Costco F3Q08 (Qtr End 5/11/08) Earnings Call Transcript

 |  About: Costco Wholesale Corporation (COST)
by: SA Transcripts


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

Richard A. Galanti

Thank you and good morning to everyone. This morning’s press release reviews our third quarter of fiscal 2008 operating results for the 12 weeks ended May 11th. As with every recall, let me start by stating that these discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and that these statements involve risks and uncertainties that may cause actual events, results, and/or performance to differ materially from those indicated by such statements.

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

To begin with, our 12-week third quarter of fiscal 2008 operating results for the quarter, our earnings per share came in at $0.67, up 37% from last year’s reported earnings of $0.49 a share. Of course, this compares to our March 5th guidance, that First Call’s then $0.65 figure for this quarter was doable and at the high-end of a very small range, so a couple of steps above First Call and our comments.

In last year’s third quarter, while we came in at a reported $0.49 a share, as I explained last year and I will do so again shortly, in last year’s third quarter what we believe to be normalized EPS was not the $0.49 reported but rather $0.56 a share. So this quarter’s $0.67 figure really represents a 20% year-over-year increase on a normalized basis.

In terms of sales for the quarter, total sales were up 13%, 12% excluding last year’s third quarter increase to the estimated reserve for sales returns, and our 12-week comparable sales figures showed an increase of 8%, continuing to benefit, of course, from both gasoline inflation and a weak dollar, or strong FX, primarily from Canada. We consider it a pretty solid underlying comp number, given the current state of what’s going on out there.

Please note that we’ll report our four-week May comp results next Thursday. That’s for the four weeks that ends this coming Sunday, June 1st, and that will be next Thursday morning, on June 5th.

Other topics of interest I’ll review this morning -- our opening activities and plans. We opened five new units during the third quarter of fiscal 2008, three in the U.S. and one in Japan, along with a new location in Mexico which we do not consolidate into our numbers as we are only a 50-50 interim partner. That was opened in Puerto Vallarta.

Fiscal year-to-date through third quarter end, we’ve opened 17 net new locations, 18 including the Mexico location. As well, we’ve opened -- we’ve done four relos this year. We have several additional relocations happening this current fiscal fourth quarter.

At third quarter end, we operated 536 locations around the world and by this weekend, we will have opened four additional locations this quarter, two new locations and two relos, to put us at total locations of 538 at that time.

Our fourth quarter openings to date, the two new locations a few weeks back in San Dimas, California, and this morning in Manahawkin, New Jersey, and two relocations, one in the Vancouver, B.C. area and tomorrow morning a relocation, a new opening of a relo in Kendall, Florida.

Also this morning I’ll review with you our ancillary results, Costco online results, membership trends, the impact of changes we made last February and March to our electronics returns policy, a few comments on recent inflationary trends, update on our recent stock repurchases, of course our balance sheet summary, and lastly I’ll give you a little updated direction guidance for the fourth quarter of the fiscal year.

Okay, in terms of discussion for the quarterly earnings, sales for this year’s third quarter, as I mentioned, for the 12 weeks ended May 11th were $16.3 billion, up 13% from last year’s 14.3, or up 12% on a normalized basis. On a comp basis, Q3 comps were up 8%. The 8% third quarter comp, while not exact months here, but as you’ll recall we reported 7% in February, a 7% in March, and an 8% in April, so the 7, 7, and 8 essentially compares to an 8% for the quarter and that’s up slightly from the second quarter comp number of 7%.

As has been the case for several months now, our quarterly comp figures greatly benefit from high gasoline price inflation, a shade under 200 basis points, about the same in Q2 and a bit higher than it was in Q1, and from the continuing weak U.S. dollar, or a strong FX showing, about a little over 200 basis points, both this quarter year over year and in Q2 year over year.

For the quarter, our 8% reported comp figure was a combination of an average transaction increase of a little over 4.5% and average frequency increase of just under 3% for the quarter. I believe that just under 3% frequency is about the best frequency number we’ve had in -- on a month -- on a quarterly basis or a monthly basis in a number of years. Typically it ranges from anywhere from minus 1 to plus 2, although probably the last year it’s been in the 1% to 2% plus range, so approaching the 3% was a little better than that.

Cannibalization negatively affected our comps, as it always does, a little bit under 100 basis points this quarter, similar to the cannibalization we’ve seen in recent quarters.

We’re certainly seeing a little more impact from inflation, not only in gasoline, which we of course call out to you, given the size of that business to us, which is now I think over 10% of our sales, which we break that out for you, but across many food, paper, canned goods, sundries items. Some offset, of course, by increasing penetration of our private label items, which offset a little of it, as well as the deflationary trends in some of the electronics categories.

In terms of any mix change between our business in Gold Star members, we really haven’t seen any. We’re asked that question quite a bit. Some I think feel that in the weakened economy, are small businesses being impacted by that -- we have not really seen a big difference in the sales penetration of our business member versus our Gold Star member. In that comment, I exclude gasoline, recognizing that’s more of a consumer item.

In terms of sales comparisons by geographic region, pretty much the same it’s been for the last few quarters. Our Northwest continues to be strong relative to the older, higher volume mature regions. California continues to be a little weaker than it had been, although it’s trended up slightly from its weakest points a couple of quarters ago. All the rest is as expected. The East Coast has been fairly good, the Southeast being a little stronger than the Northeast, and of course newer regions like Texas and the Midwest tend to do a little better, in part because they are younger units.

All told, our U.S., as mentioned, was a 6.25 and as I mentioned, we’ll report the four weeks of May next Thursday.

In terms of -- you know, we greatly benefit from -- in terms of reporting comps, or sales results the weak dollar in Canada, while the -- as translated into U.S. dollars in the mid- to high-teens, it’s in the low-single-digits, as it has -- low- to mid-single-digits as it has been for the last several quarters, so pretty consistent in local currency.

Other international is more in line as it relates to dollar versus foreign currency, both in the low double-digits.

Again, I think overall our numbers have been fairly consistent and a little better than we see out there.

In terms of merchandise categories, as I mentioned on previous calls, the last couple of calls, the basic categories of food and sundries, which is about half of our sales, and fresh foods, which is about 13% of our sales, so call it roughly 60% of our sales, those are the categories that are having comp numbers greater than the company overall and that’s offset, of course, by slightly weaker than our reported total numbers on hard-lines and soft-lines.

A little color on the comps within food and sundries -- tobacco continues to be a slight negative impact. I think the fact that the prices of tobacco keeps going up and up and it’s very expensive and with all the health issues and the restrictions out there of where you can smoke, we like everybody out there are seeing a reduction in demand there, so a slight negative impact there.

Otherwise, all sub-categories within food and sundries were up year over year on average mid- to high-single-digits, with the strongest departments being things like the deli departments and the canned foods and what have you.

Within hard lines, electronics comps continue to be slightly negative, in the mid to high singles. The highest -- offset by stronger comps in health and beauty aids, which is a hard lines category for us, as well as automotive products. Other things that you’d expect to be weak are light garden patio, hardware, and furnishings.

Within soft lines, not a whole lot there. The stronger areas, stronger categories for us are things like small electrics and certain categories within apparel, particularly men’s apparel. Again, mid- to high-single-digits. The remaining sub-categories are flat to down slightly, again nothing that different than what we’ve seen in the past. Areas you’d expect, you know, jewelry, home furnishings were down the most. Although jewelry is not as down as much as it had been in the last couple of quarters but still has a negative sign in front of it.

Fresh foods, as I mentioned, continues to be good. All sub-categories within fresh foods are just fine.

Moving down the income statement line, we reported membership fees of $350.9 million, up about 10.5% or $33 million. As reported, down about six basis points year over year. I think that’s in part due to the fact that we’ve had some pretty strong sales, top line sales results but nonetheless a pretty good number for us.

In terms of number of members at Q3 end, we had 19.7 million Gold Star members, up from 19.3 million at Q2 end. Primary business, 5.5 million. Rounding to the same 5.5 million but slightly up in terms of actual numbers. Business add-ons consistent at 3.4 million, so total members, member households, 28.7 million versus 28.3 at the end of the previous quarter. And including add-on spouse cards, 52.6 million members versus 51.8 million.

At quarter end on May 11th, our executive membership continued to do well, just under 7.3 million members. That actually is an increase of 380,000 new members, or a 5.5% increase just in the last 12 weeks. That represents about 32,000 new executive members per week, which is a combination of new sign-ups as well as member conversions. All of those have been pretty strong of late and helped by a lot of things -- more effort on our part, as well as some exciting things from some of our partners, like American Express, who is currently running a 3% cash back on gasoline when you use their co-branded card at Costco gasoline pumps, and given the top of mind of that, that helps as well.

In terms of membership renewal rates, they continue to be strong. At Q3 end, our business member renewal rate was 92%, Gold Star, 86, so -- at 87, I must say that it’s a strong 87 and one day we might get lucky and go up a little higher but for the time being, we round down to 87.

Going on to the gross margin line, third quarter gross margins were up 33 basis points year over year. Last year a 10.21 versus a 10.54 this year. Again, as I’ll mention in a moment, what we believe to be the normalized gross margin, excluding certain non-recurring items that occurred last year in the third quarter, what I think is a more relevant increase year over year is not the 33 but a 17 basis point increase.

Before I ask you to jot down the numbers, let me give you an explanation of the non-recurring item that impacted us last year in the third quarter. This related to an increase in our sales returns reserve balance. Last year in the third quarter, this adjustment resulted in a decrease to sales of $228.2 million, and a related pretax charge to gross margin of approximately $46.2 million.

The two impacts to the margin comparison year over year in Q3, the first of course is last year we took the $46 million hit, so you really add that back in. Secondly, last year we reduced sales for kind of an aggregate catch-up of the $228 million in sales, so in calculating last year’s gross margin percentage, of course, you had a lower than normalized, if you will, denominator in that calculation. So both of those things I’ll to point out to you as we compare to Q3 here.

As I always ask you to jot down a couple of charts, this is the first of those two, the margins, and we’ll go ahead and go back to -- we’ll have four columns, Q407 and Q108, Q208, and Q308. And the line items would be core merchandising, second one would be ancillary businesses. Third would be 2% reward. Fourth would be a federal excise -- IRS federal excise tax claim, which was an anomaly last year, last quarter, a year ago in the second quarter. And then the last two line items would be the returns gross margin adjustment -- that would be the $46 million I just talked about as an example -- and then the last line item would be returned sales adjustment, which would be the $228 million number, and then of course, total.

Now reading across here, the core merchandise margin, in Q407 it was up year over year by 34 basis points; in Q1, by 44 basis points; in Q2, 29 basis points; and in Q3, 27 basis points. Ancillary: Q4, 1 basis point up; Q1, 30 down -- if you’ll recall in Q1 we were comparing a very strong profit statement in gas a year earlier in Q1 versus a slightly weak profit statement in Q1 of ’08 but that allows for that 30 negative there; Q208, minus 12 basis points; Q308, minus nine basis points. The 2% reward: minus 4 basis points; minus 5; minus 4; and minus 1 in the most recent quarter. The IRS federal excise tax claim -- this related to the phone charges, excise tax on phone charges: basically 0 in Q4; 0 in Q1; minus 6 in Q2;and that has to do with the fact that in Q207, we received about $10 million from that; and then a zero, of course, in Q3. The returns gross margin adjustment: plus 7 in Q4; 0 in Q1; plus 33 in Q2; and plus 32 in Q3. As you’ll recall, this was a big adjustment that was really split in two based on our numbers at the time in Q2 and Q3 last year, so there’s an impact in both of those quarters. So plus 33 as I mentioned in Q2 and plus 32 in Q3. The returns sales adjustment, 0, 0, minus 16 and minus 16.

So we add all up that -- add all that up, Q4 last year our reported gross margin was up 38 basis points, our Q1 reported margin was up 9, again the impact of particularly in the gas business, Q2 was up 24, and Q3 up 33. Again, when you look at the chart that we’ve just written down, if you take out those last two items, the plus 32 and the plus 16 in the third quarter column, that’s how I get from the 33 reported to the 17 which I would view as more normalized.

Again, in terms of the 27 for the core business, all four major categories, food and sundries, hard lines, soft lines and fresh foods were higher year over year, ranging from low double-digit basis points to almost 100 basis points, but on average 27.

Hard lines, of course, was positively impacted by the reduction of returned items in electronics, as well as some slight reduction in our returns reserve. We picked up a few basis points there. In the fourth -- in the third quarter we estimate that within the 27, there was about four basis points of improvements just in the sales returns reserve, as the change in policy last year. I would expect to continue to benefit us a little bit for the next few quarters, as well as the last four quarters.

Hard lines, unlike in Q1 when year over year our overall company gross margin was very negatively impacted by the swing in gas profitability, you’ll note in both Q2 and Q3, gas really didn’t hurt our margins as they did in Q1. However, we’ve had a little bit of weakness relative year over year in other ancillary businesses. As I’ll point out later in my comments, we had pretty strong gas margins in Q4 last year but we do not expect the same this year, so I think that will be a challenge to this year’s Q4 results, a small challenge there.

General merchandise, as you can see, is doing fine. I think we should continue to see some benefit, both in our initiatives as well as improved availability of certain items in this weak retail economy where we can save the customers lots of money on some branded goods that previously had been unavailable to us and we generate -- on those items, we generate our full margin, which as you know is generally in the mid teens, at the high end for us.

The other question I’m sure we’re going to get asked during Q&A is you know in Q4 we start to anniversary against the “margin initiatives” and the big improvements in margins. We recognize that. It’s hard for us to quantify how much more we can do and when it comes, recognizing first and foremost we are a top line company and we are going to do what’s right by our members and by our competition to make sure we are driving sales in the right direction. We think we still have some abilities to show some improved margins, not just beyond the anniversary but it’s going to be hard to predict completely until we get there.

The impact of increasing executive membership business, this is really the smallest hit, if you will, on reported margin, the one basis point. The implication there of course is that year over year, executive member sales were up 2% year over year, so a 1% increase -- a one basis point detriment to reported margin.

In terms of LIFO, as I mentioned while we are starting to see some inflationary pressures from vendors, as we all have and we’ve all ready about it, we assume a little negative to zero impact to our P&L for at least the current -- continuing for the current fiscal year, in part because we had, we started the year with a net LIFO credit balance, due to the offsetting impact of the deflationary trends from our electronics inventories, particularly.

Again, as mentioned, this could change in the future as inflation has eaten away at some of those credits that we’ve built up over time. But it’s hard to know. My guess is that we could see some impact in ’09. We’ll give you some more insight into that as we get it, probably when we report Q4 numbers and going into ’09’s estimates.

In terms of -- before we go into SG&A, let me talk about the ancillary businesses, steady progression of adding them. We added three pharmacies in the quarter to be at 442. We had four food courts, four mini-labs and four opticals to be at 499 for the food courts, 497 on mini-labs, and 488 on optical. We still have seven print and copy centers. We added four hearing aid centers to be at 256 and five gas stations to be at 295 gas stations.

As I mentioned earlier, our ancillary comps were up 21%, up 7% without gasoline, recognizing gas has the big inflation piece to it.

Moving on to SG&A, our reported SG&A percentages in Q3 were better or lower by 26 basis points, coming in at a 9.73 compared to a reported 9.99 last year. As with the margins and those anomalies, how they impact the comparisons year over year, the decrease to last year’s reported sales figure is a result of that $220 million increase in the sales returns reserve, again made last year’s reported SG&A percentage higher on a reported basis because of the lower sales denominator.

As you’ll see in a moment, while reported SG&A year over year was again 26 basis points better, what we believe to be a more normalized fair comparison shows Q3 year-over-year improvement of 10 basis points, which is still our best SG&A showing on a year-over-year comparison in many fiscal quarters.

Again, for the second and final time in the call, I’ll ask you to jot down the following. Again we’ll go with four columns, Q407 and then Q1, 2, and 3 ’08. The line items will be operations, central. The third line item will be stock compensation. The third line item would be 409A, if you’ll recall last year in Q2 we also took a hit for protecting our employees on some stock option issues. The fifth line item would be the sales returns reserve adjustment and the sixth item would be miscellaneous, that quarterly adjustment, and finally total.

Reading across and when I give you a negative number, that means it’s higher or worse, operations was: minus 23 basis points year over year in Q407; minus 9 in Q1; minus 11 in Q2; and plus 8 in Q3. Central: minus 2; plus 2; plus 2; plus 4, so whereas in Q4 it was slightly higher year over year, in Q3 it’s four basis points lower year over year. Stock compensation: plus 2; minus 4; minus 3; minus 1. That’s going to always fluctuate plus or minus a couple of basis points, nothing really there. 409A: 0, 0, plus 30, and minus 1, recognizing the plus 30 was because we had a big charge last year. Sales returns reserve: 0, 0, plus 15, and plus 16. Again, those charges last year show a favorable reporting comparison. And quarterly adjustments: 0, minus 6, 0 and 0. The minus 6 in Q1 simply, if you’ll recall, we gave back to our employees about $8 million in healthcare benefits based on having some better than planned performance in reducing some healthcare costs in fiscal ’07 and we felt that the employees should share in that.

If you add all those numbers up on a reported basis, in Q407 SG&A was higher year over year by 23 basis points; in Q1, higher by 17; in Q2, lower or plus 33 basis points; and in Q3, lower or plus 26 basis points.

A couple of small comments -- again, operations was lower or better by eight basis points. Again, our first improvement in many quarters, primarily payroll and benefits. As you’ll recall, the dollar an hour pay increase that we did last March, that anniversaried in the first few weeks of Q3 this year and as you’ll recall in the last few quarters I’ve mentioned on a year-over-year basis, the payroll benefits hit because of that change last year was about six basis points. So that’s gone from a minus -- when you look at the minus 11 in Q208 for operations, we estimate that about 6 of that 11 was that. That would get you down a little bit but recognizing we’re not seeing that impact -- that we’re finally anniversarying that impact.

Our central expense improved a little bit, nothing huge there. The one thing that -- we certainly again have some benefits, some strong sales numbers. I think that helps that number a little bit. The stock compensation expense, as I mentioned, is going to always fluctuate a couple of basis points in either direction. And as I mentioned again, the stronger sales in things like gasoline add sales dollars but don’t add a lot of extra expense.

In terms of SG&A outlook for the remainder of ’08 and beyond, again we could be helped by at least lower expense percentages and payroll benefits to workers comp, in part due to the anniversarying of the bottom of scale wage increase we did last year and in part I think because of some inflationary sales trends, particularly in gasoline.

Again, the big question is what are your [inaudible] sales. There aren’t a lot of big silver bullets out there but we think we run a pretty efficient operation.

In terms of -- on the income statement, the next line item, pre-opening expense, pre-opening was up about $600,000 year over year from $8.4 million up to $9 million, or about a basis point lower, actually -- I’m sorry, down $600,000. Last year in Q3, we opened six locations. This year, we opened four. There’s always some crossover quarter to quarter also based on the timing of when openings are. No real surprises in those numbers.

In terms of the provision for impaired assets and closing costs, for Q307 last year we only had a $930,000 charge. In Q3 this year, you’ll note we had a charge of $9.2 million for the quarter. Nearly all of that $9.2 million expense relates to an impairment charge associated with closing, demolishing, and rebuilding a larger, better facility in Bloomfield Township, Michigan, in the Detroit area. This is [something] which we acquired and opened back in I believe 1998 as part of our purchase of six locations from what was then called Eckingers. This was closed, actually closed last Tuesday, May 13th, and is expected to reopen once it’s rebuilt on November, some time in November this year.

As you would expect from us and I’m happy to report, there will be no lay-offs. It’s good news that we have nine other locations in that market and certainly filling in for summer vacations helps mitigate that issue a little bit as well.

All told, operating income in Q3 was up 37% on a reported basis, or an increase of $127 million year over year from 339 to 465. Again, excluding the unusual items booked in Q3 last year, this year’s third quarter operating income on what I’ll call a normalized basis was up 20% or up $79 million.

Below the operating income line, reported interest expense was just slightly lower year over year in Q3, coming in at $24.1 million interest expense versus $26 million in last year’s Q3. The figures are roughly the same now that we’ve anniversaried last February’s $2 billion debt offering. In fact, the $2 million difference there, the actual cash interest expense on the debt offering was essentially the same. The big difference here is we had slightly higher with the ramp-up in expansion, slightly higher capitalized interest year over year by about $2 million.

Interest income and other was much lower year over year -- $42.8 million last year in the quarter, 23.9 this year. A lot of that lower income figure is lower interest income rates. A small amount of it is of course we’ve had a couple of small write-downs, both last quarter and this quarter relate to some of our cash investments, and I’ll mention that in a minute.

I should also note that this year’s -- as I mentioned, this year’s third quarter interest income figure, if you’ll recall back in Q2, we had a $2.8 million impairment on some of our enhanced money market fund investments. In our view, they still continue to be relatively safe as they mature and we get out of them, but it’s still a year-and-a-half to go on some of them.

During the third quarter, on roughly $300 million plus of these investments, we impaired that figure by $1.4 million. That was a small charge to the interest income in this quarter.

As I mentioned to you on our Q2 conference call back in March, if you go back to last December and the more than $2 billion of cash and equivalents we had on our balance sheet as of last August, last fiscal year-end, about half of it, a little over half of it, $1.15 billion was invested in what is known as enhanced cash funds. Generally portfolios of high rated, mostly highly rated securitized assets that historically have acted like traditional money market funds, in that they had daily liquidity and traded at a dollar net asset value.

Our $1.15 billion at the time back in early December was spread between six separately managed funds, including many well-known names that we’ve all heard of. In early December, we received a call from one of these funds that the fund was stopping redemptions and the fund would be allowed to float. This had not happened, I understand, since the early 90s. We immediately requested a redemption of all the funds and I am happy to report that as of Q3 end now, we’ve redeemed $842 million of the $1.15 billion and have reinvested in government related money funds, and have about $308 million remaining among these three funds.

By the way, the $308 million is $76 million less than we had just 12 weeks ago, so the maturities on these things generally were over a one to two-and-a-half year period and as they roll off, we are getting redeemed and with very few exceptions, we are getting redeemed for full amounts.

All of the funds that we currently have are restricted redemption, so we are in the process of getting -- undergoing the orderly liquidation of these as they mature. The underlying securities have maturities that go out as far as 2010. As I mentioned in this quarter, we took a $1.4 million write-down reflecting an impairment loss on a few of the more than 250 separate investments within these three portfolio funds. And again, recall that we took a $2.8 million impairment loss in Q2, so all told about $4 million impairment loss on what was originally $1.1 million and what is now remaining left in there, a little over $300 million.

While no one knows what tomorrow brings, things seem to be easing out there, so we have our fingers cross. We would expect that again as our Q3 balance stood at 308, that another 25% of it, or say about $75 million of this $308 million will be redeemed by August 31st, our fiscal year-end, and that all but perhaps of about $70 million remaining will be redeemed by fiscal year-end 2009, and again by roughly mid-2010, we’ll be out of it.

Lastly, the $308 million of funds, while a year ago were generally in the cash and cash equivalents category had been moved on our balance sheet and of that 308, $216 million is classified as short-term investments and $92 million as other assets, given the maturities are in excess of 12 months.

A long-winded answer for something that I think we feel a lot more comfortable today than we did early December when we got that call.

Overall, pretax income on a reported basis was up 31%. Again, on a normalized basis, as we consider it that way, this year’s pretax income was higher by 15%, up from $404 million last year to $465 million this year.

Our tax rate was a little better year over year, a little lower, 36.6% in Q3 this year versus a 37.1 last year. All that is is simply a function of a few discrete items that went our way versus balance out or go the other way sometimes.

In terms of a quick run-down of other topics, balance sheet -- bridge balance sheet and again by late morning our time, you’ll have on our website the Q&A, which will have the detailed balance sheet, as well as some other facts as well. But as of May 11th, cash and equivalents, $2.849 billion; short-term investments, 806; inventories, $5.306 billion; other current assets, $1.117 billion; for total current of $10.078 billion. Net TP&E of $10.249 billion, other assets of 876, for total assets of $21.203 billion.

On the right side, short-term debt, $63 million; accounts payable, $5.720 billion; other current liabilities, $3.743 billion; for a total of $9.526 billion. Long-term debt of $2.187 billion, recognizing $2 billion of that is the offering we did last year. Deferred and other, $298 million, for total liabilities of $12.011 billion. Minority interests of $77 million, stockholders equity of $9.115 billion, for a total again of $21.203 billion.

I’m always asked, so I’ll give you the depreciation and amortization number for the third quarter -- $150 million even. In terms of the balance sheet, while we’ve bought back a slew of stock and initiated a dividend four years ago, still quite a strong balance sheet. Debt-to-cap ratio of about 20% -- that’s again after buying back $4 million of stock and adding $2 billion of debt over the last few years. [inaudible] of continued financial strength.

In terms of accounts payable ratio, which is simply accounts payable divided by inventories, our reported number at the end of the quarter, [you shouldn’t just] simply take those two numbers I just gave you, was 108%. Part of that is construction payables. If you look at just merchandise payables as a percent of inventories, it will be 88%, recognizing that the end of third quarter is usually the seasonally low number of that, given that we are in the midst of lower sales post Christmas and getting ready for the summer.

A year ago, the 108 reported number compares to 105, so again improving, and the 88 number on a merchandise AP ratio this quarter compares to an 86 a year ago. Again I think that’s indicative of the fact that we’re turning our inventories ever so slightly greater and getting a little bit more dating from our vendors in some cases.

Average inventory per warehouse, up about $243,000 or 2.4% year over year. This year the average per warehouse was $10.506 million versus $10.263 million a year ago. Now, about -- of that $243 million, two-thirds of it or $160,000 is simply the conversion into U.S. dollars of our foreign inventories, so again that has to do with the weak FX. So really, it’s not 240; it’s more like 80 excluding that.

Some things, just looking down the list of each category -- over the counter health and beauty aids was up about a little over $100,000, in part due to some promotions that we were in the process of or getting ready to do. Basic food items -- I’m not talking fresh foods but I’m talking canned goods and pastas and coffees and things like that, up 66,000. Again, some of that probably is a little inflation and some of it is the build-up of inventory in strong areas.

Majors, down 85,000, nothing surprising there. That’s been an area that’s been a little weaker and we I think have done a pretty good on that [inaudible] inventories. Tobacco, mostly a conscious effort on our part, down 75,000 per warehouse. There are several warehouses that we don’t sell tobacco in anymore. It’s still a small percentage of the total company but less than 100 but not near the 400.

No inventory concerns at this point. We’ve been fortunate. We want to -- if anything, Jim and our merchants’ focus has been to keep our inventories as clean as -- as low as possible, recognizing when opportunities arise for price increases coming through, we want to be able to buy in and hold on to several extra weeks of inventory at the previous lower cost, so that we can keep that lower cost as long as possible for our members. And I think we are well-positioned to be able to continue to do that.

In terms of CapEx, recall that in ’07 we spent $1.4 billion. In the third quarter, we spent $370 million, or for the first 36 weeks of the year, $1.150 billion, pretty much in line with our budget. I estimate that for the whole year, we’ll still be in the $1.6 billion to $1.7 billion range, a fairly big chunk for the remaining 16 weeks but recognizing not only are we opening new units, net new units but we’ve also got several relos. I think for the year, we’ll have nine relos and I think I mentioned earlier, we had four so far, so we have five relos planned this fiscal quarter, versus zero last year for the entire year.

In terms of our dividend rate, as we announced probably a month ago, effective this month the Costco board approved an increase in our quarterly dividend from $0.145 a share to $0.16 a share per quarter. This $0.64 a share annualized dividend represents an annual cost to the company of just about $280 million based on our current share count.

In terms of Costco Online, it continues to do well at 24% sales increase in the third quarter. We should exceed $1.6 billion for the year. That 24 is down from the Q1 and 2, but given the fact that you’ve got a huge penetration of big ticket furniture items and electronics items, we think that’s still a fairly decent number.

In terms of expansion, to date we have opened 21 new units in the first three quarters. Now, of those new units, four were relos so really a net of 17 and then four relos, plus the one in Mexico that I mentioned. In Q4, we have eight net new locations plus five relos, so a total of 13 openings, eight of which count as additional open units for us.

For the year, that would put us at 34 openings, plus Mexico would be 35, less nine relos, so the 34 consolidated number would be 25 net new units plus Mexico would be 26. So about a 6% unit growth this year -- I’m sorry, ’07 it was about 6.5% unit growth. In ’08, it looks like it’s going to be about a 5% unit growth, close to a 6% square footage growth, given the slew of relocations, nine of them, as well as the 25 net new openings.

Total square footage at the end of the third quarter, some of you keep track of that, was -- and this excludes Mexico, was 71,786,000 square feet.

In terms of stock purchases, since June of ’05 and through the third quarter end, we repurchased 84.1 million shares at an aggregate price of $4.5 billion, or $53.44 a share. We still have repurchase authorization under our program of $1.3 billion, so a total authorization, aggregate authorization of 5.8, of which we spent 4.5. And if you annualize the 36 weeks on an annualized basis, I think it’s ticked up slightly from what I mentioned on the Q2 call, from about $900 million on an annualized basis for the first half of the year to an annualized basis of about $925 million for the first 36 weeks on an annualized basis.

Finally, before I turn it back for Q&A, let me talk a little bit about guidance. I did mention -- I think First Call currently is at $1.01 and it’s probably on the high end, if not too high. A few things I mentioned on the call was the fact that we are going to -- we would expect -- we see no let-up in gas price increases, while you have a day or two where they come down a little bit and then you’ve got another kick in the pants and it’s a week of upward movement, which is not good profitability wise in that area. And again, it’s just looking with blinders on just at gasoline. We think it’s done a very good impact to our business of getting people in our parking lot, many of which will then come into the warehouse.

But we would expect, not unlike Q1 where we had an anomaly, perhaps a fairly wide swing in strong Q4 profitability last year in gas versus weaker, particularly weaker numbers this year in that area.

The other question marks, of course, is we are only two-and-a-half weeks and we want to remain conservative. Again, we don’t expect any big surprises now in sales but tomorrow is another day.

The last thing I’ll mention is we are -- as you know, we are anniversarying our big increases in margin last year, some of which, you know, a good chunk of which was gas last year but a good chunk of which was also margin initiatives and if you’ll recall, I was looking back at Q4 last year, our reported $0.91 -- I’m sorry, our reported -- yeah, $0.91 normalized number in fiscal ’07 now is $0.08 a share better than our guidance in First Call, and when I look at that comparison, I probably should have looked at that a little closer last year in terms of recognizing it’s going to be a tough comparison when you did so strongly last year.

We still think we are going to be up and we will -- but it’s hard to quantify where we will come out and we will have to wait and see there.

In terms of that, I’ll turn it back over to the moderate for Q&A.

Question-and-Answer Session


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

Dan Binder - Jefferies & Company

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

Richard A. Galanti

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

And the second part of that?

Dan Binder - Jefferies & Company

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

Richard A. Galanti

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

Dan Binder - Jefferies & Company

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

Richard A. Galanti

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

Dan Binder - Jefferies & Company

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

Richard A. Galanti

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

Dan Binder - Jefferies & Company

Okay, thanks.


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

Richard A. Galanti

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


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

Jennifer Davis - Lazard Capital Markets

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

Richard A. Galanti

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

Jennifer Davis - Lazard Capital Markets

Okay. All right, thanks.


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

Deborah Weinswig - Citigroup

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

Richard A. Galanti

Well, on the initiatives, I mean, things that we’ve talked about really back in Q2 and Q3 a year ago, when we finally saw some starting in Q4 and into this year. You know, I think Jim’s comments in the past is we deserve to make a little more and we are going to do it our way and still not compromise our competitiveness. And we’ve been able to do that in certain -- probably a third to 40% of our items aren’t the commodity critical competitive items like paper good and milk and cheese and detergent and soda pop and Snickers bars that we and Sam’s and others are fiercely competitive on. And you are not going to win or lose the game because we are both making very competitive low margins on that stuff.

One area where -- you know, we all have -- even though we all have Christmas items in and wrapping paper and gift items and gift baskets, and even though we all have patio furniture and doormats and bedding, they are all different items in each location, at us versus a competitor. And on many of those items, we have to make sure that we, even though if we have a stated 14% or 15% cap on our margin, make sure that we are costing it right and one of the things historically that we really didn’t do and chose not to do was run our depot operations, which we view as a major competitive advantage, structurally in our industry and exaggerate it at Costco because of fewer items and more palette load quantities that we -- and the same thing with our department, that those deserve to be, make some profit sometimes. And we can still remain very competitive on the items.

I’m beating around the bush a little bit basically to make a little more margin on selected items, and given that when you are talking about 4,000 items, 60% of which you are not going to touch anyway, they are fiercely competitive commodity items every day, it’s pretty easy to manage on an item-by-item basis, and there’s only a few people, starting with Jim and Craig, the head of merchandising, and the senior merchants below Craig, that with Jim as the governor, we are going to still maintain our integrity and maintain the integrity of what the buyers do but still be able to learn a little bit more.

On the availability of additional goods, I’m not going to do what I did last quarter and use examples, real examples. You all go into the warehouses and you will very well see many branded items you’ve never seen before in apparel, in tools, and many of these items are great for us, and because they are high quality, high-end brand items that typically you only see at the high-end department stores and specialty stores, and in many instances because of the weakness of what I’ll call the mall business right now, there’s goods out there and they’ve got to get rid of them. And we are the highest end discount operation out there and we’ll take it all.

And there are many items out on the floor right now that if they retail for a buck and wholesale for $0.50, we are going to sell them for $0.55 or $0.56 or $0.57 and save you $0.45.

So one, I think that’s -- when you look at apparel, even though apparel -- I don’t know, you know what the retail apparel number is down in the retail apparel industry. It’s probably down 5% to 20% at different stores. At Costco, it’s up a few to 10%. And that’s because of availability of those items.

Deborah Weinswig - Citigroup

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

Richard A. Galanti

I’d say continually.

Deborah Weinswig - Citigroup

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

Richard A. Galanti

In terms of -- if you look at unit percentage where we were up 6% in units or 6.5% in square footage in ’07, and I think we started ’08 with the assumption we’d be kind of the same percentage but if we were going to have net new units in the low 30s and we ended up at 25, inevitably one or two may have died but most of them were just pushed. We are aggressively trying to get them into the year and for whatever reasons, they got delayed, which happens every year, as you guys know.

My guess would be is that it’s more likely -- I haven’t seen any finalized budgets for ’09 but my guess is in terms of net number of new units, if it were 25 in ’08, it will be at least in the high 20s in ’09 and we’ll probably start with a budget in the low 30s and work down from there a little bit.

So my guess is it will either be a stronger 5% unit increase or average up to a 6.

In terms of availability, I think two things -- one is we probably have gotten a little tougher on ourselves in some of the new markets to make sure that we are not just opening to try to get them open but make sure that we try to balance new markets versus existing markets.

I know that we are in a few shopping centers now, which we were never invited in shopping centers -- recognizing when I say in shopping centers, typically it’s on the parking lot premise adjacent to or barely connected physically to a mall. And guess what? They like it. We bring on average 3,200 front-end transactions to our warehouse, which means on average probably close to 5,000 upscale members to that parking lot. And we may sell a diamond ring or a strand of pearls but from what we’re told by the shopping center developers, the Neiman Marcuses and the jewelry stores and the apparel stores like the traffic, notwithstanding the fact that we might sell a few of those items.

So I think there will be a little more of that in the future. In terms of pricing, I spoke to Jeff [Rottman] just last week on that question and he says pricing is not going down; availability is going up. And it’s -- but it’s not a wholesale supply sale, or -- recognize too is we want prime spots and even in a down retail real estate economy, prime spots don’t go down as much. But we are seeing more availability.

Deborah Weinswig - Citigroup

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


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

Adrianne Shapira - Goldman Sachs

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

Richard A. Galanti

You know, it’s funny -- years ago, and you all have known us for a while, have heard me quote before Jim talking about couponing is like drugs. You take it and it works, but you keep needing to do more of it. And we went from what was originally probably an eight-week summer passport to a 10-week to a 12-week and then we started with a six-week winter wallet, it’s now 12-weeks. And a few years back, we did a mailer for those three days after Thanksgiving and we do some handout coupons.

We are trying -- over the last year, we’ve tried to not increase it and to wean ourselves a little, recognizing we still want to be in the net [landed cost to low] business, but we can’t sit here and say that it doesn’t work. The vendors like it. They see directed sales on those items. There are times when during that two week or whatever week period it is, they will see anywhere from a two or three times increase to a 15 to 20 times increase in their sales, particularly when it’s a new item that’s a recurring purchase, like a food item. There’s nothing better, a food item or a disposable item, whether it was years ago the Swiffer mop or a new cleaning agent.

So the vendors love it. I don’t see it going away. I don’t see it being incrementally big. We probably are doing a little better job of also fine tuning it and not just massing out the same thing to 20 million members but being a little smarter about segmenting, and the key word there is little. We still want to keep things simple and do it our way, but it’s here to stay.

You know, we look at the wallet and the passport and then we also look at what we call these multi-vendor mailers. I’m sure you’ve seen them in the mail, hopefully -- if you haven’t, call me. And again, these are more segmented to specific items. The fence, as an example, when you walk into the warehouse, one week it might be summer stuff and the next week it might be vitamins and then next week it might be an entire fence of P&G items. So there’s lots of vendors across many categories that really see very dramatically the impact of that and hey, it’s great for our members and we just have to recognize that there’s a limit to how much you can do forever.

Adrianne Shapira - Goldman Sachs

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

Richard A. Galanti

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

Adrianne Shapira - Goldman Sachs

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

Richard A. Galanti

Let me -- I think the best way to tell you the story in a vague a way as I can is back a year ago when we talked about prior to hitting very strong margins in Q4 last year but you know, back in Q2 and Q3 when I started talking about the margin initiatives and we’re going to do it this time and the whole bit, and at the time on these very same conference calls, some of you would ask well, do you think it could be 15 basis points or 20 basis points a year for the next three years? And of course, I’d say something like “I wouldn’t touch that” and then finally somebody would say do you think it would be 10 or 15 a year for a couple or three years? And I’d say maybe, but recognizing we don’t know, exactly. We’re not there yet.

And then the question became once we hit 25s and 35s year-over-year improvement, the one [facility] we started before we had last year’s -- reported last year’s fourth quarter that total consensus out there, buy-side people, sell-side people, us, you name it -- everybody was on the same page and over the next three years, we could get 10 or 15 a year and let’s round that number to 40 for three years. I’m just making this up as I go along.

If it was 40, the next question you would expect me to get is over the last few quarters, as we’ve gotten 30-plus a quarter, they are saying oh my god, is there only five or 10 left? And my comment has been when asked that question, either on a big call or on a little call, is my guess is it’s more than that. But is it still 10 or 15 a year? I don’t know. What I do know is in talking to merchants and Jim, and Jim will be the first to start every sentence with we are not going to do things that compromise our sales. We are a top line company because that’s -- only good things -- only bad things happen when you’ve got lower sales, only good things happen when you’ve got higher sales. But we are, as he said time and again, smart enough to figure out how to do it.

I think and I believe that talking to merchants and to Jim, that there is more on the table but we are going to do it our way and until we get to these next few quarters post anniversarying the first year, it’s going to be hard to know exactly how much.

I’m not trying to be cute. I’m trying to be honest and I would say it has a plus sign in front of it but I can’t tell you how much.

Adrianne Shapira - Goldman Sachs

Okay. Thank you.


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

Charles Grom - J.P. Morgan

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

Richard A. Galanti

I think for the fourth quarter, the closer to now that I look out, the more confident I am, and recognizing sales help that number. The higher sales from gasoline inflation alone hurts margin and helps SG&A, so it’s a wash to the pretax line, but -- and certainly we are continuing to have inflationary gasoline. If you just did a simple calculation, I don’t know if it’s completely correct, and just took out the inflation component of gas year over year in Q3, any number on our income statement divided by, assuming flat gas prices, same gallons with flat gas prices, was like four basis points or something, even plus or minus and again it averages out to zero.

And so my guess is that we now have anniversaried the dollar an hour increase, we have no plans to gut-punch you next quarter on anything specific, so yeah, I think that -- will it be 12? I don’t know. I’d be thrilled if it was five or 10 or zero -- as Bob just said, zero to 10. I’m not trying to bring you down because we know anything more but we’ll have to wait and see. But my gut tells me it won’t be 12 but it will be something.

Charles Grom - J.P. Morgan

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

Richard A. Galanti

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

Charles Grom - J.P. Morgan

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

Richard A. Galanti

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

Charles Grom - J.P. Morgan

Okay. All right, thanks very much.


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

Mark Wiltamuth - Morgan Stanley

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

Richard A. Galanti

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


Your line is still open.

Richard A. Galanti

Okay. Thank you.


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

Peter Benedict - Wachovia

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

Richard A. Galanti

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

Peter Benedict - Wachovia

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

Richard A. Galanti

Not really. Keep in mind also, a lot of it is seasonal stuff. You know, when we bring in lawn and garden, us and Sam’s, while we both will carry the same Tide detergent and the same M&M’s and the same Snickers, 36 count of Snickers bars, when we bring in swing sets and patio furniture and doormats, or at Christmas time when we bring in a different SKU or pack size of wrapping paper or ribbons or snow globes with the music box, or gift packs, all these things are unique and what we’ve done is to say hey, we deserve to make more money as a company. We’re not going to make it by trying to make more money on fiercely competitive commodity items, which is -- you know, you are just not going to do it competitively and where we can do it is on certain import items, certain seasonal items, and it is more of an item, just like our company is, an item driven basis of where we can do that.

You know, I use the example of, even of some produce items, I think we do one of the best jobs of being in season for more weeks a year on seasonal produce. The example that I’ve been given by our people here is grapes, which is a $100 million plus business for us now and if the food chains in the country, the supermarket chains are in grapes -- and when I say in grapes, they are in big sizes at reasonable prices half the year or 20 weeks a year, we are in grapes for 40 weeks a year or 35 weeks a year and we can make a better margin, particularly during those weeks when nobody else can sell the size and quality that we sell.

I think the recent presentation I saw, we are now procuring produce from 28 different countries and utilizing some of our international sourcing from our regional or international operations. And we can use our global buying power when somebody in Asia is going out to get some of those items in other parts of the world.

So you know, it’s nothing brilliant. It’s structurally I think we are unique in a lot of ways and that’s just one of the benefits we have.

Peter Benedict - Wachovia

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

Richard A. Galanti

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

Peter Benedict - Wachovia

Okay. Thanks very much.


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

Lisa Warner - Sanford C. Bernstein

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

Richard A. Galanti

On the first part of the question, the recent openings, I think we’ve had two or three openings in Asia in the last few months. They’ve done particularly well. I think I made a comment last quarter that one of our units, either in Korea or Taiwan that opened, if you took the average number of members that we have per warehouse in our whole company, recognizing the average warehouse does $130 million plus in sales and the average warehouse is 15 to 20 years old, so it’s been around for a long time, that I think we have about 56,000 or 55,000 members per warehouse. We opened a couple of units in Asia in the last few months which had more than 50,000 paid sign-ups on opening day, recognizing we collect -- you can come in and sign up usually during the six to 10 weeks prior to opening once we have a tent outside and the balloons and the parking lot that they can park in. So we’ve never experienced anything like that anywhere in our company, other than when we did freebies in new markets.

So those units are starting off strong. I don’t recall other international units -- you know, Canada, while it is international, it’s so much like the U.S. in terms of maturity and success and predictability that we really don’t get surprised. Those are good, successful units for us from the get-go. But in terms of new markets, I would say we’ve only opened up I think one in the U.K. in the last year, if that.

So overall, I’d say they’ve gone well. We have been -- when we see, and I think back to even a market like Chicago, which is not foreign but was new for us, and we opened our first Chicago unit at least 15 years after our competitor, Sam’s, had been there for a long time. And once we had one or two units, they did okay but they were certainly below average, recognizing it was a new market and in the first few years.

But it seems like whenever we go into any new market, be it a foreign country or even a major metropolitan area like Chicago, once you get past the three or four units, recognizing we don’t advertise but people know us better and we start to see all of them build a little bit faster. And we’ve seen that in a selected few markets that I can give you examples, like a Chicago here, and we are clearly seeing it I think in like a Taipei and a Seoul, Korea.

Lisa Warner - Sanford C. Bernstein

And how is Australia progressing?

Richard A. Galanti

By the way, my final comment on that was and these are countries, by the way, that have no gas sales, which is a big boon here in any market we go into because of it’s top of mind.

Australia is going. I don’t know -- does anybody have the -- spring ’09 would be the first unit and the second unit following within six to 12 months.

Lisa Warner - Sanford C. Bernstein

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

Richard A. Galanti

If I recall, our average ticket has been in the low 400s -- I want to say 425, 440, and I think in the last couple of quarters, it’s come down slightly. It’s still above four. I recall that from the last couple of budget meetings.

I think when we started the year back in the fall, comps were in the 40-plus range. Now they are in the mid-20s, but I have to tell you, one week it’s 10 and one week it’s 50. It’s just -- I think it depends partly on what we are selling.

I think part of it is we are still getting much better comps online in electronics, as an example that in-store, that’s what we sell. So we are still doing it our way. It’s a limited selection. It’s 80%-plus of the goods are not overlapped with the warehouse. They are extensions of what’s in the warehouse and it’s -- you know, $1.6 billion is nothing to [shout about].

Lisa Warner - Sanford C. Bernstein

Thank you, Richard.


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

Mitchell Kaiser - Piper Jaffray

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

Richard A. Galanti

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

Mitchell Kaiser - Piper Jaffray

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

Richard A. Galanti

No, because I don’t know if we have calculated it out that way. Our MO is again pretty simple and straightforward. We are going to hold prices as long as we can, and as long as we can means if we bought in, we are going to keep it longer than everybody else at the lower price and not make anything, but -- whereas some retailers will choose to bring up the price quicker. And also we are going to be subject to what our competitors do. Even if we feel we need to raise the price on a very competitive item, we’re not going to be the first one to do it.

I think the good news there is that we all are in the same boat. We all have inflationary cost expenses to deal with and I think the expectation of our customer is that there’s some inflation out there that has to be passed on, but we are always going to be the last to do it. Now, last doesn’t mean we’re waiting a year. Last could be we’re waiting until after they do it and then we are going to -- it’s also subject to see if there’s a big impact on sales volume, but again I think anecdotally, the story I told before about a couple of years ago with rising commodity costs increasing for wood and pulp and energy costs related to producing all kinds of paper goods, from Pampers to toilet tissue to paper towels to copy paper, you had to -- I remember hearing the stories here internally back in early ’06 that the manufacturers are talking to the retailers, be it us or I’m sure Wal-Mart and Target or the supermarkets as well, that we are going to have start raising some of those -- they are going to have to start raising some of those prices to us.

And I think it was the purchasing power of us collectively that was able to A, hold off on some of those increases and B, when they came through, they probably were less than the manufacturers originally wanted to. Ultimately, they said next Thursday, this is the new price. We did our job of holding them off as long as possible.

I think in today’s environment, we see more manufacturers just bringing you increases. Now, we have a little bit of an advantage in the sense that we don’t have to sell all four brands and all six sizes of something, so if anything, we can push a little harder, knowing that we are prepared to sell Brand A instead of Brand B, because they are both high quality, national brands.

But I think probably there’s an expectation out there that you know, there’s nothing you can do with energy costs and production costs and freight costs going up like they have.

Mitchell Kaiser - Piper Jaffray

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

Richard A. Galanti

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

Mitchell Kaiser - Piper Jaffray

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

Richard A. Galanti

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

Mitchell Kaiser - Piper Jaffray

Okay. Fair enough, thanks. Good luck.


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

Joseph Feldman - Telsey Advisory Group

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

Richard A. Galanti

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

Joseph Feldman - Telsey Advisory Group

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

Richard A. Galanti

Well, I think -- I believe it’s two things. I believe that the economy is hitting big ticket sales and even -- and the other thing is as flat screens went from $4,000 to $3,000 to $2,000 to $1,000, that people were buying them, so a combination of a weaker economy and the fact that everybody always has two or three of them, that all those things together impact it.

I give the story personally that for 10 years, let’s say throughout the 90s, our family had one big expensive $2,000 Mitsubishi 35-inch, plus a couple of little TVs, and one camera. I think since 2000, we’ve got three or four flat screens and five cameras. Every time they come out with more megapixels and a smaller size and they give the old ones to the kids and you -- so I think everybody’s got a bunch of this stuff.

Even things like Blu-Ray, not everybody is rushing out to buy Blu-Ray yet. People are tired of spending several hundred dollars on a new machine and they don’t want to do away with everything yet.

So I think consumer electronics will continue to come out with great, cool stuff and it will -- it’s been so strong for so long, in my view it’s almost like a breather, and there’s still a lot of great stuff coming out but in these trying times, even if what you perceived was a -- well, you know, you can get a great laptop now for under $1,000. It wasn’t two years ago that it was over $2,000. And so I think that even though it is under $1,000, you are not just rushing out to get the new and latest and greatest because your old one does movies and Internet, e-mail, just fine. And not everybody needs 28-gigahertz, or whatever.

Joseph Feldman - Telsey Advisory Group

Right. Great, thanks very much and good luck.


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

Robert Drbul - Lehman Brothers

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

Richard A. Galanti

I look at it as even though it was lower by six basis points, you know, it’s 10.5% member growth or dollar growth, and on 6% square footage growth, I think we’re doing pretty well.

Again, when we first looked at it, I said what the -- because it’s usually flat or something. If you just take out gasoline inflation, and that’s a simple mathematic equation, it’s minus two or three basis points, not six. But again, if you take out cost of sales, we’re a lot more profitable too, so you can’t just take out things.

I think our marketing, our membership department feels very good about the initiatives we have underway. I think we’ve seen it in frequency, we’ve seen it with even some of the things that our partner, American Express, has done. You know, 3% on top of the 1% you get on all other Costco things at Costco gas stations, is -- and it’s nothing we’re paying for, it’s getting more people to get that piece of plastic in their wallet, that’s working. And anything that we can do to drive business, I think we are doing a pretty good job of doing that.

What we are not doing is TV advertising or crazy stuff that’s not on our list, and I think we are going to be focusing on the value proposition. So I think that we are doing fine there.

Robert Drbul - Lehman Brothers

Okay. Thank you very much.


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

Sandra Baker - Mortez & Caldwell

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

Richard A. Galanti

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

And the second question was?

Sandra Baker - Mortez & Caldwell

Competitive environment.

Richard A. Galanti

I think we and Sam’s continue to be fiercely competitive. When we look at our most competitive markets that we define as our new markets, where in the last six or eight years we’ve gone for the first time and they had been there for 15 years, like Texas, like the Midwest, on a market basket of 100 commodity items, there’s very -- you know, there’s less than a half-a-percentage point different sometimes, and we are both in each other’s warehouses more than once a week club shopping key items. And so they continue to be competitive, and [it’s not getting any worse]. I think that BJ’s has gotten more competitive since some of their management changes of late. It seemed like for a couple of years, we were not club shopping them nearly as often because margins were so different. They are still not as tight as us versus Sam’s but we club shop to them more regularly.

And so there’s no rush to improve profits by being less competitive. I mean, it’s still fierce out there.


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

Lisa Warner - Sanford C. Bernstein

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

Richard A. Galanti

I’m confused a little too, but I’ll give it a shot. I think first of all, as a good retailer should be, we push hard not to get price increases from our manufacturers. Ultimately we recognize that when such an increase does come through, it’s only after we’ve delayed it as long as possible and mitigated the size of it. At such point that it comes through, we are going to buy in as much as we can at the low price. Typically manufacturers will allow you to buy in a certain number of weeks of your average prior week sales, purchases from them. And then we are going to typically hold the low price longer than our competitors.

But ultimately, we are not in the business to lose money. Are we in the business to make a little less, if necessary? Yes, but I’d say it’s not 100% efficient but 80% efficient in terms of the timing of when we can pass through things. But we don’t just look at something, well, it cost us 3% more from the manufacturer so we’ve got to raise the price 3% tomorrow.

I think where we can offset some of it to the extent that it [inaudible] sometimes in that, is on those other initiatives, whether it’s private label penetration or identify those items where we can add, if you will, a little margin because of the value of our depot operation in our import department.

We can talk offline and try to better explain it but there’s not a whole lot to explain there beyond what I think I just said.

Lisa Warner - Sanford C. Bernstein

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


(Operator Instructions)

Richard A. Galanti

Okay, well, thank you, everyone.


There are no further questions at this time.

Richard A. Galanti

Thank you, everyone.

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