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Costco Wholesale Corporation (NASDAQ:COST)

F4Q08 Earnings Call

October 8, 2008 11:00 am ET

Executives

Richard Galanti - Chief Financial Officer, Executive Vice President and Director

Analysts

Adrianne Shapira - Goldman Sachs

Mark Miller – William Blair & Co.

Mitch Kaiser – Piper Jaffray

Charles Grom - J.P. Morgan

Robert Drbul – Barclay’s Capital

Peter Benedict - Wachovia

Mark [Lodameath] – Morgan Stanley

Dan Binder - Jefferies & Company

John Lehman – State of Wisconsin

Uta Werner - Sanford C. Bernstein & Co.

Charles Cerankosky – FTN Midwest Securities

Deborah Weinswig - Citigroup

Neil Currie - UBS

Sandra Barker – Montag & Caldwell

Joseph Feldman - Telsey Advisory Group

Operator

Welcome everyone to the fiscal fourth quarter and year-end results and September sales release for Costco conference call. (Operator Instructions) Mr. Galanti you may begin your conference.

Richard Galanti

As with every conference call I will 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 16 week fourth quarter of fiscal 2008 operating results for the quarter, we came in at a reported $0.90 per share compared to last year’s fourth quarter of $0.83 per share. Both fiscal fourth quarters included a couple of items that were pointed out in this morning’s press release. In last year’s fourth quarter we reported a one-time non-cash charge of $56.2 million pre-tax or $0.08 per share related to refining our accounting for deferred membership fee revenues. Excluding this charge our company has reported $0.83 fourth quarter last year in the fourth quarter it would have been $0.91.

Also mentioned in this morning’s release, this year’s Q4 included two items; a $0.05 per share LIFO charge, our first significant LIFO charge in years, and a $0.02 per share charge related to a litigation settlement. Together, these two items impacted the $0.90 fourth quarter number this year by $0.07. Excluding these items this year’s fourth quarter results would have been $0.97 and on an apples-to-apples basis the $0.97 would have compared to a more normalized last year $0.91. So, a 6% year-over-year increase on an apples-to-apples basis.

For the fiscal year we came in at a reported $1.28 billion or $2.89 per share compared to $1.08 billion or $2.87 per share for last year’s fiscal 2007. As you know, and as I will outline for you in a few minutes, there were a few other items in last fiscal year both in Q2 and Q3 of 2007. Again, I will go through all the details in a few minutes but for an apples-to-apples comparison we would look at a more normalized fiscal 2000 [sic] earnings amount of $2.63 per share and a more normalized fiscal 2008 excluding the two items we mentioned in the press release this morning at $2.96 per share. So on an apples-to-apples basis that is 13%.

In terms of sales for the quarter, as we reported on September 4 our 16-week comparable sales figure showed an increase of 9%. The 9% was comprised of 9 in the U.S., actually about an 8.5 and 11% internationally. I’m sorry, it was a 9.

We also reported September sales results for the five weeks of September with the U.S. coming in reporting 8, actually closer to 8.5; international coming in at 2 and therefore the total company coming in at 7.

For the five week September period the strong 8 comp would be a 6 without roughly 2.5% impact from gas inflation and given the real turnaround in the U.S. currency, the U.S. dollar’s relative strength to foreign currencies in the past month, the exact opposite of what occurred most of last year. Whereas most of last year we benefited when we converted foreign sales into U.S. dollars. In the first month here that 2% international comp would be an 8 if expressed in local currencies.

Other topics I’ll review this morning is our opening activities. We opened a total of 24 net new locations during fiscal 2008 which ended August 31 plus one in Mexico. Of those 24, 15 were in the U.S., four in Canada, one each in the U.K., Taiwan and Korea and two in Japan. We also relocated a record 10 units in fiscal 2008 to bigger, better located facilities compared to no relocations at all in 2007.

For fiscal 2009, our current plan is 25 new locations, about ¾ of which are in the U.S. plus two in Mexico as well as possibly 2-3 relocations.

Lastly, I’ll review with you our in-store business results, our online results, membership trends, data on recent stock purchases, a few comments about inflation, our balance sheet for fiscal year end and lastly I will provide you some guidance and direction for Q1 and the upcoming fiscal year.

As I review with you our fourth quarter and fiscal year results I will discuss not only the reported figures but also the year-over-year comparison on an adjusted basis. That is without the various notable items that impacted our fiscal 2007 second, third and fourth quarters and the impact of the items we mentioned in the press release today on the fourth quarter for 2008. We believe these more normalized results are important as they provide a meaningful comparison of prior period to current period earnings exclusive of these items. These normalized results are also expected to be more representative of the future recognizing full well that things like LIFO are pretty unpredictable and litigation tends to be the name of the game these days.

So with that said, reported sales for the fourth quarter, the 16 weeks ended August 31 were $22.6 billion, up 13% from last year’s $20.1 billion. On a comp basis, Q4 comps were up 9%. For the quarter our 9% comp sales results were a combination of an average transaction of a little bit better than six for the quarter with continuing strong average frequency increase of about 3% for the quarter.

Keep in mind the 9% U.S. comp and the slightly greater than six average transactions both include about 300 basis points from gasoline inflation year-over-year in the fourth quarter.

Now for the five weeks in September, again U.S. comps came in at a reported 8 or 8.5 with about 2.5% of that coming from gas inflation so again about six without gas. So both for the quarter and the first month of this year the non-gasoline U.S. comp would have been a 6.

Our international results in the fourth quarter had an 11 comp again through all of last year and again it has continued trending towards the other way in the fourth quarter and still the U.S. dollar was relatively week year-over-year so our international results our 11% international comp was actually an 8% in local currencies. Again, with that big 180 degree swing in just the last several weeks the 2% international comp in September was really an 8% in local currency.

Our average building continues to enjoy great sales productivity. In 2007 company wide our average warehouse generated $130 million in annual sales and for the U.S. $132 million. For fiscal 2008 the average company wide has gone from $130 million to $137 million and the U.S. has gone from $132 million to $138 million. So very strong average sales productivity per location.

In terms of, I’ll give you a little flavor geographically what is going on with comps. Certainly the Midwest and Southeast are of course the strongest regions. The Midwest is relatively young relative to the Southeast so both had pretty good showings both in the quarter and in September.

Internationally our Asia operations were the strongest. We are seeing some great growth in the three countries we are in over there in terms of sales strength. In terms of merchandise color from the comps, certainly the last several months has become a story of almost bimodal comps. The non-discretionary food, sundries, health and beauty aids, fresh foods, tends to range anywhere from the high single digits to the mid-teens whereas the bigger ticket non-discretionary items like furniture, jewelry, electronics and even some of the lesser ticket food items like house wares and domestics tend to be in the zero to minus 10-12 range. So all over the board there. Certainly benefiting from the food strength and getting people into our buildings.

Within food and sundries, notwithstanding the fact that food and sundries is a high single digit comp, that includes a negative comp in tobacco which is about 11% of food and sundries so reflecting an even stronger if you take that out. While food is showing strength in the economy as I mentioned non-foods has not. Within our slightly positive hard lucks comp, office and major were slightly negative, actually a shade better than they had been on the major side. Most of the other categories were mid single digit positive so not terrible.

Within the slightly negative supply comps the unusual outlier on the high side was small electrics, up low double digits with both men’s and women’s apparel being just slightly below flat. I think that is an indication that notwithstanding the fact general retail apparel sales are quite weak, our ability to access many brand names in that area has helped us in that area.

Fresh food came in the high singles with bakery, deli and produce being in the low doubles and being in the mid singles. Ancillaries again taking out gas which is off the charts high with gas inflation and a little bit of gallonage comp, excluding gas ancillaries tend to be in the mid singles.

In terms of September sales results, the 7% total company comp again included an eight in the U.S., a six without gas inflation, a two internationally and eight without foreign currency on a local basis.

FX for September, again last year it was generally 50-200 basis points positive to our company comp. In September it was a hit of 130 basis points to the whole company. As I mentioned, gas inflation is a little over 2.5%.

In terms of looking at the 8% number for the U.S., the average ticket is pretty evenly split between the average ticket and the average traffic, about 3.5% each.

Moving down the line items in the income statement, membership fees again last year we reported member fee with $56 billion charge to it, a non-cash charge to it, so last year’s reported membership fees were $388.2 million or 1.93% compared to this year $473 or 2.09%. Excluding this one-time hit to membership fees last year, again on an apples-to-apples basis, our membership fees last year would have been $444 or 2.21% compared to $473 or 2.09%. So an increase of $29 million exclusive of that one-time charge last year, about 7% increase in reported dollars. About 8% on a cash basis and about 12 basis points lower.

Again, that negative basis point is skewed somewhat by the fact you have a disproportionate increases in sales in gasoline which distorts many of our percentages which I’ll go over again in a minute as it relates to merchandise gross margin and SG&A.

In terms of number of members at year-end; Gold Star 20.2 million, up about half a million from Q3 end; business primary 5.6 million, up about 50,000; business add on about 3.4 million. So all totaled 29.2 million total members or about 57,000 per warehouse average, a shade better than the 56.8 thousand we had at Q3 end.

Including spouse cards we ended fiscal 2008 with 53.5 million cards out there versus 52.6 million just a quarter ago and 50.4 million a year ago.

At fiscal year end on August 31, our executive membership continued to grow 7.63 million members. That is an increase of 344,000 just in the 16 week fourth quarter or about 21,000 a week increase during the quarter. For the year, paid executive membership increased by 1.3 million members or just over 20% of the base increase. The 1.3 million increase in executive membership is actually slightly greater than the 1.1 million increase we had in fiscal 2007. Benefiting in part from rolling out in Canada well over a year ago and certainly continuing to promote it on our own end.

I should point out that this 26% of our membership base, up from 23% a year ago, generated about 57% of our total U.S. and Canadian sales. This percentage continues to increase faster than the remaining part of our membership.

In terms of renewal rates they remain strong with an all-time high renewal rate of 92% on the business side, 86% on the Gold Star side and 87% company overall.

Going down to the gross margin line, please bear with me as I go through our year-over-year Q4 margin comparison. There are a lot of moving parts. LIFO inflated gasoline sales, gasoline margins, sales and exchanges such as weaker higher margin soft line sales and of course the lag in passing some of the inflationary product and freight costs which I spent a bit of time discussing on our July 23 guidance conference call.

So starting with our reported gross margin it was lower year-over-year by 45 basis points coming in at 10.29 this year versus 10.74 last year. I’ll try to limit all the numbers I actually put on the matrix but let’s do three columns; Q3 2008 year-over-year, Q4 2008 year-over-year and then fiscal year 2008 year-over-year.

The line items would be merchandising, core merchandise; second line item would be ancillary businesses; third would be 2% reward; fourth would be LIFO; the fifth line item would be the federal excise tax claim which will go away soon; the next line item would be the returns gross margin adjustment; the last item would be the returns sales adjustment. Keep in mind those last two relate to the changes we made in fiscal 2007 to our sales returns and how we accounted for sales returns and the reserve not only for sales but associated gross margin where we had some big variations in our percentages there and then total line.

So going across, merchandising year-over-year in Q3 we picked up 27 basis points, +27. Q4 minus 19. All of 2008 +17. Ancillary businesses, -9 in Q3, -6 in Q4 and -13 for all of 2008. 2% reward, -1, -2 and for the year -3. LIFO, zero Q3, -14 basis points in Q4 and -5 for the whole year. Federal excise tax claim, zero, zero and -1. Returns gross margin adjustment +32, -4 in Q4 and +14 in 2008 for the whole year. Return sales adjustment, -16, zero and -8. Totaling all those numbers for the total Q3 year-over-year we had +33 basis points, Q4 -45 and for all of 2008 +1.

Now let’s start with the core merchandise margin being lower year-over-year by 19. As I’ll discuss in a minute, three of the four departmental gross margins were up year-over-year and that is despite some of the lags in passing on some of the freight and merchandise costs I spoke to you about on July 23 as well as our decision to hold prices on a few items like the rotisserie chicken example I gave on July 23. That simple example, I estimate, was about $3 million to margin in the quarter.

Our core merchandise sales, which is food, sundries, hard line, soft lines and fresh foods, represents between 75-80% of our total sales. During the fourth quarter three of these departments, all but fresh foods, showed year-over-year gross margin gains ranging from 10-90 basis points. One showed a gross margin reduction of about 50. Altogether these four core departments divided by their respective sales, again representing over ¾ of our total company sales, actually showed a year-over-year gross margin increase of 19 basis points and that is on top of last year’s fourth quarter year-over-year increase core gross margin of 34 which of course is when we initiated some of the margin initiatives and we had a big quarter starting last year. So despite the fact we anniversaried that and despite all the things I just talked about, the core business is doing just fine in terms of margin strength and having pretty decent sales results relative to industry.

Where we get hit of course is reduced sales penetration of these areas as our low margin gasoline business saw few full year-over-year sales penetration increase from 8% of total sales last year in Q4 to 12% of total sales in this year’s fourth quarter. I’ll speak to that in a moment.

In terms of our major ancillary businesses, pharmacy, optical, one-hour photo, food courts and hearing aides, which was a -6 basis point to the total company gross margin variance, pharmacy and hearing aides actually showed a bit of improvement year-over-year in Q4. However, one-hour photo, food court, optical and gas were lower year-over-year. One-hour photo of course is a challenged business right now given the nature of people printing some of their own things and the whole transition over the last few years. So, again we still are quite profitable in that area but in terms of year-over-year there is a negative there.

Our food court margins were down year-over-year in the fourth quarter but they actually showed some significant improvement trends in the first three quarters of this year compared to the first three quarters of last year our profitability in our food courts showed a detriment of 200 basis points on margin. Whereas, in the fourth quarter on a year-over-year basis it was about ½ percentage point to 55 basis points. A lot of that has to do with the fact we maintained prices on things like pizza and hot dogs. If you’ll recall it was probably a year ago when raw material costs like cheese was up I think about 80%. Some of those things have subsided and we’ve gotten a little bit better in that area as well. Nonetheless, a little bit of a drag.

Gasoline sales are the big factor here. While I’ll show you in a moment how it helped our SG&A percentage, the tremendous increase in gas prices, 36% year-over-year in Q4, this big increase in gas sales penetration and remember gas on average runs 700-800 basis point lower margins than the rest of our business overall. That much gross margin on 400 basis points of higher sales significantly and negatively impacted our total margin. You see that in the core margin explanation I just described.

Before I continue on with other items impacting Q4 gross margin a quick comment on gasoline profitability in the quarter. As you recall, Q4 began back in mid-May with significant jumps in the price of gasoline and the expectation at that time that price increases in gasoline would continue throughout the fiscal fourth quarter. As you recall, we make less or lose a little money during those times of rising gas prices and during times of falling gas prices the converse happens.

We said as much on the May 29th Q3 earnings conference call. Then on our July 23 conference call where we were revising downward our overall earnings expectations we mentioned as one of the factors is that gas, while it would still probably be negative, it wouldn’t be as impactful as we had anticipated back in May. In the end the impact year-over-year was not a negative impact.

Next on the gross margin explanation list is LIFO. As outlined in our press release, LIFO represented a $32.3 million or 14 basis point charge to gross margin in the quarter. As I discussed on July 23, the rate of merchandise cost increases as well as freight cost increases in the then prior eight or so weeks had begun to expand and accelerate with more cost inflation showing up in our U.S. inventories, which LIFO is a U.S. merchandising accounting concept. A potentially large LIFO charge was likely. Ultimately, the charge was the $32.3 million we took or $0.05 per share.

The LIFO charge of course is a non-cash charge to our cost of sales resulting in from a timing standpoint a positive cash flow. Now why a charge now when there were not LIFO charges in the second and third quarters of last year? There was certainly a little inflation then. Well we began fiscal 2008 with a $57 million LIFO credit reflecting slight inflationary merchandise cost trends prior to fiscal 2008. While you can’t book a LIFO credit to income, you can use it to offset future LIFO charges. So in fiscal quarters one, two and three any merchandise cost inflation and therefore some LIFO charges were offset by our $57 million LIFO credit built up from previous years.

I stand corrected. It is $52 million LIFO credit, not $57 million.

Year-to-date through the third quarter our beginning fiscal 2008 LIFO credit went from a little over $50 million to a little over $10 million so we began fiscal fourth quarter with the expectation that any Q4 inflation would be offset at least in good part by the remaining LIFO credit. Of course that was indeed the case.

Okay back to our gross margin for Q4. The finalized amount in our matrix of factors is the margin impact in quarterly changes in our sales return reserve and the related impact to gross margin reserve. In the fourth quarter it was a -4 basis point hit to margin. Basically a line item to our matrix I added a year ago when we started seeing the benefit to this item resulting from the change to our electronics returns policy a year and a half ago in March, the -4 figure is still an improvement but a much smaller improvement as compared to last year’s fourth quarter figure. Essentially it is zeroing out now and this is a line item in the matrix I’ll probably take off in the future and it will just be part of core business.

So all told, a -45 basis point year-over-year decline in reported gross margin includes continued margin improvement in our core merchandise sales; fresh foods, food and sundries, hard lines and soft lines, greatly offset by a significant sales mix change from 10-12% margin in core merchandise sales to 2-5% gross margin in gasoline sales. Add to that some weakness in our ancillary business margins and a 14 basis point LIFO charge and you end up with the 45 basis points. Hopefully that gives you a little explanation and more importantly a little comfort that our core business is just fine and one day we’ll get off this seesaw with the craziness in gasoline and inflation.

In terms of our gross margin outlook going forward as you just witnessed with my long-winded explanation of Q4 year-over-year gross margins there are a lot of moving parts. The impact from increasing executive member business should continue to be a small hit to the reported gross margin, low single digits it looks like. LIFO, who knows? Some of the inflation pressures we were starting to be concerned would continue have subsided a little bit, certainly as it relates to commodity pricing and gas pricing. It is hard to know for how much and for how long.

In our budget this year we simply assumed an $8 million LIFO charge each quarter but that is only an estimate and a guess. If the economy stays weak the LIFO may be less and if there is a lot of money pumped into the system it may be more. Your guess is as good as ours on that. But we expect our core merchandise groups should continue to be okay, slightly positive at least so far in the first month of this year that is current.

Moving on to SG&A. On a reported basis SG&A was lower year-over-year or better by 15 basis points coming in at 9.66 versus 9.81. Again, I’ll just ask you to jot down a matrix and in this case we’ll go back to Q2 so four columns. Q2 2008 year-over-year, Q3 2008 year-over-year, Q4 2008 year-over-year and then the whole fiscal 2008 year-over-year.

The line items are: Core operations; second line item is central; third line item is stock compensation both a combination of options historically and RSU’s; fourth line item is 409A, a small item; fifth item is sales returns and lastly quarterly adjustments for a total which would be the last line item.

Scrolling across, core operations year-over-year in Q2 2008 was -11 basis points meaning I use minuses as bad here so higher minus means higher SG&A year-over-year. -11 in Q2. +8 or better in Q3. +21 or better in Q4 and +5 for the whole year. Central, +2, +4, +3 and +3 for the year. Stock compensation, -3, -1, -3 and -2. 409A, +30, -1, +1, +5. Sales returns reserve, +15, +16, zero and +7. Quarterly adjustments, zero, zero, -7 and -4. So all told, Q2 year-over-year was lower or +33. Q3 was lower or +26. Q4 was lower or +15. The whole year lower or +14 basis points.

Now, first of all 409A recall in Q2 2008 it was simply the fact that in Q2 2007 we took a huge charge related to the stock option protection we offered to our employees and some of the charges we took related to the stock option dating over a ten-year private period. So that is just the offset that Q2 2008 is comparing favorably against that. The -1 was just a small update to that number. +5 of course is for the whole year-over-year comparison.

The sales return reserve again back in Q2 and Q3 of 2007 we reduced our reported sales by greatly increasing the sales return. So while by reducing sales in 2007 in 2008 we are comparing against that so that is the reversal of that. So that shows a plus here. A little confusing but basically take it out to look at a normalized.

Going back up to the top of this chart our operations were lower by 21, primarily payroll and benefits and certainly some of that was helped by increase in gasoline sales which is unfortunately a very low SG&A business to go with its low margin side. But overall, from our perspective payroll and benefits we did a good job during the quarter controlling it.

Our central expense improved year-over-year by three. Again, no big surprises there. Stock compensation expense higher year-over-year. That is simply the fact that when the grants were made a year ago the stock price was unusually strong so it was a little higher. This annual grant will be a little lower as you might expect because it is all based on what the stock is on the date of the grant.

Certainly SG&A has benefited from gasoline sales. In terms of SG&A outlook for FY09 a lot depends on sales levels; total company sales levels as well as gasoline. Remember, huge increases in sales hurts our gross margin but helps our expense percentage. That notwithstanding it is fairly unpredictable given what is going on out there with the various moving parts.

Next on the income statement is pre-opening expense; higher this year by about $1.850 million. It came in at $17.8 million versus $15.9 million. Quite a few more openings in Q4. Recognizing there is always some lag or actually some expenses that hit earlier than the actual opening, sometimes in previous quarters but last year fourth quarter we had eight openings. This year we opened 13 including six relo’s. So eight new openings in Q4 2007. Thirteen including six relo’s in Q4 2008. No real surprises in those numbers.

In terms of the provision for impaired asset closing costs in Q4 2007 we had a $4.9 million charge. In Q4 2008 we had a net benefit of about $6 million, a combination of some closing costs and more than offset by some gains and the sale of assets where we moved some locations and sold the underlying assets.

So all told, reported operating income in Q4 was up year-over-year from $555 to $604 or 9%. Again, excluding the charge last year in Q4 to membership of $56 million and excluding the two items in this year’s press release, that 9% number would have been up 7%.

Below the operating income line, reported interest expense was essentially the same year-over-year coming in at $32.1 million this year versus $32.3 million last year. Interest income of course was quite a bit lower, down by $24 million coming in at $35 million in the quarter versus $59 million a year ago. Primarily, a reflection of much lower interest rates as our cash balances have been relatively robust.

I would like to spend a minute speaking about our cash investment balances, which I spent a little time on the Q3 conference call and I think on the Q2 conference call. Recall in early last December we had about $1.1 billion of cash spread in several what was referred to as enhanced money market funds. In early December last year we received a call from one of the funds that the fund was stopping redemptions and that the net asset value of the funds would be allowed to flow and break the buck. This had not happened, I understood, since the early ‘90s at that time.

We immediately requested redemption of all the funds and fortunately as of last week we have redeemed $960 million of the little over $1.1 billion which was in essence reinvested in a variety of government funds. So we have about $190 million remaining. The underlying liquidation, as the underlying securities within these funds mature they are being paid off. A few of the maturities go out as far as early 2010, but pretty much on a prorated basis and so we’re seeing nice chunks of it come off and that has been in line all through this turmoil.

To date we have taken impairment charges of about $5 million and anticipate taking an additional charge in Q1 of $2-3 million. Again, a shoe drops occasionally in this area but it seems like there are still a lot of good credits in there and the good news is more than 80% of it has been redeemed with very little debt.

So it has been significantly more a liquidity issue than a risk of principle issue. We are fortunate of course that we have got much more liquidity than the funds we are invested in.

Now, when we switched from enhanced money market funds and we went beyond 2a-7 funds, normal corporate money market funds to government money market funds, one of those – the Reserve U.S. government fund which we had about $3 million in, as you recall about three weeks ago another reserve fund I believe called the Pilgrim Fund, which is a 2a-7 fund, a corporate fund, announced it was halting reductions and allowing to break the buck. Another first as I understand out there in a number of years.

With that, anything with the name reserve in it is what I understand had a run on the bank if you will. All the assets, all the underlying securities in these funds are government securities, some of which are now being backed by the big government – the federal government. But that too halted redemptions two weeks ago and they are developing a pay forward liquidation. The maturities of those spread generally over the course of one year and the average maturity is less than that. So, again we are not terribly concerned about any impairment in that at this point but it just shows you what is going on out there with liquidity. Again, we are very fortunate that we are among several of them and there have been no issues with any of those. Even with this one, it was a little unfair and had a little more to do with the name and there was a run on all the funds given the fact the other one broke the buck. This one has in fact been perfectly fine to date and again fortunately we don’t have liquidity we need here.

So that is what is going on out there. Just to fill you in on that.

Overall, pre-tax income was up about 4% year-over-year and up about 3% if you take out the items that I talked about ad nauseum here.

On to our tax rate, we had a couple of discrete items in Q4 that worked to our benefit including us winning an appeal on a tax previously paid and accrued for. The tax rate was about 1.5 point lower than it had been last year.

A quick run down on the balance sheet. Our August 31 balance sheet and of course we will have the question-and-answer available with some other information on our website shortly, mid-day today. Cash and equivalents $3.275 billion. Inventories $5.039 billion. Other current assets $1.148 billion for a total current assets of $9.462 billion. Net fixed assets $10.355 billion. Other assets $8.65 with total assets $20.682 billion.

On the right hand side, short-term debt is 140. Accounts payable $5.225 billion. Other current $3.509 billion. Total current $8.874 billion. Long-term debt $2.206 billion. Deferred and other 328 for total liabilities of $11.408 billion. Minority interest 82 and stock holders equity $9.192 billion for a total again of $20.682 billion.

Very strong balance sheet. Debt to capital about 20% with plenty of financial strength. As you will see here in terms of recorded accounts payable as a percent of inventories was over 100%, 105% last year fourth quarter end and 104% this year. That includes of course a lot of payables related to construction since we have $1.7 billion in annual capital expenditures. As I have said, if you took that out and really looked at merchandise AP to merchandise inventories at 87% a year ago and 86%, nonetheless 96% of our inventories are being funded with trade payables.

Our average inventory per warehouse is actually down about $157,000 year-over-year. It is really our best showing year in terms of reductions per warehouse. Last year in the fourth quarter end it was right at $9.99 million. That sounds like a retail price point. This year’s fourth quarter $9.843 million, so $150,000 less year-over-year. Additionally these figures also include a little extra buy-ins we are doing right now as prices go up and we are able to buy in additionally some supply, thereby allowing us to hold down the sell price a little longer for our members.

Really no inventory concerns. Our model itself is blessed with what we sell. Certainly our volumes and our inventory turns within our industry are blessed from the standpoint we are generally not at big risk for things and to date we haven’t seen any concerns there.

The reduction in average inventory per warehouse is consistent with our goal I mentioned last year in a couple of conference calls by reducing inventory per warehouse by half a million or a little more over a two year period. We are working on that and so far so good.

In terms of capEx fiscal 2008 for the year we spent $1.65 billion. I estimate that our fiscal 2009 capEx will be in the range of $1.7 to $1.9. My guess is it is more in the $1.7 to $1.8 range. Not only about 25 new units and two or three relo’s but also a little over $100 million for planned depot expansion across stocks and a big increase in our remodel activities.

I also want to mention our dividend. Every April for the last 4-5 years we have announced an increase as we did this past April. So now on a quarterly basis of $0.16 per share, $0.64 per share annualized dividend represents a cost to the company of a little under $300 million for the year.

Costco.com did well in the fourth quarter although its growth has been a little depressed the whole year. Sales growth in Q4 was 26% versus 34% for the whole fiscal year. Sales for the whole year coming in just shy of $1.7 billion, certainly beating our own budget. However, we have seen in recent weeks a slight reduction in the average ticket, not in frequency of transactions, but an average ticket. Recall that our average ticket here is over $400 so again indicative of the fact that big ticket items have certainly slowed and when you turn on the TV every day and see the news.

Next on the discussion list is expansion. For all of 2008 we opened as I mentioned 25 units, one in Mexico. We actually opened 35, ten relo’s and one in Mexico. For 2009 we expect again 26-30 new, 2-3 or maybe 4 but my guess is 2-3 relo’s, so 24-26 total and in addition to that Mexico in which we are going to consolidate a couple there.

If you look at 2008 the 24 net new units, again I don’t include Mexico because we don’t consolidate it, based on last year’s [any] base of 488 was 4.9% unit growth so a little over 5% square footage growth. Probably 5-5.5%. We ended the fiscal year with 72.6 million square feet. Fiscal 2009 if we assume we add 25 net new units on the base of 512 again that would be about 5% unit growth or again about 5.5-6% square footage growth.

Stock repurchases, since June of 2005 and through the end of fiscal 2008 we purchased 87.8 million shares at an aggregate price of $53.99. We still have repurchase authorizations on our programs of a little over $2 billion. We have a total of $6.8 billion of authorizations in the last four years. Authorization expires at various times between now and mid-2011.

For all of 2008 we repurchased 13.8 million shares for $887 million or $64.22 a share. We’re going to see what happens now. With liquidity issues we are going to wait and see, recognizing offsetting that is what is going on with not only our stock price but everybody’s stock price out there so we’ll see how the next year ago. We certainly have very strong balance sheet to do what we want to do.

Before I provide some guidance for the upcoming year, as we all know things are tough out there. Thankfully our comps have remained relatively strong. We believe we are continuing to build market share in our business and I think we have been in a good position to take advantage of available merchandise from manufacturers who wouldn’t sell to us in the past, to continue to be opportunistic on real estate possibilities and given the fact our food business has been so strong and our gas business has been strong bringing people into the parking lot. We have been fortunate in that regard.

As I mentioned, we have a strong balance sheet with good cash and investments. Our cash flow from operations both in 2008 and open 2009 are approaching or slightly exceeding $2 billion and strong membership fee income and strong renewal rates as well. So we are certainly congruent of what is going on out there with the economy but have appreciated the fact we benefited from a few things like selling food, like being the extreme value proposition, like having availability of some of those types of brands that historically wouldn’t sell to us, some of them are currently not selling but at least it is more available out there.

So we are hopeful we can continue to build and grow our business this year and certainly feel that we will gain market share during the course of it. Finally, before I turn it back to Tina for question-and-answer some direction for the quarter and the year.

I believe current first call for the first quarter is $0.64. We are comfortable with that and probably have a range which throws a few cents below it and a penny above it, but somewhere in the $0.60 to $0.65 but we feel that is an appropriate range.

For the year, I believe first call is down from six to 325 yesterday. We, like you, read the news every day and we are approaching fiscal 2009 very conservatively. I’m going to give you a very wide range of $3-$3.25 which is the top end of the range. Hopefully we can do more outwards the top but there are no guarantees out there. We are starting off with a decent first month which we closed but that is one of 13 four-week months we have here so we have to see. Again, we think whatever happens out there we are well positioned to do better than the average and we’ll see what happens.

Actually in terms of looking ahead 2009 as I mentioned we will post to the Costco Investor Relations site the balance and EPS calculations and a few other tidbits of information?

We will open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from

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[Author:kg]

Adrianne Shapira - Goldman Sachs.

Adrianne Shapira - Goldman Sachs

I was just wondering if we could spent a little bit more time on the core merchandise margin. If I understand it correct, perhaps to understand the classification, can you help us understand what gas impacted Q1 of last year?

Richard Galanti

I don’t have that handy. Gas last year it was a lot less of an impact just because of sales. You can take your own numbers; anybody can take some numbers and just to assume to get to a weighted average when it was 92.8 a year ago in the fourth quarter and now it is 88.12 in terms of sales penetration on GAAP versus non-GAAP. Pick a number on the levered 12 range for the company and actually if we are reporting something in the high 10’s it has got to be 12-ish and then gas is in the low single-digits and you can get a sense of how it is impacting. So the impact was a lot lower last year because it was only 2/3 of the penetration, 8 instead of 12.

Adrianne Shapira - Goldman Sachs

I’m trying to understand in terms of the classification of the core margins because it sounds as if the +19 basis points is encouraging but it seems like the swing is all due to the greater penetration of gas. I’m just wondering if we think about on a go-forward basis if gas maintains these levels what is the mix impact to margins going forward.

Richard Galanti

Right now it is going the other way. But now is now and tomorrow is tomorrow. It is so unpredictable. If gas were going to go up 30% a year, the price of gas, then you would see that continuation of what we saw in Q4. Keep in mind Q1, Q2 and Q3 while the core was up which includes gas, one we had more margin initiatives. We had not anniversaried them yet. We were still in our first year of honeymoon there and the year-over-year gas was 8 going to 9 to 10 going to 11. Now, again I look at it as the core itself was up notwithstanding the fact we have anniversaried and we are down to our second year of showing some margin initiatives but you’ve got hammered by this giant increasing gas penetration.

Similarly if a year from now in Q4 2009 gas penetration is tense because gas has come down another $0.50 a gallon that will be just the opposite. You’ll see a huge benefit to reporting gross margin on core merchandise margin. That is why I have tried at least to share with you the underlying components.

Adrianne Shapira - Goldman Sachs

That is my point, I guess that the core you are seeing encouraging but it is more of a penetration impact and so again if that wanes it should be an opportunity.

Richard Galanti

None of us want to be optimistic in a naïve way. Right now you can be conservative on the economy and feel pretty comfortable gas prices are going to go down, not up with changes in the world demand and what is going on out there. Again, it is entirely unpredictable.

Adrianne Shapira - Goldman Sachs

Just looking at the SG&A, good improvement on the payroll benefits. Kind of help us understand how we can think about that on a go-forward basis.

Richard Galanti

You know, it is tough. It is tough for us and we have all the detail. What we find is we are pretty good at predicting some times bottom line and you know the sum of the big three things; members, gross margin and SG&A, then you pick which one you want to change a little bit. I’m not trying to be flip about it, but it is tough. Again, given that there is some expectation of some moderate year-over-year gas inflation, not gas deflation year-over-year that would give you a little bit of a tailwind and benefit to SG&A. So, if you are modeling out there I would assume, and given the gas right now at least – right now is not four weeks ago and not four weeks from now, but the trend continues so even if there is a modest amount of gas inflation not 36% year-over-year you’ll see that impact to margin mitigate and show not as big a detriment, hopefully at some point a positive, and you’ll see the SG&A benefit be a little less too.

It is kind of tough to model.

Operator

The next question comes from Mark Miller – William Blair & Co.

Mark Miller – William Blair & Co.

I’d like to have you elaborate a little bit more on the merchandise mix and how much of the margin impact is coming from the faster growth, lower margin consumables versus the non-consumables? So if you take gas out, what would that impact be?

Richard Galanti

Again, you add up the 75-80% of the business, year-over-year it was up 19. Actually, what I’ll call food and sundries tends to be close to the company average if not a shade higher like in fresh foods. Where you get hit a little bit is having essentially flat or slightly down constant soft lines. Soft lines is typically a higher than average. It is a higher than average gross margin business. So it is not only the gas, but certainly food soft lines…weakness in soft lines has hurt you a little bit on margin. Hard lines tends to be a little bit more in line, a shade – not a lot, but a shade less than the company average.

Mark Miller – William Blair & Co.

In your range for fiscal 2009 EPS roughly what would the comp range be excluding gas, excluding currency? What in that range would the mix assumptions be?

Richard Galanti

It is in the mid singles, but again I could give you a 3-dimensional matrix which I’m not assumptions here. Our assumption is the underlying comp is going to be a little less than it was in September, our original budget. But, again it is hard to predict.

Mark Miller – William Blair & Co.

Then in terms of the mix?

Richard Galanti

If you just think about on a base sales of $71 billion, every percentage point in comp is $710 million, arguably at 4.5% pre-tax, is like $32 million pre-tax, $0.045 per share. A good kind of base metric to help you would be somewhere between 4-5% pre-tax on an incremental percentage point. So an extra two percentage point helps you by $0.08 to $0.10 and two percentage points lower hurts you by that amount.

Mark Miller – William Blair & Co.

My other question is on the gas impact on the business. The margin comparisons are very confusing. I was hoping you could help us on an EPS basis. You said it was not a negative. Was it actually a positive in the quarter? Because wholesale gas prices have fallen. Most convenience stores are showing much higher profit margins year-over-year so I was wondering if there is some anomaly in your business.

Richard Galanti

It was a very small benefit instead of being a negative. However, we had unusually strong profits a year ago.

Mark Miller – William Blair & Co.

If gas prices fell $0.50 or $1.00 per gallon a year from now would that be…

Richard Galanti

We would be happy with how it impacts our P&L.

Operator

The next question comes from Mitch Kaiser – Piper Jaffray.

Mitch Kaiser – Piper Jaffray

I was hoping you could talk about the four major categories. You guys have experienced some very good core merchandise margin expansion in those. If you look to 2009, kind of how do you feel in terms of continuing that trend and where do you think…which inning do you think we might be in those?

Richard Galanti

Clearly the sales strength, which gives me more confidence with margin strength, is in food and sundries, which is what 40+ % of our business David? Food sundries is over 40% of our business. Fresh foods, which is another 13% or so of our business. So that is where I have the most comfort. The biggest challenge, of course, we like many retailers out there have approached Christmas with toys and trim a home and trim a tree with the exception of things like the Wii, conservatively. Particularly we don’t want to end up with any Christmas ornaments the day after Christmas since we don’t like a lot of markdowns. So we are not being conservative but we are being, I would say, less aggressive. If we are wrong, you can always get hit a little bit there but again our merchandise is spread across so many categories there might be a weakness in that stuff but there is strength in apparel because of the availability of goods. We have some great names coming in.

Mitch Kaiser – Piper Jaffray

Your optimism on food, sundries and fresh food, is that based on the underlying input costs or better purchasing leverage? How should we categorize that?

Richard Galanti

Part of my confidence is the people in charge of those two areas exude confidence in our budget making as recently as yesterday. Recognizing that we feel comfortable that it is very competitive out there and nobody is more competitive than we are. Notwithstanding that we have shown we can show some improvements there. So we don’t see anything changing that model right now.

Mitch Kaiser – Piper Jaffray

So it is more costs rather than taking pricing?

Richard Galanti

Clearly more cost than taking pricing. But as we talked about buy-ins, there are again we buy-ins are offered to everybody from supermarket chains to Wal-Mart to Target. We think we have a unique ability with our depot and cross-talk operations that we can bring in an extra 6-8 week supply or two weeks or whatever the vendor will allow at a lower price. We’ll keep it low for as long as we can but still make a little on the tail end of it. Those things help you a little bit. The big underlying thing is just the stuff we sell every day and certainly within, again the risk more is going to be on the weaker sales results like the big ticket items with the exception of apparel principally because we can almost sell and piece much of the stuff that we can divert or buy directly on brands you never saw before.

Operator

The next question comes from Charles Grom - J.P. Morgan.

Charles Grom - J.P. Morgan

When you look at the gross profit outlook embedded in your 3-325 view can you give us a range if you assume gas is neutral? You’ve got a lot of things you are cycling in the first half of the year.

Richard Galanti

Not really. I mean, I just don’t have that ready here.

Charles Grom - J.P. Morgan

Would down 10-20 basis points seem about right? Every 10 basis points is usually about $0.10-$0.11 of earnings, so just kind of back of the envelope?

Richard Galanti

If you look at a range of 3-325 that is $0.25 on $7.4 million a penny, divided by 0.63, that is 37%, is $2.93?

Charles Grom - J.P. Morgan

I’ll get back to you on that. Just to switch gears, MFI growth in the quarter was a little bit slower, not much slower on a 2-year basis but a little bit slower. I know you gave the statistics on renewal rates but I’m just wondering if we can dive into the churn rate a little bit and if there has been any change in the churn rate and renewals for people in year two? I’m just wondering if you’ve seen any change in that product because Sam’s has spoken a number of times about having that as an issue. I was wondering if you could comment on that front.

Richard Galanti

We have not seen that. Again, our renewal rates have been frighteningly consistent over the last several quarters. Frightening in a good way given what is going on in the economy. So, the answer is no we have not seen that. It is interesting, in a given week all of a sudden we’ll see a slow down or pick up in business membership sign ups or a slow down or pick up in executive members and inevitably what it is is what the marketing department here at central is pushing out to the warehouse in terms of activities that focus on this four-week period. What we have done, but nothing new this year, is when we see a little weakness out there we put a little more effort into it and generally it works.

Charles Grom - J.P. Morgan

I may have missed this but with the dollar weak this year did you quantify how much of a benefit you guys received from FX translation? I don’t know if you said it.

Richard Galanti

No we didn’t but in our own budget what it clearly, if you look when the 10K comes out next Friday, you will see the segment analysis and clearly we picked up an extra 10% last year in 2008 versus 2007. We adjusted our budgets for what we saw between mid-August and the second week in September downward a little bit. So it is incorporated in there.

Operator

The next question comes from Robert Drbul – Barclay’s Capital.

Robert Drbul – Barclay’s Capital

Two questions that I have. When you look at the quarter you just ended and you look into the holiday quarter what happens to the sales mix and merchandise mix of discretionary/non-discretionary? How does it change as you head into the holiday season?

Richard Galanti

You know it is funny, you pick up on the food side because there is a lot more family dinners and holiday dinners and weekend activities. You clearly have a big pick up in the toys area and certainly you have a whole new area like all the trim-a-home and trim-a-tree and gift baskets. So, in looking at the sales penetration there is about a couple hundred basis point switch towards non-food during the last couple of months of the year because people are buying more gifts for people.

By the way, I want to respond a little bit to that previous question about the FX headwind this year. If you just, again when it comes out next week you take our own segment mix stuff and adjust it based on making assumptions on currency because we have proven to not be a good predictor on what is going to happen next week with currency exchange rates but if you take what has happened in the last month with currencies you are talking, we adjusted our own budget down by about $20 million on a pre-tax life. So it is not a big deal. It is $0.03. But we have incorporated what has happened so far. Sorry, go ahead.

Robert Drbul – Barclay’s Capital

The other question I have Richard is have you seen in terms of your private label initiatives and the consumer at all sort of trending more towards your private label and sort of how in the environment you have seen inflationary versus branded how has that developed for you over the last few months and into the next couple of months?

Richard Galanti

There has been a small tick up, I just asked this question to our two key merchants last week and particularly our food and sundries merchants, and they have seen a small tick up but it is not like it is “oh my God look at this big change” in private label. So small pick up and nothing you could see a few hundred feet away and say wow look at the difference.

Robert Drbul – Barclay’s Capital

The last question I have Richard, as you look into the holiday quarter any new vendors or new product you guys are excited about or things you can talk about you have seen that you haven’t seen before? Any specific product names or anything?

Richard Galanti

Well, yes but I don’t have the merchants here to let me know which ones I can tell you about yet. Sometimes when I mention something we find out the next day it is no longer available and so we want to get it in first. Something that is a pleasant surprise right now is the sale of five $20 Starbucks cash cards for $79.99. That is out there in the warehouses already.

Operator

The next question comes from Peter Benedict – Wachovia.

Peter Benedict - Wachovia

Just to follow-up, can you talk a little bit about the growth outlook that you are assuming in dollars to get to that 3-325 and you said the cash MFI would grow about 8% in the fourth quarter? How about on kind of an income statement basis? What do you think we should be thinking about MFI growth for 2009?

The MFI growth for 2009? I think you said the cash MFI was up about 8% in the fourth quarter. What do you think on an income statement basis we should be thinking about for MFI growth for 2009?

Richard Galanti

I would assume roughly the same, if not a shade lower. Generally speaking there is no current interest in changing the current prices of our membership fees this coming year. So all things being equal if you have a little bit positive comp you probably have a slightly detriment, 2-3 basis point detriment there.

Peter Benedict - Wachovia

Just to confirm, it sounded to me like you are expecting gas prices to be above year-ago levels throughout 2009. Is that correct?

Richard Galanti

We really don’t know.

Peter Benedict - Wachovia

I know you don’t know. But you say 3-325. You are not saying you expect gas prices to be significantly below last year or anything like that?

Richard Galanti

The reason we put a range on it for the year is that I jokingly said to Jim a couple of months ago every four weeks we have a budget meeting. We close our period on a Sunday. We close our books two days later on Tuesday. By Thursday all the input on a grounds up basis from every merchant, every warehouse manager inputs new numbers to update the month they are now in, 4-5 days into. So we already know how the month has started and we already know how last month ended. When we look at the year, and if you think about a company that does pre-tax in the high 1.7 or 1.8, divided by 13 four-week periods you are talking about $120-135 million a period on average, despite such wonderful in put from so many people from the ground up, we can miss our update for the month by $20 million right now. I jokingly said to Jim we could take our variance public. I mean it is so profitable. A couple of times it has gone the other way but not as much.

The fact of the matter is there is a lot of moving parts. Gas being the biggest variable there have been fiscal months where we budget we are going to break even and we make $10 million and there have been guesses where we budget $5 million and we break even. It is all over the board.

Peter Benedict - Wachovia

Just lastly, you commented a little bit about this in your prepared remarks, but just in the discussions you are having with vendors now and how they have evolved over the last couple of months with respect to the vendors trying to push through some cost increases. You have oil down to $90. It is not $140. How quickly are you kind of returning or pushing back for lack of a better term on prior increases they have asked for under the old kind of oil price environment? Can you just talk a little bit about that please?

Richard Galanti

All the commodity stuff whether it is beef and poultry, or all the materials that go into the baked goods, things like that those change daily and weekly and they change downward as well. When you are talking about basic goods like soap detergent and paper towels our collective view is then while it is important for us to understand why a price increase, what caused the price increase, our view also is that some of it was pent up demand if you will for the retailers having incredible strength to hold back price increases from the manufacturers because all the power was with us. Again, we saw that window of opportunity last quarter when we saw the fund gates opening and everybody coming to us.

On the freight side of it I believe we started fiscal 2008, a year and a month ago, with a freight rate based on a base of 100 a year or so before that…something in the 120-125 range. I think it peaked at 150 and now it is back at 130. So, I mean again those freight surcharge rates change daily or weekly. I think on some of the items what you have seen as a slow down of late is that the flood gates have closed a little bit. Everybody is worried about sales. The manufacturers are worried about getting their product out there and pricing has come down. I would guess there is a little less increase. The inflationary trends that we were concerned might continue for awhile, as of today and only today, they have subsided a little.

Operator

The next question comes from Mark [Lodameath] – Morgan Stanley.

Mark [Lodameath] – Morgan Stanley

I was curious what kind of consumer reaction you are getting to the areas where you have been putting through the inflation. Have you seen any scaling back on volumes at all?

Richard Galanti

You see our comps. Again, our view is we hold off as long as possible but inevitably it has to be passed on. I think we are comforted by the fact we have always been the extreme competitor and we have not seen any issue there.

Mark [Lodameath] – Morgan Stanley

Is there any way you could walk us through some of the regional differences on how the comp is trending out there?

Richard Galanti

On a qualitative basis, sure. If we look at probably a big strength, if I look back all the way to 2007 when the U.S. was a five for all of 2007 and then all of 2008 the U.S. was at eight. I’m sorry; U.S. for the whole year was 6.5. Now the five was probably close to a five, maybe a 4-4.5 without gas and 6.5 is probably about a 4 for the year X gas inflation. Now within those numbers the two strong regions from 2007 to more recently is the northwest and southeast. The northwest is one of our most mature regions and highest volume regions save southern California. California again has always been weaker than the rest but that is where we have done a lot of cannibalization and we start with the highest volume units. I think the best way I described it was several months ago, maybe 8-9 months ago when I was describing sales, if you look back over the previous couple of years if you split the U.S. into California and the rest of the U.S. it was roughly a 1/3 or 2/3 or a little over 1/3 and a little less than 2/3 split among the country; California versus the rest of the country, then whatever our weighted average comp was for all of the U.S. if you looked at just the gap between California and the rest of the U.S. going back a year or two years that gap used to be in the 200-250 basis point range. At its widest gap, call it six months ago; it was 3.5-4%. It has come back. It is not quite back at 2 but it is not 3.5-4% anymore. So there has probably been a slight improvement in California relative to the rest of the country, a nice improvement in the northwest and southeast, but still being hit by the lower comp California areas.

The biggest strength we have throughout our company is Asia. We are having wonderful comps. We recognize part of that is it is relatively young. When you have 4-5 units in a 25 million population city and it catches on your comps go through the roof and it takes some time to get some more units going.

Operator

The next question comes from Dan Binder - Jefferies & Company.

Dan Binder - Jefferies & Company

As you look around, recognizing your prices are anywhere from 20-30% lower than local grocers, but if you look around you are seeing folks cut prices and I’m just curious if you think about next year if you see the gap shrink between lets say grocers and Costco on price. Are you inclined to open that gap up again to keep the top line going? How much are you willing to let the gap shrink if you don’t feel the need to do that?

Richard Galanti

I think the answer is yes. We are always going to drive sales. I’m less concerned, notwithstanding, with what all the others do. We have a little bit of a unique ability because it is not…first of all there is not a whole lot they can do on so many high volume commodity items where we are both working on low margins to start with. It is all those specialty items where we can bring in cheeses and whole meal replacement items and unique co-branded items whether it is Pepperidge Farm cookies – I don’t even know if that is a co-brand anymore…I’m just trying to think of examples. So many of our items, part of our goal is to upscale and to be more gourmet so we are competing even in the supermarket business, clearly we are competing with them on all the commodity items; soda pop, detergents, analgesics, health and beauty aids and paper towels. It is those specialty items and upscale items which if you haven’t tried it that big 40 oz can of those Crispy peanuts, Virginia type peanuts, nobody can compare. We are $6.99 for 40 oz and the local supermarket where my family shops is another $1.00 for eight peanuts. So there is so much room there. I really don’t lose a lot of sleep over that question.

Dan Binder - Jefferies & Company

I think on the last call you talked about having a wage agreement in place with your workers. Can you remind us when does that come up for renewal and is it next year? How would you anticipate that impacting the SG&A?

Richard Galanti

First of all we have 540 some odd warehouses. 60 locations are affiliated with Teamsters. The same 60 that were here the day of the merger of two roughly 100 unit companies, Price and Costco back in the late 1993, so good relations. Wages and benefits similar to what we pay employees in the other 480 warehouses, although it is all U.S. wherever that is, and we basically have in place for our unaffiliated employees which is the vast majority, an employee agreement which is republished every third March. Right now we are about a year and a half between it. So we are right in the middle of that three years. So nothing will happen between now and a year and a half from now.

Recall that about two years ago, maybe two and a half years ago, we raised the bottom of the scale from $10 to $11 and $10.5 to $11.5. We’ll have to see. I think the pressures on us are a little less than the pressures on other retailers that pay less. Our average wage right now, average hourly wage in the U.S. is roughly $19 which is several dollars, if not more, than most big boxes out there per hour. So, now that being said we always want to be the one that has that big gap.

We’ll see. Could something happen in March 2010? It is possible but we’ll have to wait and see. There is no expectation at this point. We’ll always find a way to raise the top of the scale. Even people who have been at the top of the scale for ten years know there is going to be some nominal amount of increase.

Dan Binder - Jefferies & Company

If you can give us a little color on what is happening with TV sales right now and the inventory in the channel and how you think that may impact pricing and margins for the holidays? Lastly, prior to today we were factoring in about $1 billion of buyback for the coming year. Based on your comments earlier it sounds like it might not reach that. Any thoughts in terms of what kind of buyback assumptions you have in the guidance you provided today?

Richard Galanti

Electronics changes month to month. Back in August, I haven’t seen the detail on September yet, back in August on what we call majors which is all electronics was down I think mid single digits. Within that TV’s were actually closer to flat. Still down and negative but approaching a flat. Our challenge actually this Christmas is again availability, particularly on LCD screens. So, to the extent others are cutting back that will help us a little bit. We are not being aggressive on it but so far we don’t see any big issue there. Recognizing for us we don’t have 75 SKUs of televisions and a three-month supply of each one. We have 15-20 SKUs if that, probably 15-20 and five of which are pending delete because we are down to the last two units on a pallet, and if we over buy maybe it takes an extra week or two to sell through the 8-10 we supplied that we bought in on SKU.

Was there another part to the question?

Dan Binder - Jefferies & Company

Just the last question that had to do with buyback assumptions.

Richard Galanti

Buyback assumption is simply lets face it…it was a week ago the stock was in the mid to high 60’s. Certainly expectations change a little bit. The comment I made on the call was simply with concerns about liquidity out there, and again when we were shocked with enhanced money market funds back in December of last year, we did what we though prudent, earnings even less of a return but being just in government funds. No, outright direct treasuries, but government funds. Then one of those locks up. So it is more for the comment that let’s see what shoe drops tomorrow and hopefully while shoes are dropping daily and who knows what is going to happen each day that 2-3 months from now things change quite a bit.

So on the one hand as the stock comes down we want to be a little more aggressive, given the liquidity issue right now…today we can’t buy anyway because we are in blackout, but after tomorrow we’ll see. There is no commitment yet other than we’ll let you know at the end of each quarter.

Operator

The next question comes from John Lehman – State of Wisconsin.

John Lehman – State of Wisconsin

I’m trying to get myself wrapped around the range of earnings per share. What percent of that range, the $0.25 range, would you consider due to the volatility of gas prices?

Richard Galanti

For the year?

John Lehman – State of Wisconsin

Yes. What I’m saying is the range totally due to your uncertainty of gasoline prices or is it driven by something else?

Richard Galanti

My guess would be half of it. But, pardon my French but it is truly a crap shoot. Two weeks into a month of what our predictability of gas profits are. Mind you, right now we are having fun this week.

John Lehman – State of Wisconsin

I certainly appreciate that.

Richard Galanti

Four or five weeks ago we were going, “Woe is me.” It is a nutty business.

John Lehman – State of Wisconsin

Secondly, wrapping up on your name sticking to coverage, what percent of the footprint do you share with Sam’s and Wal-Mart?

Richard Galanti

It is in Mexico too but we don’t consolidate that. In the U.S. depending on how you define it. As an example, in the Pacific Northwest and Washington we have upwards of 20 units. I believe they have two or three. Some would say that is 20 versus 3 in that competitive footprint. We would argue the other extreme it is as little as 4-5 versus their 2-3. So maybe if you make it 4-5, 7-8 everybody would be happy in the analysis. But something over half are competitive in the U.S. with the U.S. being about 80% of our company. I believe Sam’s in Canada has 4-6 units in and around Toronto I believe, mostly, and we of course have 75 or so throughout the country.

John Lehman – State of Wisconsin

So if I understand you share about 50% of the same close location as Sam’s or Wal-Mart?

Richard Galanti

Sam’s. Not Wal-Mart. Wal-Mart is everywhere. Mostly everywhere. But whether it is Wal-Mart or Target, Home Depot or Kohl's, those are everywhere. The biggest issue is the direct competition with Sam’s and DJ’s. We are certainly doing comp shops with others from super market chains to Home Depot on different categories, Office Depot and Staples, but the real competitive issue has to be with clubs.

Operator

The next question comes from Uta Werner - Sanford C. Bernstein & Co.

Uta Werner - Sanford C. Bernstein & Co.

You had mentioned earlier on the call the non-discretionary items had been comping in the high single digits to mid-teens and some of the furniture, jewelry, electronics and house wares have been minus 10-12%. Would you mind commenting on what the mix is on the dot com channel?

Richard Galanti

The mix on dot com is very little food. If anything there is some gift baskets and some steaks and some wine and cheese. It is almost nonexistent. Electronics, furniture, sporting goods, jewelry, exercise equipment, by far the biggest category is electronics. I mean it is not half. It is probably not even 25% but it is not 5%.

Uta Werner - Sanford C. Bernstein & Co.

So if the overall channel has been growing at mid 20’s…

Richard Galanti

This past month, we still have a positive comp of 20+ in the last month. But we have seen a change even within that number. Traffic has been good. The number of transactions has been fine. It has all been on average ticket. But our average ticket has been historically over $400 in the last couple of years. So, again no matter how good the savings on that $2,800 furniture set or sofa or gadget, on a macro basis some people are saying we’ll hold off a little bit.

Uta Werner - Sanford C. Bernstein & Co.

When you look at the combined sales in these more bigger ticket items across stores and dot com, how much of that slower growth you are potentially seeing is really coming from the macro environment or potentially that your consumer base is starting to get saturated with those items?

Richard Galanti

Who knows? I mean, defensively one might argue when asking that question that hey the Wal-Mart’s and Target six months ago are showing decent electronics gains and your major sales have slowed down a little bit. Well, we also for two years prior to that running we had 20+% comps in a deflationary business, so units wise even more than that. So yes you are right. Our customer bought faster and bigger earlier. So there is probably a little bit about that. But we just worry about what today looks like. So far relatively speaking we are holding our own.

Uta Werner - Sanford C. Bernstein & Co.

When you think about how consumers pay currently, has there been any change in terms of how much has been charged on credit cards versus other methods of payment?

Richard Galanti

Keep in mind our relationship with Amex was started about eight years ago now. If you go back 15 years ago it was all cash and check. There were no debit. Today, and there is a private label credit card as well which is a small percentage. Credit card is probably in the mid 30’s. Debit a little less than that. The rest cash and check. There has been no drop off in credit card purchases in the last couple of months but there has been a constant increase of penetration. That has more, I think, to do with the fact our partnership with American Express, is a very good and strong one and we work well together and in our warehouse daily activities and in their marketing efforts to channel people into Costco. So it has worked well for both of us in that regard. We have not seen any giant drop off or anything.

Uta Werner - Sanford C. Bernstein & Co.

Can you comment a little bit on cannibalization over the last quarter?

Richard Galanti

Cannibalization in the fourth quarter was -70 basis points, trending less towards the end. In May it was -80 and in August it was -50. Generally speaking, at its peak a couple of years ago it was almost 200 and when we were doing very little cannibalization it is like 30-50. My guess is it stays in the high double percentage numbers here. Maybe it goes a little over 100 and then down to 50 again. It will just fluctuate in that range.

Operator

The next question comes from Charles Cerankosky – FTN Midwest Securities.

Charles Cerankosky – FTN Midwest Securities

Richard when you are looking at the new members, as you rotate some out and have some new ones coming in, how are they shopping the club? What I’m looking for is there a balance between both sides of the club or are they mainly joining for the non-discretionary items and staple items?

Richard Galanti

Well, this is more anecdotal but I heard some of the operators talking about when gas spiked a few months ago there was another run, if you will, to sign up. When there is that spike it is always because the topic de jeur on the news stations is where is the cheapest place to buy gas. 95% of the time it is us so that helps. With that exception I haven’t heard a whole lot.

Charles Cerankosky – FTN Midwest Securities

Do you look at what these people are buying? The newer members? Do you sort of train them or coach them to shop the entire club?

Richard Galanti

No. You know, we are probably a little simpler than that. As Jim would say we spend most of our time making sure we are not out of stock on toilet paper and coming up with some really cool treasure hunt items and always being the great value proposition. Again, looking at sales penetration the fact that you are seeing bigger comps in those other areas by definition, but we haven’t really segmented it – I haven’t segmented it, looking at it that way between new members and old members.

Operator

The next question comes from Deborah Weinswig – Citigroup.

Deborah Weinswig - Citigroup

You had alluded to previous questions in regard to Asia being strong. Can you talk about the other areas of globally you are operating in and just your performance in those areas?

Richard Galanti

I’m sorry; there was a little noise here. Can you repeat that?

Deborah Weinswig - Citigroup

Basically you had spoken about Asia being a strong international market for you. Can you discuss your other international markets as well?

Richard Galanti

In local currency Canada had actually been slow a couple of years ago in the low single digits and it has come back a little. Still low to mid single digits but overall pretty good for us. Their economy has not been impacted nearly as bad as the U.S. with their strength in natural resources. The U.K. has actually shown some strength of late in the mid to high single digits after arguably a couple of years of what I’ll call slightly lower average comps versus the rest of the company.

Deborah Weinswig - Citigroup

With regards to square footage growth where do you think you are with various opportunities internationally?

Richard Galanti

Well percentage wise it is clearly Asia because we only have 4-8 locations in each of those three countries. The U.K. opportunity is great. The speed of which approvals come in that country are greater, or the lack of speed, so we are lucky if we can get two units open there a year on a base of 20-ish or 21.

Deborah Weinswig - Citigroup

On private label can you give us your current penetration level and can you also take down the road 3-5 years what do you think those could possibly reach?

Richard Galanti

Right now right around 17.5-18. The feeling is over the next 5-8 years if you get into the mid 20’s. If you followed us for 20 years we are always doing a little bit better than what we think. It’s not like we have this great effort all of a sudden because the economy is going to be weak for a year that we’re going to put a new effort on it. We’ve got a pretty strong effort to develop new products both private label and co-brand private label.

Deborah Weinswig - Citigroup

Lastly, obviously a lot of questions and concerns on the inflationary pressures of the business. Can you give us any additional details on what you are doing to mitigate those pressures?

Richard Galanti

The biggest in terms of mitigating inflation is buying as much as you can when there is a price increase announced, or happening. We are not bringing down price points. We are not lowering the quality of the price point of the goods, to look at it that way. Other than that I don’t see a lot we can do.

Operator

The next question comes from Neil Currie – UBS.

Neil Currie - UBS

You said earlier you saw membership spike up as gas prices peaked. If gas prices come down do you think there will be a traffic impact on the negative side? Or do you think basically as people have taken out the memberships and gotten used to coming to Costco if they weren’t used to coming before, do you think traffic levels are pretty robust here?

Richard Galanti

We certainly haven’t seen that yet and probably in terms of my most arrogant response of the day I think once we get you in the place we generally do a pretty good job of keeping you.

Neil Currie - UBS

Another question about the economy, maybe a different way, is obviously yourselves and Wal-Mart and DJ’s are doing a fantastic job of taking market share as people clearly see you as a place to save money, maybe the one thing that differentiates you from Wal-Mart is that you have to spend quite a bit in terms of cash flow to get the savings because you buy in bulk. Do you think if the economy continues to worsen and the credit squeeze continues to consumers there might be a risk of cash flow challenge of shopping at Costco could diminish a certain proportion of your shoppers?

Richard Galanti

It sounds like I remember when even a couple of years ago people were saying hey the economy might slow down here and that should help you because you guys are in the value proposition. I would retort back every time, there is also the other side of that when people are saying hey I spend $300-400…I can’t get out of there for less than $300-400. Actually you can get out of there for about $140 because that is our average, $138 or whatever. The fact of the matter is we have not seen that. I think what you are seeing is our members coming in and they are maybe being a little bit more disciplined and they are holding off on buying those big ticket items. But, if our rough gross margin is 11-12% and regular supermarket chains are in the low to mid 20’s and the Home Depot’s and Lowes are in the low to mid 30’s and mall stores are in the 35-50’s, our savings are so extreme that you can’t not come there. I am biased, mind you, but that has not played out. It certainly is an argument.

Neil Currie - UBS

Have you ever seen it play out historically?

Richard Galanti

I think it is kind of hard to tell because someone asked me just yesterday about how do we think our performance has gone just on sales and we have already reported the last few months, compared to previous recessions or weakness in the economy? I say frankly one was in the early 2000’s and the previous one was in the early 1990’s. Well in the early 1990’s we were 7-8 years old and still growing and we didn’t know that anything was going on outside our world. Even in the early 2000’s, relatively speaking we had just come off of enjoying the late 90’s where earnings were compounding at 27% a year. So this is really kind of the first time we have been like this and we are so far pretty pleased with our ability to drive business in this environment.

Neil Currie - UBS

Just a final question, the tax rate you got a useful benefit in the quarter compared to what we expected. How about for 2009? What are your expectations on the tax rate there?

Richard Galanti

Probably 36.5%, maybe 37% to be conservative. I think generally speaking we have had the benefit of more positive discrete things. In other words, something helping our tax rate instead of the negative, in part because I think we have done a pretty good job of being conservative in how we accrue for things there and occasionally actually winning an appeal on a disputed item.

I think you always have to assume something in the mid 36-37% as our base rate.

Operator

The next question comes from Sandra Barker - Montag & Caldwell.

Sandra Barker – Montag & Caldwell

I just wanted to clarify a couple of things. When you talked about delaying the pass through of inflationary price increases how far along are you in that? How much do you still have to catch up on things that you really feel need to absorb?

Richard Galanti

A lot further along than we were when we chatted on July 23. Given that there has been a little subsiding of those price increases coming through, recognizing some of these are coming through right now were done 4-6 weeks ago where we were able to buy in so they are just hitting right now. I would say it has slowed a little bit.

Sandra Barker – Montag & Caldwell

So just what you are already still absorbing will affect the next quarter but then you will sort of be on a more normal footing?

Richard Galanti

I think it impacts the first quarter a little bit but not nearly as it did before.

Sandra Barker – Montag & Caldwell

Secondly, are you noticing any difference in trends if you compare sort of the Gold Star customer versus the business customer or maybe looking at executive members or the American Express card holder? Is there a lot of difference or is everyone pretty much shopping similarly?

Richard Galanti

Overall, we would go with the latter. Clearly our executive members when they first become an executive member spend a bunch more over the next year and then start comping back to the general public’s average but at that higher base. So we still see that with new executive members. Beyond that there is not a lot that we have discerned from it as far as difference.

Sandra Barker – Montag & Caldwell

Also, when you talked about these extraordinary items and treasure hunt type things you haven’t normally been able to get, are you still getting good sell through of all those things or are you running against buyer resistance on those things too? Or is it just those things are still such a great unexpected item?

Richard Galanti

Those things are no-brainers. We got our hands on 5,000 units of X; it is a no-brainer. 10,000 units or 1,000 units because the value is so much there.

Sandra Barker – Montag & Caldwell

To spell out a little bit more about your attitude about your margin initiatives. I know there are a lot of things going on. Are you still trying to improve that given everything else that is going on? What is your attitude about how much progress you can make?

Richard Galanti

I would say we are being prudent about it. Jim reminds the merchants each month let’s not get ahead of ourselves. Again, we were comforted by how we did in the first four weeks of this fiscal year and Jim is out there reminding us let’s make sure we don’t get too ahead of the game here.

So I think again the gap between us and everybody has been so great for so long and mind you even within our direct competition where the opportunities are to make a fair margin a little fairer if you will is on those items they are not directly competitive. We have different brands, different items, different custom packs, whatever it is. So clearly as we all know, as we know as DJ’s and Sam’s knows we are not going to let them get away with anything and they are not going to let us get away with anything that they can. So when we have unique items that helps you a little bit.

Operator

The last question comes from Joseph Feldman - Telsey Advisory Group.

Joseph Feldman - Telsey Advisory Group

Just one more follow-up on pricing a little bit. As you think about the LIFO charges going forward and I know it is fairly difficult to project, but should we think about it in the same kind of magnitude you saw in the fourth quarter? I know the quarter was a 16-week quarter but is it going to be a few pennies for at least the first half of the year as you kind of until we get into a more normalized operating environment?

Richard Galanti

We analyze it each quarter. If I extrapolated out the first four weeks of this 12-week quarter the answer would be no it would be less. But who knows what tomorrow brings?

Thanks everyone and Jeff and Bob and I are around. We appreciate your patience in hearing all the explanations.

Operator

This concludes today’s conference.

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Source: Costco Wholesale Corporation F4Q08 (Qtr End 08/31/08) Earnings Call Transcript
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