent of sales. The continued benefit from the remnants of the $5membership fee increase we did about 16 months ago because of the way deferredaccounting works continue to have good renewal rates and also while slowingdown a little bit, still increasing sales penetration of the executivemembership conversion to the $100 executive membership fee.

In terms of membership base, we had 18.9 million Gold Starmembers, up about 300,000 from the end of the year; 5.5 million primarybusiness, up about 100,000; and 3.4 million business add on, rounding to flatwith a 3.4 million at year end. All told, 27.8 million member households, whichis about 400,000 above the end of the year 12 weeks earlier and includingspouse cards, right around 51 million cardholders out there.

If you looked at the 27.8 million member households and justsimply divided by the number of warehouses we operate, the average warehousehas about 52,500 member households per location. That represents averagelocations that do our company average $130 million in sales and are probably15-plus years old.

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

In terms of executive memberships, we had 6.69 million atquarter 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 numberjumped quite a bit. I should point out that these roughly 24% of our membershipbase, they generate now over 50% of our sales.

In terms of renewal rates, as I’ve talked to you I think inthe last two or three quarters, it teeters at 86.5 -- one month it’s 86.4, thenext 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 rightthere at 86.5-ish.

In terms of gross margin, we were up by nine basis pointsand in reading some of the calls out there this morning, reading some of thethings that were put out some sell side, some concern about that. I think -- letme 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 downthe left-hand side, we’ll have core merchandising margin, and what this chartis, for those of you who are new, is simply a year-over-year basis pointvariance and how do we get to the nine basis points where the margin was higheryear over year by nine. So the first line item would be core merchandising, thesecond line item would be a new one, ancillary businesses, and I’m -- wereseparating that out simply because gas was such a big swing. The third lineitem would be 2% reward. Fourth line item, LIFO. The fifth line item would bethe 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 salesreturns adjustments that we did last year in Q2 and Q3, and we try to help youunderstand we are getting a little benefit from the change in electronicsreturns policy, not only in the fact that returns in absolute dollars arecoming down but also the accrued amount of the sales returns reserve and theassociated margin reserve adjustment to that is improving slightly as we goforth. So it will be returns, gross margin adjustment would be the next lineitem, and the last one will be sales, returns sales adjustment and that againhad to do last year with the adjustments, and then the total.

I’ll let you write down basically three columns. All offiscal ’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 basispoints 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 forthe 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 thenext two columns.

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

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

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

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

All of these four major departments were higher year overyear, ranging from 22 to 69 basis points better. Hard lines, of course, was thetop one there and that had the added positive impact by the reduction inreturned items and electronics. This is both an improvement in the returnsreserve, which is that three basis point number I gave you, as well as just interms of getting returns back each day and what goes into the current quarterresults as more prior sales are passing -- more previous sales are passing the90-day returns threshold.

Our year-over-year gross margin in the retail business, as Imentioned on our fourth quarter conference call back in early October would bedown and again, it was down this year but as important, it was very strong lastyear so it was a combination of that being whipsawed. And most of that, nearlyall of that 30 basis points is in the gas with a small amount being in a coupleof 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 thinkit’s positive at this point. We shouldn’t see the big negative gross marginvariance from gas as we did in Q1. We shouldn’t see that in Q2. Gas hasactually turned the corner for now. As well, last year in Q2, we had a bigslowdown in profitability in gas as well, so we’ll be comparing against apretty normal number last year and actually starting off, although we’re onlytwo-and-a-half weeks into the quarter, pretty well.

General merchandise is doing fine. We’re coming out of ourseasonal stuff cleanly and we don’t expect any big markdowns and again, we’llstill see a small negative impact to margin from the increasing executivemember business but that’s getting to be, as you see, a smaller and smaller hitand 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 frominflation. I know we hear about things going on every year. Through the firstquarter, there’s -- of course, what’s driving the inflation in our case iselectronics but we’re not seeing a heck of a lot elsewhere either, even in thefirst three months. So that seems to be not a concern this year from a reportedstandpoint.

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

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

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

Moving on to SG&A, our SG&A percentages Q1 over Q1were higher by 17 basis points, coming in at 10.15% of sales this year comparedto 9.98 last year. Again, if you’ll bear with me a second and last table thatI’ll ask you to jot down, the line items will be as follows: operations; thesecond line item will be central; the third line item will be stock or equitycompensation; the fourth line item will be -- I’ll just call it 409A -- thishas to do with the stock option issues from last year and some remnant expensethere; sales return, which again is an impact to ’07 is the next one; andlastly, 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, forthose of you who are new, minus means bad or higher. So these are basis pointsyear 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 inQ108, minus nine.

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

409A was minus six in ’07 -- that’s when we took a bigreserve 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. Andlastly, quarterly adjustments, plus one in ’07, zero in Q4 and minus 6 in Q1and I’ll talk about that in a second.

So the total of those are for all of ’07, SG&A washigher year over year by 22 basis points; in Q4, it was higher by 23; and inQ108, it was higher or negative 17.

A little editorial; as you can see, first of all operationswas higher by nine year over year. Recall first and foremost that the dollar anhour bottom of scale pay increase that we did back in March, includingbenefits, that’s about six basis points of the nine. That, as I mentioned to youbefore, will pretty much anniversary after the second quarter. I think itanniversaries about three weeks into the third quarter, so the little remnanteffect of that to the negative in Q3 but essentially that is an anomaly thatshould anniversary shortly.

Our central expense improved by two basis points -- nothingbig to say there. In terms of stock compensation expense of minus three -- I’msorry, minus one, as I mentioned before we now are -- there’s a full amount ofvesting or five years of one-fifth vesting in this number, a combination ofprevious stock option grants plus in the last two years, RSI grants, restrictedstock 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 thestock as you know had moved nicely upward and so on the date of grant on thisyear’s -- we do our big annual grant back in October, so that had the impact ofjust picking that up a little bit. Not a terrible issue there.

And lastly, the next, the 409A, this is to increase theaccrual 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 hascome out with what is called the 409A issues, some of the other governmentswhere we have employees who have received options, not all the rules arefinalized and basically, there’s a small impact there. It’s essentiallynon-recurring. We might still get little remnants of it over the next fewquarters 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 thecall 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 changedour healthcare benefits such that after nine or 10 years of not charging ouremployees, not passing on any of the healthcare increases, we went to them atthe end of calendar ’03 and said we do have to pass some of it on to you andrest assured, we will do everything to mitigate it and really it’s been acombination of some of the changes we made but more importantly, our employeesbeing better consumers of healthcare and as you might expect, we felt thatgiven 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 $8.9million or about six basis points. There’s no guarantees in the future butthat’s certainly an anomaly in this quarter.

So if you look at the 17 overall -- and by the way, thatlast comment was related to that quarterly adjustment component of my littlechart of minus six -- if you look at it overall, you’ve got the dollar an hourpay increase of roughly six basis points of this number, you’ve got the 409A ofthree, and you’ve got the benefit sharing of six, which arguably even if youthought we do it in the future and there’s no guarantees, if this is a wholeyear’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 lotbetter than we did in Q4, relatively speaking and that’s quite encouraging.

Next, going down the income statement line, pre-openingexpense 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 12units. This year we opened 10, six plus four relos, but they all havepre-opening. And we also, of course, in those numbers are some small expensesrelated to upcoming openings after quarter end as we incur those as we do priorto opening.

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

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

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

Interest income and other was better, higher year over yearby $6 million coming in at 33.3 versus 27.1 last year. Most of that -- nearlyall of it, not all of it, though, is higher interest income. This is the othercomponent of that title of this line item is an increase in earnings from our50% interest in our Mexico operation since we don’t account for that on aconsolidated basis but rather on an equity basis and any change in our half ofthose 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 impactsof the healthcare cost sharing with our employees, as well as the other thingsI mentioned.

In terms of the tax rate, again I mentioned that was alittle bit of an anomaly to our benefit in Q1. The tax rate came in at 35.3versus 37.4 last year. I think frankly the 37.4 would be what I would budgetfor the year, recognizing you are always going to have discrete items in aquarter based on solving or completing audits with various state, federal, andcountry taxing authorities. Usually they all go -- a few go one way and a fewgo the other and it’s not a big issue. In this case, we benefited from two orthree 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 beout 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 $1.319billion; 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 $21.004billion.

On the right hand side, short-term debt of 37; accountspayable of $6.168 billion; other current liabilities of $3.489 billion; fortotal current liabilities of $9.694 billion. Long term debt of $2.182 billionand of course the $2 billion related to what I mentioned earlier about a debtoffering we did back in February. Deferred and other, 2.95, such that totalliabilities 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. Ihaven’t actually talked about a debt-to-cap ratio in a while but now that wehave a -- the debt-to-cap ratio at quarter end was 20%. Not bad given thatwe’ve in the last two-and-a-half years have bought back over $4 billion ofstock and added $2 billion to our debt side, so certainly a little bitdifferent complexion, as planned, to the balance sheet over the lasttwo-and-a-half years. Still plenty of financial strength.

In terms of -- a number that we always look at is accountspayable as a percent of inventory. On a reported basis, it improved from lastyear’s Q1 end at 103 to this year’s first quarter end at 107%, recognizing thatthe payables -- the denominator in this calculation is merchandise inventories.The numerator is a combination of merchandise payables as well as otheraccounts payable, most notably construction related payables. And so backingout 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 upabout 2.5% or $286,000. Nearly all of it, $260,000, is the simple calculationof assuming that your currencies were flat rather than -- your foreigncurrencies were flat rather than strong relative to the dollar.

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

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

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

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

Costco Online actually did better than we had planned andits 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%. Weshould 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 quarterwe opened 10 locations, four of which were relos. Currently, we expect to openseven in Q2, a few of which have already opened, of course. I think five ofthose have already opened or will have by the end of this week. No relos, sonet of seven for Q2 compared to a net of six for Q1. In Q3, we anticipateopening seven, including two relos, so a net of five. In Q4, we plan to open 15less three relos or a net of 12, which would put us 39, including nine relos ora net of 30.

As with any of these estimates, particularly looking out toQ4, there’s always a few that slips but it looks like now that our best guessis the 30. In addition, we anticipate opening one additional unit in Mexicothis year.

If you look at the 30 on our beginning base of 458, now the458, this is consolidated numbers so the 458 does not include Canada -- doesnot include Mexico but 30 on a base of 458 would be about 6.5% unit growth anda shade over that in square footage growth, recognizing that new units tend tobe a little bigger on average and the relocations, of course, always are biggerbecause you are relocating from a smaller unit.

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

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

Notwithstanding the stock price being up, we are buying butat a lower amount, usually on a regularly daily basis. We haven’t in the lastcouple of weeks, simply because we buy through blackouts using the 10D51filings. Those of course have to be put in place a few weeks before quarter endand three or four weeks ago, the stock was substantially lower than it wasyesterday 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 clippingmore 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 forQ&A, a little direction for Q2 and ’08 overall. I think First Call today isat 74. You’ve heard this like a broken record. That sounds good. Probably atthe 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 74is a good number.

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

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

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

Question-and-AnswerSession

Operator

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

Chuck Grom - J.P.Morgan

Good morning, everybody. On the TV returns over the pastcouple of years, could you speak to at what points during the calendar year youexperienced the greatest spikes in those TV returns and particularly over thenext few months, that that was a high period. And if you also could speak tohow this has trended since the policy change went into effect, and if you couldessentially speak to July going forward, obviously the 90 days from the April1st change.

Richard A. Galanti

In terms of calendar issues, it generally -- I think weourselves exacerbated the issue over the last few years with the two couponbooklets 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 acustomer bought a flat screen TV when they had finally gotten down to $2200. Hecame in, bought if for $2200. A year later, he gets a passport or a winterwallet and not only has our normal price gone down -- I’m making this up, butsay $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 walkingout 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 littlebetter. Recognizing that the sales -- most of the improvement that we seeshould be in the core number because that’s just the returns we get in thequarter. They are actual, physical returns and how we account for them based ondoes it go back to the shelf, which in electronics is rare. Does it -- is itdisposed of via salvage at $0.60 on the dollar or $0.20 on the dollar or $0.80on 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 thesecond part of that question of that’s based on the lag. And what happens nowis here we are in September, October, November sales for Q1, we now have achunk of sales from roughly mid-March to now that every day, a higherpercentage of future anticipated returns relate to more recent sales, that thatshould 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 sevenbasis 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 littlebit has to do with just how our estimate model works. It is still based ondaily lags of historical stuff.

All I can tell you is -- I probably go back to what I saidto anybody that would talk to me about this six to nine months ago. If you tookroughly $4 billion in departmental sales and looking back over a five-yearperiod, 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 longerthan most, or mostly all, and we had more than -- and we installed a conciergeservice, which has a cost, and we added a second year warranty to TVs andcomputers, which has a cost. The way I kind of dialoged it to anybody who hadcalled was if we are talking about a number that’s $160 million plus, even ifwe get half of it back and it takes two or three years, that’s 10 to 12cumulative basis points, maybe three or four a year. I guess that’s still mybest 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 numberand if I just look at dollars, the dollars -- in the first quarter, if I lookat total sales dollars in electronics and total dollars of returns ofelectronics, irrespective of its to go back to the shelf or disposed of orsalvaged, in absolute numbers as a percent of -- electronic returns dollars asa percent of sales dollars in the first quarter year over year is down byalmost -- 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. Itwould 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’sClub has said publicly that they are not interest in fighting the penny warwith you going forward. What sort of opportunities can this open up for thecompany on the margin front down the road?

Richard A. Galanti

Tell them thank you. But clearly, you have to recognize thatwe 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 salesare what I would call commodity. Maybe not half anymore but roughly half arecommodity 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 surethey do us, we still shop them every week in every market, if not morefrequently and I think we will always play that fierce -- we’ll always be verycompetitive.

Whether to the extent that they’ve chosen not to go down bya penny, great. Then we won’t have to do that either but who knows. I don’tthink we’ve really ever done that a lot but we’ve always -- we and them havealways 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. Canyou talk a little bit about what you are doing from a promotional perspectiveand also how the Black Friday handout went? And then maybe if you can justprovide some additional color on the membership revenues. It seems the growthis 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 alittle bit and how the Black Friday handout went. And then secondly, if you canprovide some additional color on the membership revenues.

Richard A. Galanti

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

In terms of membership fees, again I know -- I heard thatagain at the Wal-Mart analyst meeting, they had indicated they saw somechallenges with member sign-ups. Thankfully we have not seen it. We are stillgrowing our mature warehouses slightly, slightly more than covering the renewal-- the non-renewers and again, our renewal rates have held frighteningly steadyright, 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 littlebit more executive membership conversions in Q1 than we have had on an increaseyear over year, that helped it a little. Each month now going forward throughJuly when we’ll be at the second anniversary of the $5 price increase andbecause deferred accounting takes it all the way out there in terms of how yousee incremental benefits from it.

My guess is if you look into ’09, one, executive membershippenetration, 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’sbeen about every five years, so if you assume in ’09 we did no increase, andI’m just making observations here. We haven’t made any decisions or evendiscussed it, but if you assume there was no increase there and you assumethere is increasing penetration of executive member but less increasingpenetration, then you probably see membership as a percent of sales start toflatten out, if not go down a basis point or two.

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

My guess is that we’ve enjoyed, because of executivemembership rollout over the last five years, the fee increase two years ago, ora year-and-a-half ago, we’ve enjoyed an increasing -- membership fees as apercentage of sales continue to show improvement. My guess that number on theincome statement as a percent of sales is up this year, is up or flat or closeto 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 marginexpansion of 41 basis points, I just wanted to clarify something -- did you saythe majority of that was because of the change in the return policy, so it wasreflected through the hard lines margins?

Richard A. Galanti

No, I said of those three core components, of those fourcore -- food and sundries, hard lines, soft lines, and fresh foods, and I saidthe range, each of those departments were up year over year and in fact, therange was anywhere from 22 to 69. Normal deduction would say the hard lines is69 because of the benefit in electronics but hard lines is what, 15% of totalsales or 17% of total -- something in the mid to high teens as a percent oftotal 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 bettersourcing? 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 thinkwe’ve tried to be pretty open with people over the last nine months as wetalked 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 -- ourdefinition of fair as you will expect is lower than many of your definitions offair out there. We’re still going to be fiercely competitive and penny game ornot, 50% of your items are fiercely competitive to start with.

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

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

Christine Augustine -Bear Stearns

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

Richard A. Galanti

It was an after-the-fact thought and that’s why we didn’tcharge last year, frankly, but once we decided last month in reviewing ’07 andlooking at our healthcare plans into ’08 and ’09 and not only what are we doingfor the employees, how can we improve the existing benefits? There was a littleextra, extra cost that we used to improve other aspects of the plan that willcost us a little money but this is -- we haven’t said to the employees how weare doing it yet. It will be something that will get to them in February, Marchbut since it relates to how we all, including them, performed on healthcareduring 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 merchandisemargins, last quarter when you reported the 38 basis points, you cautioned usnot to expect that pace of improvement. Obviously you’ve exceeded that thisquarter and I’m just thinking as you head into the second quarter and as youpoint 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 wasfrankly my goodness, that’s a lot. And that’s how I think each month we saw itimproving, we just kind of looked at it and human nature is that how can we getthere so fast. And the fact that Q1 is -- I agree with your question. I wouldstill probably temper it. Maybe not temper it as much as I did in Q4 -- tempermy comments because what I told somebody recently on a phone call and usingtheir model, and I’ll make the example up here, but let’s say they assumed thatover 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 thaton a quarterly basis year over year, to achieve X there will be quarters on ayear-over-year variance where it will be X minus 10 or 15 and there will bequarters where it’s X plus 10 or 15.

I certainly agree with you that we now have two quarters ofvery 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 itbut 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, giventhat the mix should also help with general merchandise growing as a percent ofthe mix. Obviously a holiday quarter and as you point out, the 22 to 69 basispoints with hard lines being strengthened, you would expect that mix to grow aswell 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 mixchange. First of all, let’s say hard lines penetration will come -- well, let’ssee. In hard lines, you’ve got all of Christmas but then you’ve got January andFebruary, 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 inone direction.

Adrianne Shapira -Goldman Sachs

Okay, thanks, Richard. And then just lastly on the -- youtalked about bigger ticket and discretionary items perhaps being impactedbecause of the environment. Can you talk a little bit of the small businesscustomers? Are they sensing any difference or are you seeing any difference interms of buying patterns and any resistance there in terms of some of theinitiatives 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’tseen a big change to our business penetration.

And the improving pricing structure in certain categories isa 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 andcalling up and yelling at buyers, saying when did we go up on that, or why arewe here and bringing a few of them down and that’s fine. That’s what he’s incharge 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 pricingdeclines that you saw, or the deflation in November. What we’ve been hearing isthat supply has been pretty tight, both on LCD and plasma, so I was hopingmaybe you could decompose the price declines a little bit in terms of LCDversus 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 likeitems. Those were exact like items, recognizing probably the price pointdeflation per item is not as big a drop because people are trading up as wellto something bigger.

I think some of the pressure on price is not to go down asmuch because of tight supply in flat screens, mostly the LCDs. That isconsistent with what our buyers and GMs told us and told a few of you becauseyou 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 indicatingthat despite a great increase in manufacturing capacity, LCDs had picked upstrongly and there is so much more demand now coming outside of the UnitedStates for this product capacity. That is holding prices.

What our buyers told us at that time was is they pretty muchhave locked in declining pricing through the end of the calendar year based oncommitments we had made back in June and July for this season. The manufacturers-- again, I’m referring back to this conversation six months ago, themanufacturers would like you to believe and had led in discussion with ourbuyers that they would anticipate in calendar ’08, little if any deflation, ifnot a little inflation. The buyers’ perspective was that is probablydirectionally right but a little bit of wishful thinking.

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

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

So it’s still pretty healthy. I wonder when it will run outof steam. I already have enough TVs and cameras but at the -- I want tocontrast 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 up15 instead of 20. And just in the last few months, we’ve seen a bigdeterioration in jewelry, more so in non-diamonds, more so in watches andpearls and silver, which I would call maybe a little more discretionary.

Diamonds, people still get married, people still haveanniversaries for earrings and whatever else, or upgrades of diamonds andagain, 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 youcould talk about the MP3 category within electronics. I know you had someoutages on the iPod last quarter, I believe it was. Are you feeling pretty goodabout the stock there and the demand or sell-through on those?

Richard A. Galanti

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

Mitchell Kaiser -Piper Jaffray

Okay, good. Thanks and good luck.

Operator

Your next question comes from Uta Werner.

Uta Werner - SanfordC. Bernstein

I was very impressed with the gross margin increases you’vejust reported and I was wondering whether you see further gross marginincreases or something of a step change this year with the flattening out overfollowing years or whether you think we are going to see similar improvementshappening 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 thatwe wouldn’t have gotten as much as quickly. Clearly we are not going to getincrementally this much more next year and the following year but it would leadme 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 offso strongly.

Now, I’ll be the first person also to caveat that and saythat’s based on not compromising our competitiveness and not having a majorrecession where all of us are impacted, perhaps us a little less thantraditional retailers but nonetheless impacted. But we’re not -- we still havea 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 youis that we are -- when people have always asked over the years who is ourtoughest competitor and my answer is us -- it’s us and I think that does giveus a little movement and a little room for movement here but we are going tostill look to see how -- make sure we are wowing you every day.

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

Uta Werner - SanfordC. 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 notthat analytical and smart. I would say that if we felt that if any price changewould hurt a comp, we would not change it and you never know exactly what it isbut you’re not talking about big numbers here also. You’re talking about newitems, 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 perceptionbecause if it were, you would see a change in comps.

Uta Werner - SanfordC. Bernstein

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

Richard A. Galanti

On the first question, clearly electronics dominates andit’s -- or anything electrical, whether it’s electronic games or game consolesor -- as you know, we have about similarly about 4,000 items online but only10% or 15% overlap with the warehouse, so it’s clearly more heavily skewed tonon-foods and some bigger ticket items.

I would say that given that there are some manufacturersthat 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. Itis a lower gross margin overall than our company, than the warehouses, and ahigher pretax, as you might expect because there is not a lot of majoroverhead.

Uta Werner - SanfordC. 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 ofcurrency on earnings and if you were to look at the gross margin metrics andthe 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 orSG&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 -- Ihaven’t done that in front of me. Certainly it’s a positive, given that allforeign countries I believe are positive now. A couple of the new countries areslightly positive but given that and the fact that the currencies, particularlyin Canada, are going the right way, I think it would clearly help EBIT. I thinkit is not as discernible to the percentages because all your percentages areimpacted -- your sales percentage, your sales dollars for Canadian dollars arehigher expressed in U.S. dollars than they would have been with a flatcurrency, as are your expense dollars up there, as are your earnings dollars.

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

So you take that, those numbers and if the currencies are up15% or whatever, or on average for all of last year they weren’t up that muchbut let’s say they were up 10% -- I’m guessing here, by the way. You could lookat it that way.

Mark Husson - HSBCSecurities

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

Richard A. Galanti

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

Mark Husson - HSBCSecurities

Great. Thanks very much for your help.

Operator

Your next question comes from Bob from Lehman Brothers.

Bob Drbul - LehmanBrothers

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

And then the second question is did you do any hedging ingas 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 thingshappened over the last few years since Jim allowed us to try it. Mostimportantly is it’s still a low margin business and the cost of hedging hasprobably gone up some because of the volatility in gas prices. And so allthings being equal, at the end of the year you’ll make on average the same butyou’ll spread out your P&L a little bit better instead of having these upsand 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 marginsto start with are lower, it didn’t make sense.

In terms of -- if I look at the L.A. region, if you go backover the last couple of years, generally speaking -- and I’m making thesenumbers 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, socall 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 lookingat that metric, that gap.

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

And so relatively speaking, while everything has come down alittle 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 thatdelta because we certainly have done a disproportionate amount of ourcannibalization in California over the last two years.

But even with that out, maybe it’s 100 basis points but Idon’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. Thehousing market arguably has been hit harder there than in some markets but thehousing market has been hit in other markets that haven’t been as impacted.

So that’s what we know.

Bob Drbul - LehmanBrothers

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 deltachange. Is that something that was getting worse through the quarter or is thatfairly stable?

Richard A. Galanti

I think it was -- I’m looking as we talk here -- I think itwas pretty stable. California comp, if I look at September, October, orNovember, there is actually -- the lowest number was in September. Now, it wasprobably lower in August because if you’ll recall, as a company we had a prettycrappy number in August. But basically, California comp was almost flat inSeptember 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 theSG&A increase that we could point to as being perhaps one-time in thequarter and I know in the normal course of business, there’s all kinds ofone-time things that come up from one quarter to the next but if you just sortof -- let’s just say for the benefit, you have to strip that out right now andlook at the SG&A on a fairly strong comp, I guess I’m a little bitsurprised there isn’t more leverage on an 8% comp, or even if you wanted tolook at it on a 4% comp at the core. Is there any sense that we would be ableto 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 thatenergy costs are going up and again, taking out the anomalies, even the onesthat we cause ourselves, like the bottom of scale or the sharing of healthcaresavings, it’s -- as I’ve said before, there are not a lot of silver bullets outthere. It’s not like we’re very inefficient and we can improve efficienciesgreatly, so we do need some comp.

You’d like to think that on a relative -- you know, as I’vealso said, a little inflation wouldn’t hurt and I hope it’s not a lot andalthough when you read the news every day, there is certainly some inflationcoming 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 outthere, given margin initiatives and given other things, was is that hey, theCostco story out there was if I had to again summarize consensus, was that thecompany can get 9% or 10% top line growth, it can get 4% or 5% or 6% from EPSaccretion and on top of that, if they can get 10 or 15 basis points ofanything, 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 themid to high teens.

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

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

Other than that, that’s the general storyline that we lookat.

Dan Binder -Buckingham Research

I guess if we look out over the course of the year, gas maynot 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 becausegas or currency isn’t an issue or as much of a contributor, or if the corebusiness slows a little bit, what’s the ability to adjust the expenses down? Iguess I’m just trying to get a sense -- if we’re not going to be able to see a lotof SG&A leverage on a mid to high single digit comp, is there someprotection on the way down to adjust?

Richard A. Galanti

I don’t think there’s a lot of protection. I think the FXthing helps and/or hurts all lines of the income statement, so that reallyshouldn’t be an impact. Gas should, to the extent -- gas is not falling out ofbed overnight, by the way, but finally it’s not increasing. It’s decreasing alittle 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 talkedabout jewelry, TVs -- are there any other areas of the club that you would sortof throw on the discretionary area that is showing any kind of marked change intrend?

Richard A. Galanti

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

Dan Binder - BuckinghamResearch

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 whatportion of that ticket increase is inflation versus other stuff. So stop me ifI’m wrong here -- if it’s 5.5% ticket and 2% traffic, once you take out the FXand 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 passsort of inflation? Now you guys raising prices but basically passing throughincreased costs on those commodity type items that as you described I thinkbefore, are not new items where you are getting a little extra margin but the70% or 80% of the items that are just existing items where you are seeing somepass-through.

Richard A. Galanti

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

If you look at -- if I look at specific items withininflation, 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 isnot electronics -- pistachios, I think we bought in well. That’s down in themid teens. And of the top 30 LIFO items, that’s the only one that’s not in theelectronics department. So we are seeing a little bit but then things thataren’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 fourmonths ago, which is kind of like the vitamin waters. It’s called -- there’s aregional bottler out here that does a water called Talking Rain and now they doVita-Rain, Kirkland Signature Vita-Rain by Talking Rain. And let’s say the18-pack of the vitamin water is $20. The 18-pack, the exact same bottles, theexact same colors, the exact same sizes, it says Kirkland Signature on it andagain it’s a slightly different -- it’s a different manufacturer, is more thana third to 40% lower price point.

And by definition, if we only sold the first one and now allof a sudden, I’m not sure what the penetration is but even if it’s as low as30% of the unit sales, that had a deflationary impact.

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

Gregory Melich -Morgan Stanley

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

Richard A. Galanti

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

Gregory Melich -Morgan Stanley

And then second, I guess related, you talked about themargin as sort of longer term progression and Jim going around the clubs andcalling 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 anabsolute 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 impactingcomps. Or do you look at it on a purely relative basis versus the market andcompetition?

Richard A. Galanti

Without knowing exactly what he would say, my guess, mystrong guess would be it would be the latter. If the underlying normalized compfor 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 -- orWall Street would be less unhappy with us than others.

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

Again, I remember after talking about some initiatives andthen 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 theanswer was no.

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

Gregory Melich -Morgan Stanley

Great. Thanks.

Operator

[Thomas Fort].

Thomas Fort

I have two questions; the first one is when we think of gassales, you talk a lot about the gross margin impact but I wanted to know towhat 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 andhow that can drag the gross margin down, but is there a certain level of gassales where the comp can actually benefit the SG&A, where you can leveragethe SG&A on the higher comp sales due to gas sales?

Richard A. Galanti

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

Thomas Fort

And the second question was I wanted to know if you wereseeing 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 youare talking about competition, certainly our biggest competitor is Sam’s, interms of number of locations we compete with somebody on and we’re bothwarehouse clubs.

They got a lot tougher about five years ago when they had amanagement change. They have remained tough. Again, I am happy to hear thatthey commented that they are not going to play the penny game but at the sametoken, neither of us are going to let, are going to fall asleep at the wheelhere 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’slooking 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 youincreased fees on the base members every four to five years and with that inmind and considering that you didn’t move the executive fee last summer and Idon’t think you’ve ever increased that fee, how should we think about strategywith respect to the executive fee going forward?

Richard A. Galanti

Well, I think -- we don’t know. When we talk about it, welook at the menu of what we could do. I remember even when we went from 45 to50, we looked at various alternatives -- keep it at 100, because it’s a niceround number; go up 5, which is kind of an odd number; go up more than 5 butthen try to figure out what else you could give back to implicitly say it’s 5and feel it’s 5 and at the end of the day, we looked at it and said if we keptit the same, break-even on the 2% reward would go from $2750 to $2500 -- inother words, 2% of the $50 difference instead of the $55 difference. And bydoing so, we would -- there would be about 2.5 million members that in theoryare now above the break-even threshold on executive member. Not to say we aregoing to get a lot of them but even if we can get 10% of them, that’s anotherquarter of a million people that we can switch that will spend more and buymore and will be more loyal. So that was the motivation for doing that.

It really has not been a topic of discussion for the lastyear, nor do I expect to see it as a topic in the next several months. Beyondthat, who knows? I think at some point we will look to increase it, assuming itcontinues 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 yourrenewal rates overall have held up pretty well, is there any regional variancethough that you’ve been seeing there? Is there any pockets of the country whereyou are seeing some pressure?

Richard A. Galanti

Not really. The only thing that we ever see regionally, eachwarehouse has a certain amount of payroll that we call marketing. Marketing isa 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 largeemployer groups for their employees. It’s the people that have the RF handhelddevice that go up to you and scan your card while you are waiting in line andlet you know that based on your last year’s purchases, you would have made outwell on the executive membership.

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

So overall, I would say the answer is no. You’ll see someregional 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 expectyou to buy back just over $1 billion worth of stock this year, or just thatyour current pace of buying is at that rate?

Richard A. Galanti

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

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

Peter Benedict -Wachovia

Great. Thanks so much.

Operator

Todd Slater.

Todd Slater - LazardCapital Markets

Well, this call has gone on a long time, so I will justspeak 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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