Costco F4Q07 (Qtr End 9/2/07) Earnings Call Transcript

| About: Costco Wholesale (COST)
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Costco Wholesale Corporation (NASDAQ:COST)

F4Q07 Earnings Call

October 10, 2007 11:00 am ET


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


Deborah Weinswig - Citigroup

Chuck Grom - J.P. Morgan

Gregory Melich - Morgan Stanley

Todd Slater - Lazard Capital Markets

Christine Kilton-Augustine - Bear Stearns

Mark Husson - HSBC

Robert Drbul - Lehman Brothers

John Jabb

Thomas Forte - Marquis Investment

Michael Exstein - Credit Suisse

Sandra Barker - Wachovia

Adrianne Shapira - Goldman Sachs

Teresa Donahue - Neuberger Berman

Neil Currie - UBS


Good morning. My name is Frances and I will be your conference operator today. At this time, I would like to welcome everyone to the fiscal 2007 earnings and September sales release conference call. (Operator Instructions) Mr. Galanti, you may begin your conference.

Richard A. Galanti

Thank you, Frances. Good morning to everyone. As with every conference call, I will start by stating that the discussions we are having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and that these statements involve risks and uncertainties that may cause actual events, results and/or performance to differ materially from those indicated by such statements.

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

To begin with, our 16-week fourth quarter of fiscal ’07 operating results, which by the way compares to last year’s 17-week fiscal fourth quarter, for the quarter, we came in at a reported $0.83 a share compared to last year’s fourth quarter of $0.75 a share. As outlined in this morning’s release, excluding the non-recurring, non-cash pretax charge of $56.2 million, or $0.08 a share related to the refining of our accounting for deferred membership fee revenues, the company’s fourth quarter net income and earnings per share would have been $408 million and $0.91 per share respectively, representing a 15% increase in net income and a 21% increase in earnings per share and, as I mentioned, last year’s fourth quarter had one extra week.

These results also compare of course favorably to our May 31st guidance of $0.81 to $0.83 and current first call at $0.83.

For the fiscal year, we came in at a reported $1.083 billion, or $2.37 a share, compared to $1.103 billion, or $2.30 a share. Of course, the $2.30 was last year’s 53-week fiscal year. Essentially down 2% in net income, about flat if you account for the extra week last year, and up 3% in EPS.

As you know, and as I will outline for you in a few minutes, there were a few other unusual items this fiscal year in the second and third quarters. Again, I will go through all the detail in a few minutes but for an apples-to-apples comparison, we would look at the more normalized fiscal 2007 earnings amount of $1.20 billion, or $2.63 a share.

So on a normalized basis, earnings and EPS for the fiscal year would have been up 9% and 14% respectively year over year. Again, this year has 52 weeks compared to last year’s 53.

In terms of sales for the quarter, as we reported on September 5th, our 16-week comparable sales figure showed an increase of 5%; 4% in the U.S. and 9% internationally.

Other topics of interest I will review this morning are our opening activities. We opened a total of 30 net new locations during fiscal 2007, plus one in Mexico, which we don’t consolidate into our numbers, this year ended September 2nd.

Of the 30, 25 were in the U.S., three were in Canada, and one each in the U.K. and Japan. For ’08, we plan to open 30 to 35 net new locations, plus at least one more in Mexico, as well as up to 10 relocations, and that compares to no relocations during 2007.

I will also review with you today our fourth quarter adjustment impacting membership fee income, our ancillary business results, Costco's online results, our membership trends, the change back in February and March to our electronics returns policy and how we believe that impacted our fourth quarter, an update on recent stock purchases, our balance sheet, and lastly I will provide you a little updated direction and guidance for Q1 and the year.

As I review with you our fourth quarter results, similar to when I reviewed the second quarter results and the third quarter results three and six months ago, I will discuss not only the reported figures but also the year-over-year comparison on an adjusted basis. That is, without the various unusual items that impacted this year’s results.

We believe these 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 future operating results.

With that said, we’ll get started here. Reported sales for the year’s fourth quarter, the 16 weeks ended September 2nd, were $20.09 billion, up 3% from last year’s fourth quarter sales of $19.5 billion, up a little over 9% if you adjust for last week’s extra week, 16 versus 17 weeks.

On a comp basis, Q4 comps were up 5% for the quarter. The 5% fourth quarter was comprised of a 7 in May, a 6 in June, a 7% in July, and then of course the 2% that we recorded last month in the five-week August month.

For the quarter, our 5% reported comp sales were a combination of an average transaction increase of about 3% and an average frequency increase of about 2%.

I might add that for the fiscal year just ended, company wide our average sales per location were $130 million, up from $127 million in ’06, and if you just look at the U.S., the 130 for the company would be 132, just for the U.S.

Included in the average transaction increase of about 3% in the fourth quarter, FX represented about 100 basis points boost to the quarterly comp. That’s reflected in our comp number because of the weak dollar. We got hit by about 10 basis points due to the Canadian tobacco issue. I’m sorry, gas deflation was about 10 basis points to the negative, and the Canadian tobacco issue, which goes away this month, October, that was a shade over 100 basis points negative impact as well.

In terms of cannibalization, our expansion, with most of it in the existing info markets, it impacted comps by about 125 basis points to the negative in the fourth quarter. So all those items are within the reported numbers.

In terms of sales comparisons by geographic region, I guess what I probably most want to talk about is the August 2% versus the September 6% and within that, the U.S. August 1% versus the September U.S. 4%.

Compared to a weak August comp of 2, and again 1 in the U.S., September’s 6% comp included a 4 in the U.S. It represented a nice comeback, although just like I was explaining to many of you in August, some of the anomalies, certainly some of the improvement includes some anomalies as well. I’ll get to that in a minute.

In terms of the three percentage points of comeback, if you will, in the U.S., from a 1 to a 4 in August and September, northwest, southeast, and Midwest did a little better than that spread, a little better than that change, with California and the northeast similar to the U.S., up three percentage points from where they had been, so overall pretty good and pretty spread out.

International’s strong comp showing in September relative to August was primarily due to the increasing strength of the Canadian dollar, recognizing about 12%, I think about 11% or 12% of our sales come from Canada and the Canadian dollar, as you know, is now pretty much on parity with the U.S. dollar.

In terms of merchandise categories, again looking at the fourth quarter here of 5%, within food and sundries, we’ve been hit by tobacco and I won’t go into the detail, but essentially a year ago in Canada, the Imperial Tobacco stopped selling through what I consider sales as a wholesaler and it had a big hit to our tobacco sales and we’ve been including that explanation for the last 11 months and of course, past September, it won’t be an impact anymore. But within food and sundries, tobacco is about 12% of food and sundries and in fact 5% of total company sales. That department, tobacco, is down 14% in the quarter.

Notwithstanding that, food and sundries overall was still up similar to the company as a whole. No big out layers outside of tobacco, nothing really to speak of within food and sundries.

Within hardline comps, majors and sporting goods were tops in that department and those sub-departments. Within softline comps, media was actually a standout, which is -- I think it’s the first time I can say that in a few years, with low double digits in that area, and both men’s and women’s apparel were up slightly.

Within fresh foods, all had pretty good showings, with produce continuing to be the standout.

Within ancillaries, nearly all the businesses comped nicely -- nearly all of them comped nicely during the quarter. Gas was up slightly, given the slight deflationary trend in the pricing during the month, although we’ve seen that reverse itself again.

In terms of September sales for the five weeks, where we have a 6%, FX benefit was bigger. If you’ll recall, I said, as I mentioned on the -- for the course of the quarter, FX was about 100 basis points -- it included 100 basis points to the better. Within September, it was 180 and again, that’s reflective of the Canadian -- principally reflective of the Canadian dollar strength.

Gas inflation, which was slightly deflationary, ever so slightly deflationary in Q4, actually was up about 70 basis points.

So those two things alone were up about 80 basis points each versus Q4.

In terms of average ticket, within the 6% reported comp average ticket was up 4 with of course FX being part of that and gas inflation being part of that. Average traffic again was up about 2.

Tobacco was a negative hit for about 65 basis points and cannibalization has been pretty consistent, actually coming -- the detriment coming down a little. In the month, it was about 115 basis points to the detriment, relative to Q4 when it was 125 basis points.

In terms of the company’s comps going from the 2 to the 6 from August to September, when we look at it, a little over half of it is FX, tobacco and gas inflation, with the rest of it being I think a fundamental increase in coming back from where we thought we would after August.

Now moving down the line items of the income statement, I’ll start with membership fees. Reported in Q4 last year was $379.5 million, or 1.95%, compared to $388.2 million or 1.93%, up about two percentage points on a reported basis and actually down a couple of basis points, only about a $9 million increase.

Again, we had the big charge in there and I’ll talk about that in a minute. On a normalized basis, exclusive of that charge, membership fee dollars were up $65 million, up 17% or up 26 basis points, exclusive of the $56.2 million adjustment.

It’s a good showing but if you’ll recall from last year’s fourth quarter, when we had a 53-week year and a 17-week fourth quarter, I was explaining why it was a little lower than plan, or lower than one might think. Similarly here, some of this increase is because we are comparing a normal 16-week quarter now compared to that unusually low number last year, and I’ll go through that in a second.

In terms of that, when you look at the normalized figures here, it shows that membership fees as a percent of sales were up 26 basis points. About half of that is due to the impact of last year’s fourth quarter being a 17-week quarter, and let me explain that.

Since we have historically recognized membership fees using a monthly convention over 13 periods, 13 months, if you will, 13 four-week periods -- membership fee revenue in our 53-week was the same as if it has been a 52-week year, so when comparing membership revenues as a percent of sales, the percentage appears lower in a 53-week year because the membership fee revenue, the numerator, is comparable year over year, while the sales, the denominator, is not exactly comparable because the prior year included an extra week; similarly, the prior quarter included an extra week.

So while last year’s fourth quarter had a higher reported book membership amount on August sales, this year was back to normal, so we are comparing normal to something that was unusually high.

In terms of the number of members at year-end -- by the way, so even if half of that 26 was unusual, still is a good showing year over year being up 13, if you will.

In terms of members at year-end, we had 18.6 million goldstar. That’s up from 18.3 million at Q3 end; business primary, 5.4 million, the same; business add-on, 3.4 million, the same as the third quarter; so all told, 27.4 million, up about 300,000 from the 27.1 million. Including spouse cards, up about 700,000. It rounds up to 700,000, so that’s 50.3 million.

At fiscal year-end on September 2nd, our paid executive members totaled 6.331 million. That’s an increase of 303,000, or 5% over the last 16 weeks, or about 19,000 a week increase. For the year, paid executive memberships increased by just over a million members, or just over 20%.

These members represent now 23% of our membership base and generate about 52% of our total sales, and this percentage has continued to increase slightly.

In terms of renewal rates, they continue strong, although as compared to Q3 end, they are down about two-tenths of a percent, so we round down to 86% instead of up to 87%. Business membership renewals remain steady at 91.5%; goldstar, which had been at 85% are now 84.8%, and again -- so the 86.6% last quarter, which rounded up to 87%, is now an 86.4% rounding down to 86%. Not a big deal either way.

In terms of the membership fee adjustment and charge, let me spend a minute discussing this non-cash adjustment we took in Q4. In fiscal ’99, we changed our accounting for membership fees from a cash basis to a deferred basis, whereby membership fees were recognized ratably over 13 periods -- a periodic or monthly convention, if you will, beginning with the period in which the fee was collected.

In the fourth quarter of ’07, we performed a detailed analysis of the timing of the recognition of the membership fees based on each member’s renewal date. Our analysis recalculated deferred membership fees using a daily convention. This represents an improvement over our historical method and also corrects an accumulated understatement in our deferred membership revenue liability.

These adjustments are necessary as our analysis showed that a higher proportion of our members pay their renewal fees earlier than we previously estimated and outweighed the membership payments that are paid late.

While this is positive from a cash flow perspective, our historical accounting treatment did not ensure these early payments were begin recognized over the specific term. As a result, we recognized a $56.2 million non-recurring, non-cash reduction to membership revenues and a corresponding increase to our deferred membership fees -- the deferred membership fee liability on our balance sheet.

Going forward, we are now recognizing membership fees on a daily basis and, based on the specific membership terms and timing of the payments. Prospectively, we will account from membership revenue on a deferred basis over one year using the member’s renewal date, a daily convention, if you will, instead of the month in which the renewal payment was received.

We think it’s an improvement in how we look at it and on a positive note, we also account for membership fee income for tax purposes on a deferred basis. This is something we pursued with and received permission from the IRS back in 1999 when we went from cash accounting to deferred accounting, and therefore the $56 million pretax hit to earnings will actually generate a positive cash flow -- it’s a timing issue but it’s nonetheless positive cash flow, of about $20 million via the associated reduction in our income tax liability.

While this is again simply a timing issue, as long as we are in business, it should continue to grow and we can always earn interest on it.

Now going down to the gross margin line, our reported gross margin in the quarter was higher year over year by 38 basis points, coming in at a 10.36 last year versus a 10.74 this year in the fourth quarter. It was a very strong gross margin result with not that much of it being considered unusual.

In very simple terms, our fourth quarter gross margin’s 38 basis points increase year over year is comprised of three main things; a 35 basis point improvement in overall merchandising, a 4 basis point detriment year over year from the 2% reward, i.e. a slight increase in the penetration of sales and therefore higher membership reward amount, and we estimate about 7 basis point improvement in Q4 related to the change in our returns reserve related to the change in our returns policy and electronics that we did back in February and March.

In terms of our overall merchandising gross margin, we also were helped we estimate by probably about 6 basis points related to the lower sales penetration year over year in our tobacco business, which has a sub 3% gross margin.

So again, those are a couple of the anomalies. Still, even if you take that out, it’s a very strong showing. Our core merchandise businesses, food and sundries, hard lines, soft lines, and fresh foods, as a group they were up year over year in Q4 by about 32 basis points. Within these major departments, food and sundries and fresh foods were higher by quite a good amount. Hard lines was up slightly, even with the year-over-year decline in the majors department, not as much of a decline as historically, and soft lines was down ever so slightly.

In terms of the majors department, when I was explaining in the last few quarters how our margins have been impacted dramatically to the negative from the continuing reduction in gross margin in that department, I think I recall the last quarter’s conference call that year-to-date through the third quarter, that department, which his about 6% or 7% of sales, was down in excess of 150 basis points year over year, so it impacted our total company’s gross margin by over 10 basis points.

In the Q4, that department was still down but not down as much, down about 50 basis points, so we are seeing the impact of our returns policy change that began back in February and April.

Fresh foods, as I mentioned, was also up nicely, reversing a slight negative trend year over year in Q2 and Q3.

Also, Q4 gross margin was impacted, I mentioned by the four basis points from the higher sales penetration of the executive membership and nothing is unusual there. Year over year, the basis points hit, if you will, to Q1, Q2, and Q3 this year versus Q1, Q2, and Q3 last year were minus 10 basis points, minus 6 basis points, and minus 7.

The minus 4 actually might be a little bit of an anomaly. We do expect it to continue to go down over time. I know in the first month of this fiscal year, it is back in the minus 6 or 7 range, I believe, so not a big impact either way but we would expect that to come down over time.

Pharmacy gross margins continue to be strong, actually up a little year over year in Q4, notwithstanding the increasing penetration of Medicare Part D, as well as the competitive issues with generics, which we certainly are a part of.

And as I mentioned a minute ago, we estimated that the Q4 margin benefit from improving sales returns reserve was about 7 basis points, mostly from the change in our electronics policy.

In terms of our gross margin outlook going forward, the reported gross margin in Q1 of ’08 should be positive but we’ll have to see by how much. Again, I mentioned we’ll still see some impact from the increasing executive membership base, nothing huge but something in the mid to -- probably in the mid to high single digits.

LIFO, we’ll have to see. For the year just ended, LIFO was essentially flat, almost to the basis point. Deflation in electronics pretty much offset some inflation in other areas but overall it was flat for the company.

Our core merchandise groups should be okay in terms of margin. I should mention that I was looking back at our Q1 conference call in ’07 a year ago and I did mention that some of the margin strength in Q1 a year ago related to strong gas margins in the first quarter. So far, we haven’t -- it’s not horrible but we haven’t seen the strength that we did last year, so we might get hampered a shade by that in the first quarter.

In terms of returns policy change, I think we can say now that in Q4 it started. In ’08, it should continue to improve going forward and we’ll try to share that with you as we go along.

Other initiatives, again we’ve been a little vague on what the other initiatives are but we have some underway and they too have started. I think you see that in the quarterly numbers, even taking out some of the anomalies that I mentioned.

So the outlook for ’08 should be increased gross margins, but I would ask you not to look at Q4 as a template for the upcoming year. There are some anomalies in there and we think it will be good but certainly Q4 had some extra good.

In terms of our ancillary businesses, pharmacies, we added seven to be at 429 at year-end; food courts, we added eight, to be at 482; one-hour photo labs, eight to be at 480; optical, optometry shops, we added eight to be at 472; the print and copy remain at eight; we added 10 hearing aid centers to be at 237; and seven gas stations to be at 279.

Moving down to SG&A, our reported SG&A percentages fourth quarter over fourth quarter were not very thrilling. On a reported basis, SG&A was higher year over year or worse by 23 basis points, coming in at a 9.81 versus a 9.58 last year in the fourth quarter.

In terms of looking at Q4, the 23 basis points, there were really three components; core operations was worse or higher by 23 basis points; central was slightly higher by two basis points; and we actually had a slight tick-up from stock option expense year over year, or equity related compensation expense of a pick up of 2 basis points.

Now, a little editorial on that and I kind of look back to some of the budget meetings we’ve had where the numbers weren’t, or a particular expense category wasn’t good and as Jim would say in the meeting occasionally when the numbers weren’t good, we’ve all managed to screw this up together this time.

In terms of the 23 basis points in core business SG&A, payroll and benefits were about 11 basis points of it. Now, about six of that, four for wage and two for benefits, relates to the $1 an hour increase, which we will cycle through coming up in the beginning of the third quarter. I am sure that the 2% August comp didn’t help, even though the comp for the quarter was pretty good. When you miss the number, you get hurt a little more than when you make the number and benefit from it.

U.K. and Korea, particularly U.K., their expenses as a percent of -- SG&A as a percent of sales was actually up close to 100 basis points year over year. There were some anomalies in that but overall it was not a good showing. That small piece of the business impacted the 23 by six basis points.

And then the last thing is the extra week. There are some expenses, not many, but there are some expenses that are spread over 13 four-week periods, or in the case of last year, an extra fifth week, so you had a little benefit last year. We estimate that’s about seven basis points of the number, so there are a couple of anomalies in here.

Certainly the $1 an hour increase, the bottom of the scale, certainly the extra week, I’ll take the U.K. and the rest of the detriment and chalk it up to not doing as well as we thought we could have.

I am sure that we are not going to fix all of this in the first quarter, but at least in the fourth quarter we saw good strength, probably better-than-expected strength in margins offsetting a little worse-than-expected weakness here.

In terms of the outlook going forward, again payroll will be challenged, with part of it through the second -- through this end in the second quarter, when we anniversary the bottom of scale.

Next on the income statement is pre-opening expense. It was pretty much the same, about $800,000 higher year over year, coming in at $15.9 million versus $15.1 million a year ago. Last year in the fourth quarter we had nine openings. This year, eight, so no real surprises there.

In terms of the provision for assets, impaired assets and closing costs, that was up year over year in the quarter but last year in the fourth quarter it was $1.6 million. This year, it was $4.9 million. The main reason for this increase in Q4 is simply the upcoming plans for eight to 10 relocations in ’08 versus a year ago, our expectations for relos in ’07 was zero.

Once we decide to go ahead on a relo, all remaining depreciable assets that are to be written down are then amortized over that shorter time period and so basically, I think just two warehouses alone were about $3 million of that number.

So all told, reported operating income in Q4 was up year over year from $514 million last year to $555 million this year, or up 8%. Excluding the membership charge of $56.2 million, operating income would have been up 19% versus last year and again notwithstanding it being one less week this year.

Below the operating income line, our reported interest expense was higher year over year with Q407 coming in at $32 million versus only $3 million a year ago. This of course reflects the $2 billion debt offering that was effective the first day of Q307. Basically, $2 billion at roughly 5.5% times 16 weeks, that’s roughly your $30 million plus.

In terms of the $2 billion debt offering, we completed that in mid-February. The offering was comprised of $900 million of five-year debt, with an all-in interest of 5.36% and $1.1 billion of 10-year debt at an all-in of 5.57%. Again, that was booked on our balance sheet in Q3 as the transaction was funded just after Q2 end.

On the interest income side, it was not up as much as interest expense because we are spending the money. It was up $15.2 million year over year for the quarter, coming in at $59 million this year in the fourth quarter versus $43.8 million a year ago.

So overall, reported pretax income was up about 5% year over year in the quarter to $581 million, but on a normalized basis exclusive of that membership charge, pretax was up nearly 15% versus last year’s quarter. And of course, again the adjusted 16 versus 17 week quarter.

On to our tax rates, pretty much the same year over year, coming in a shade under 36% this year and last year in the quarter. In terms of our balance sheet, we’ll have this in -- online later today in that Q&A that we do that has a few other statistics as well, but I’ll give it to you here: cash and equivalents of $3.356 billion; inventories of $4.879 billion; other current assets of $1.089 billion; total current assets of 9.324; net PP&E of 9.520; other assets of 7.63, for total assets of 19.607.

On the right hand side, short-term debt of 1.14; accounts payable of $5.125 billion; other current of $3.344 billion, for total current of $8.583 billion, giving you a long-term debt total -- I’m sorry, total current liabilities of $8.583 billion; next, long-term debt of $2.108 billion; deferred and other, 225; total liabilities of 10.914; minority interest of 69; stockholders equity of $8.623 billion; for a total of $19.607 billion.

Debt to cap, about 20%, notwithstanding the added debt. Plenty of financial strength. In terms of our AP ratio, accounts payable as a percent of merchandise inventories, on a reported basis is up five percentage points from 100% last year to 105%. Again, a chunk of that relates to construction payables with all the expansion we’ve got going on, so if you look at just merchandise payables as a percent of inventory, it too improved by about four percentage points from 83% to 87%. With $4 billion of inventory, every percentage point is $40 million in cash.

I am happy to report that average inventory per warehouse -- last year for the fourth quarter, the average per warehouse was $9.959 million. This year, it is $9.999 million, so we are up just under one -- about 0.5% or $40,000. I can’t recall the last time we had such a small number there.

By comparison in Q3, year over year in Q3 our average inventory per warehouse was up just under $500,000 per warehouse, or up 5%. Looking at the first month this year, it is actually down ever so slightly year over year, so as we said last call, we are working on trying to reduce inventories a little and I think we’ve gotten off to a good start in the last quarter.

We don’t have any inventory concerns at year-end. Our fiscal inventories came in at record low shrink numbers.

In terms of CapEx, for all of fiscal ’06, we spent just under, a shade under $1.4 billion. We estimate that our CapEx in ‘08 will be more likely in the $1.7 billion to $1.8 billion. I think our budget is a shade higher than that but we never make our budget. It’s always a little -- inevitably, some things get delayed so probably a good estimate is in the $1.7 billion, $1.8 billion range.

Not only up to 40 new openings, including the eight to 10 relos, but also a little over $100 million for depot expansion and a big increase in our remodel activities, which of course are glued to relos.

In terms of dividend, back in April we announced an increase from $0.13 per quarter to $0.145. This $0.58 per share annualized dividend represents a cost to the company of just under $250 million annually.

Costco Online, it’s continued to do well, a 36% sales increase in the fourth quarter. Again, adjusting for the extra week, if you adjusted for the 17 weeks versus 16, that would imply something in the low to mid 40s. And a 39% increase for the full fiscal year, with sales for the whole fiscal year coming in a little over $1.2 billion.

In terms of expansion, I mentioned total openings of something in the low 40s. That assumption includes eight to 10 relos, so something in the low to mid 30s in terms of net new units.

In ’07, just to review, we added 30 net new units plus one in Mexico. On last year’s ending base, exclusive of Mexico, the 30 on base of 458. For the year, it was 6.6% unit growth and probably right around 7% square footage growth, recognizing some remodel activities include expanding square footage, as well as new units tend to be a little higher than the company average of around 140,000 feet.

In terms of ’08, if we are assuming, just in terms of net new units, we add let’s say 32 or 33, that too on a base of 488 would be unit growth in the 6.5%-plus range and approximately 7% square footage growth.

In terms of stock purchases, repurchases, since June of ’05 and through September 2nd fiscal year end, we’ve repurchased approximately 74 million shares, or about 15% of the shares outstanding, at an aggregate purchase price of $3.853 billion. That averages out to $52.05 a share.

Recently, our Board approved an additional $300 million. That was simply to add to the existing $4.5 billion, so if we’ve spent just under 3.9, with the 300 added we’ve got about $947 million still available authorization as of fiscal year end.

We did the additional $300 million simply to get through the blackout period. You never know what’s going to happen in the market and wanted to have some available if we needed to.

For all of ’07, we repurchased 36.4 million shares for just $20 million under the $2 billion mark in dollars, or an average price per share of $54.37.

Finally, before I turn it back to Frances for Q&A, looking at first call, again I ask you not to go too crazy on the numbers. When I looked at the first call sheet yesterday, you had a first call number of $0.59 -- or first call had a number of $0.59 for the first quarter and a total for the year I believe of $2.91.

I think this happened about a year ago. When we look at our own budgets for the year, the first call numbers tend to be skewed a little bit stronger in Q1 and a little less strong in Q4, and if I take the same percentages of last year’s actual, of ‘07’s actual numbers and applied it to the first call numbers, the $0.59 would come down a couple of cents and the fourth quarter would go up a few cents.

In terms of our range, in terms of looking at Q1, again compared to the $0.51 number this year, I think the $0.59 may be a shade high. I mentioned gasoline, that it was very strong a year ago in Q1 and it was okay in September of this year but we will have to see how the next two months go. Even with that, I think we would see a number in the mid to high 50s as a range.

For the year, again I assume the expectations were up a little. Our own budget, before we even finished Q4, was up a little from where First Call is. At this point, I would probably give a range from the high $2.80s to $3, and hopefully we can do a little better than that but it is early in the game. You don’t know what’s going to happen with the economy. We’ve got to improve our expenses a little and we think the margins will be fine but again, I try to share with you all the anomalies, both positive and negative there.

But we are getting off, we are starting off well with some challenges, given the strength of Q4 and we have -- you know, we are pretty optimistic about the year so far.

Lastly, in terms of outlook, again membership should be fine. We have no anniversaried, even on a deferred basis, the $5 increase that we did almost two years ago. Gross margin, again, get a little hit from executive membership penetration but that’s okay. Electronics should be a positive and the initiatives that we have underway should continue to improve a little bit.

SG&A, again we are now cycled through options so we shouldn’t see a big plus or minus there at all. As I mentioned, the bottom of scale increase, we still had two more quarters of and if you include benefits in that, that’s about 6 basis points of a hit. And then we’ve just got the challenges of doing a little better than we did in Q4 there.

Again, later this morning we’ll have some additional financial information we post to the Costco investor relations site, including the balance and EPS calculation detail and what have you.

With that, I will turn it back over to Frances for Q&A.

Question-and-Answer Session


(Operator Instructions) Your first question comes from the line of Deborah Weinswig.

Deborah Weinswig - Citigroup

Thank you and good morning, Richard. Can you talk about in light of some of the weather trends we’ve seen the most recent months kind of how the sale of seasonal items has trended, and anything that you are thinking about doing differently as a result?

Richard A. Galanti

Well, I was just talking to the apparel buyer yesterday and the outerwear is going out crazy here in the Northwest because it turned winter on us. It’s been in the 50s and low 60s and rainy. However, as you well know, from Chicago to New York and in parts of the southeast, it’s been unseasonably warm up until very recently in some parts.

We don’t have any big concerns about markdowns. In fact, markdowns relative to our expectations for markdowns in the first month were a shade better than plan. I’m talking about in the $100,000 range better, so in other words, no indication that we have any issues there.

But outerwear I think is the one issue that you have and recognizing apparel is a single digit, low to mid single digit department for us, men’s and women’s outerwear -- men’s and women’s apparel and outerwear is a component of that. Other than that, we haven’t seen a lot yet.

In terms of seasonal holiday stuff, as we shared with all of you in trying to explain that August we felt was at least included some aspects of a blip in that we weren’t terribly exciting in the second half of August. We definitely feel that the places are more exciting and what little seasonal stuff we have, we’ve done fine with. And we are in stock in seasonal stuff.

Deborah Weinswig - Citigroup

Something I thought was interesting was you said the fresh food trends had reversed from the negative trend in the second and third quarters into a positive trend in the fourth. Is there anything you are doing different there? Why do you think the change in the business?

Richard A. Galanti

In talking to Jeff Lyons, who is the Senior VP of Fresh Foods, I think it is a little bit the comment that I made and that Jim says occasionally, we all manage to screw up together. If you look back at the last couple of quarters, there was some issues of higher D&D, or spoilage, where we were -- inventories were a -- a little bit too much was brought in when sales were, you know, just even a couple of percentage points, you can get some extra spoilage. And they’ve been working on it.

I think that’s a good example of where they are managing to screw up a little and they improved some of the components -- not the pricing, but the components of a margin like spoilage.

Deborah Weinswig - Citigroup

Last question; we’re starting to hear, especially as we are approaching holiday, a lot about the competitive environment and how retailers are, you know, it looks like it is going to be a very promotional holiday season. Can you just talk about how you are thinking about the competitive environment and what we might see? Obviously don’t give away any company secrets but what we might see out of Costco for the holiday season?

Richard A. Galanti

We’re a little bit of an anomaly in that, too. It is fiercely competitive out there. We are fiercely competitive. We haven’t seen any big change in anything. Certainly when the traditional retailers, whether it is Target or Wal-mart or Best Buy, does something promotional, that gets some more traffic in there.

We think that some of our marketing efforts, which as you guys know have grown over time from what was originally a summer passport to the winter wallet to some weekly handouts and some other couponing, that stuff has down well for us and I don’t think there’s any big change year over year but that is certainly helping.

In terms of competitive pricing, I don’t -- I haven’t heard anything that there is any need to do anything crazy there, other than the normal craziness that we are anyway.

Deborah Weinswig - Citigroup

Okay, thanks again, Richard, appreciate it.


Your next question comes from the line of Chuck Grom.

Chuck Grom - J.P. Morgan

Good morning, Richard. Thanks. Just on the margins, is there anything more on the initiatives that you talked about last quarter and a little bit earlier that you could share with us? And I guess how much of that may have helped the most recent results today?

Richard A. Galanti

I don’t want to go into a lot of detail. Again, if I had -- as we were trying to pencil it out ourselves, it’s probably something about a quarter to a third of the improvement. But again, we’ll have to see what next month and the next quarter brings.

Chuck Grom - J.P. Morgan

Okay, fair enough. We were recently down in Southern California and one observation was on the seasonal category, particularly how much Kirkland product seemed to be there versus last year. Was this just an anomaly on our end or could you remind us where you were historically and is this a focus in some of the non-competitive categories that you can expand some of the Kirkland brands?

Richard A. Galanti

My guess is what you may have seen is all -- there’s probably an increase in a lot of what I will call trim-a-home and trim-a-tree and some of the Christmas stuff, and that’s bulky and big and you see it out there. So all the lighting and things like that, that may be part of it.

It’s continued to increase. Other than from a seasonal point, you might have seen a big chunk of the new stuff. It’s growing. If I had to guess, it grows at 0.5% to 1% of penetration a year.

Chuck Grom - J.P. Morgan

Okay, and then just last, just to switch gears a little bit, could you speak to the returns and the margin profile of some of your international stores, particularly outside continental America and I guess where you see the biggest opportunities for store growth on this front?

Richard A. Galanti

It’s funny. Every country’s a little different. Some countries have nationalized healthcare and therefore, benefits are a lot less as a percent of sales. Some companies, of course, have lower wages. We have high wages relative to that country but as a percent of sales, instead of being 4%-plus it’s 2%-plus. Turn around and the occupancy cost is an extra point or two. So it’s funny how it all seems to wash out and be pretty close in terms of total types of expenses.

On the margin side, we historically -- Canada and the U.S. is pretty much consistent. I think Canada if anything might be a shade higher. I think the other countries, sometimes we start off a lot lower, in part because you start off with lower volumes in a new market, but I think they are all trending towards the numbers that we see in our company.

There’s a couple of countries of smaller, in Asia, that have higher-than-average margins. We have some units over in Korea and Taiwan that do in excess of $200 million and one unit that does in excess of 300. That’s on, relative to five and six years ago, a weakening currency over there.

So for whatever reason, everybody likes value and we seem to have been clicking. Now, that doesn’t mean that we are going to ramp up international expansion dramatically. We still are focusing a lot on the U.S.

I guess it’s pretty much public knowledge we’ll be going into Australia over the next year but again, if history repeats itself in the U.K. and any of the three Asian countries, don’t expect to see more than a couple of units to start with.

Chuck Grom - J.P. Morgan

Okay and just one more, if I could; of the gross call it 40 to 45 you are going to open next year, how many are U.S.? Is it about two-thirds?

Richard A. Galanti

No, I think it’s a little more than that. Hold on a second. Do you have that? Why don’t I --

Chuck Grom - J.P. Morgan

I could just get it offline.

Richard A. Galanti

Yes, get it offline and we’ll go to the next question and they’ll look that up.

Chuck Grom - J.P. Morgan

Okay. Thanks a lot.


Your next question comes from the line of Gregory Melich.

Gregory Melich - Morgan Stanley

A couple of questions; one is first on the membership fees. If I caught you correctly, the 17% growth that we had once we add back the charge was helped because of the week -- I guess the change in one week in the quarter and it’s 2% if you take the as-reported. If you think about how membership fees are actually trending on a like-for-like basis and what we should think about what you want it to be, is it still in that low double-digit type growth range? Is that sort of the optimal number for you guys?

Richard A. Galanti

I’m just looking here. Yeah, I mean, it looks like it should grow on a reported basis slightly above top line sales growth.

Gregory Melich - Morgan Stanley

I guess I’m just trying to get to a clean number as we think about the future. We should sort of take this year as the base as a percentage of sales and use that when we try and --

Richard A. Galanti

I think that’s fair, yeah. I think that’s fair.

Gregory Melich - Morgan Stanley

Okay, and then the second question is on the cash. Is it fair to assume going forward that you now have the debt you want and the capital structure you want so that the -- well, do we have the right number of cash and equivalents just to run the business, or could that be lower?

Richard A. Galanti

We have a lot more cash than we need. At year end, we had -- if we had $3.4 billion of cash and equivalents, about 1.4 of it is the stuff that I talked about, the debit, credit card receivables and monies in various trusts and things. There’s easily $1.5 billion to $2 billion of that number that is excess as it relates to our needs.

In terms of what the outlook was, when we did the $2 billion offering, debt offering in mid-February, in very broad, simplistic terms, you’ve got net income both in ’07 and ’08, something in the low one-point-blank amount, you have depreciation in the $600 million amount; you’ve got dividends in the 250 amount, so in very simple, big rounded numbers, you’ve got -- I’m sorry, net income of the 1.1, depreciation in the 600s, we still have $200 million to $300 million in stock option exercises, my guess is at least for another couple of years, so you are talking about cash coming in and approaching the $2 billion range each year. And then in ’07, of course, we spent $2 billion. So at mid-year, and if you just simply annualize that through the end of ’08, what we -- what the math would show would be is that we had -- what we were doing was adding at mid-year when we had about 2.6 I believe in cash, so about $1 billion of excess cash, by adding $2 billion to that, $3 billion of excess cash which, at a $2 billion stock buy-back rate, is $1 billion every half of year, gets us through the end of ’08.

Now, there’s no guarantees that we’ll buy $2 billion a year. We bought $1.4 billion in ’06 and just under $2 billion, $1.980 billion or something in ’07. Our MO has been to be in the market generally on a daily basis, through blackout periods using 10B51s, but there is always that caveat as market conditions warrant.

Typically, we’ve not tried to be too smart or too silly. When it goes down a little bit, we buy a little and when it goes up a little, we buy a little less. We’ll have to see where we go. I would imagine we will continue to be in the market and we’ll continue to adjust accordingly.

From a comfort standpoint and a leverage standpoint, and this is simply all you guys or your banks could do the same kind of analysis, in terms of there’s still, even with this debt level, there’s a lot of capacity to still maintain our debt ratings. We are not looking to do that right now. We’ll take it one step and one quarter at a time.

Gregory Melich - Morgan Stanley

And what’s the board’s attitude to a special dividend versus buy-backs?

Richard A. Galanti

That attitude hasn’t really been looked at I think in a few years. The attitude back when we were deciding what do we do with our balance sheet and how do we change its complexion a little bit, and this goes back two-and-a-half years ago, the thought was let’s initiate a dividend and raise it occasionally. Let’s ramp up expansion, which frankly we were doing anyway, and let’s buy back stock.

As you have seen historically over the last two-and-a-half years, two-and-a-quarter years, we’ve done that at a slightly increasing higher level. Going back two years ago, one of the decision processes was special dividend versus stock buy-back. At that time, the decision was to buy back stock. I don’t really think we thought about it much in that regard since then.

Gregory Melich - Morgan Stanley

Okay, great. Congrats on the margins and I’ll let someone else go.

Richard A. Galanti

But before I do, let me just mention the number in terms of the -- of the 32 to 33, about 85% of the new units will be U.S. and Canada, with a few of those in Canada, and about 15% internationally outside of North America. Next question, please.


Your next question comes from the line of Todd Slater.

Todd Slater - Lazard Capital Markets

Thank you. My first question is just back on the gross margin, because I’m just trying to understand, especially the merchandising piece, the 35 basis point increase in that one because I don’t remember that size of a change from one quarter to another or year to year in -- I don’t know, the 14 or 15 years or so I’ve been following it, so I’m just trying to -- if you could help us understand what is changing in the model or in the buying strategy or -- I mean, I understand the other moving parts that you mentioned but on the merchandising side, what’s changed there?

Richard A. Galanti

Real quickly, first of all I did mention we estimate about seven basis points related specifically to the improvement in our sales returns reserve, because that’s the beginning of that trend with our change in returns policy.

Todd Slater - Lazard Capital Markets

But was that in this 35 or -- I know the 38 total was seven but then it was 35 just on the merchandising.

Richard A. Galanti

I’m sorry, you’re right. I think one of the earlier questions from Chuck or someone was what piece of this action was initiative related. I said a quarter to a third. It’s probably closer to a third and that’s taking a swag at it. My guess is there’s a few -- those are some things that are very definitive that we saw. My guess is there’s a few other straggling basis points out there that are part of that.

Arguably, of the 35, if it were a third, that’s about 11 or 12. If it were half, it’s about 17. probably somewhere between there, call it 14 or 15 for a good estimate I guess would be the beginning of those initiatives.

The fresh foods margin again, I think we picked up a few basis points there simply because after a couple of quarters of being down year over year, we were up and that I think is sustainable because, as I mentioned in Q2 and Q3, we felt that there were some anomalies in there, that we could do a better job just on operations and it had nothing to do with pricing.

I think as it relates to the initiatives, where is it? Again, for competitive reasons, we’re not going to say a lot, recognizing you are not making it on commodities and on Tide and Crest and Snickers bars, but we’ve always fought this battle with being extremely disciplined and extremely low on margins, irrespective if our competitors even had the item.

There are ways, as we’ve looked at it, there are things like imports and things that go to our depot where we’ve never, if you will, benefited in our view from the full benefit of having those benefits, trying to pass on all of it to the members, or virtually all of it.

As we try to see how can we get some more margin, not go crazy because recognize under Jim, we’re not going to go crazy, we feel that there were some avenues that we could improve a little margin and maintain the integrity of what we try to do in terms of constantly try to figure out how to lower prices as well.

That’s a roundabout answer but that’s what it is.

Todd Slater - Lazard Capital Markets

Okay, and then I was just wondering about on the expense side, if you could just give us your sense for ’08 of what the positive or negative pressures on expenses in terms of direction in the big buckets like labor and benefits and distribution, utilities -- is there anything else that you think is important for us to note?

Richard A. Galanti

Recognize benefits are about 40%. For every $1 of labor, there’s about $0.40 of benefits, and that’s everything -- FICA, vacation, contribution to employee’s 401K plan, healthcare -- healthcare of course being the Big Kahuna, FICA and vacation being the next couple.

So through the first half of the year for Q1 and Q2, we will have not yet anniversaried the $1 an hour increase, so that’s about -- you know, four plus two, labor and benefits, that’s about 6 basis points. Actually, into the first month of Q3, so maybe a basis point-and-a-half in Q3.

Again, equity compensation should be roughly zero, so it’s not a negative but it’s not a help. Utilities, my guess is that they are going to run up a little bit as a percent of sales just because you hear about that on the news every day, that everybody’s utilities are going up, notwithstanding the fact that we are doing, we’ve done a lot, as everybody has, with computer programs to manage the lights and the temperature and all that.

I don’t -- again, as I’ve said before, there’s not a lot of silver bullets in that. I think clearly Jim Murphy, who runs international, feels that the U.K. will do better. It’s not going to be overnight but that kind of detriment, the estimated 6 basis points of detriment from the U.K. to the company should come down and ultimately flatten out.

I still believe that a lot of it is comp related. If we perform like we did in September, I think we can be a little better, relative to what we saw and if it falls to 2% -- there’s no indication it’s falling, by the way, but we’ll see. I mean, this week is good. As I said a month ago, the first day of September was good and we came in fine, but we’ll have to see.

Todd Slater - Lazard Capital Markets

Thank you, Richard. Good quarter.


Your next question comes from the line of Christine Augustine.

Christine Kilton-Augustine - Bear, Stearns

Thank you. Richard, could you tell us maybe specifically what sort of initiatives you have underway to reduce the inventory per club? Are you actually reducing SKUs or is it something to do with the flow of the inventory to the club?

Richard A. Galanti

Well, we are reducing SKUs, although as trends always have it, a year ago there were companies at every budget meeting, Jim was saying if you guys can’t do it, I’ll do it. It will take about a half-an-hour.

There have been some regions where they got a little less than they should have by 100 SKUs, but I think right now we are pretty much on target with our SKU selection and we have probably 200 fewer SKUs today than we had a year ago, maybe 150. That does help you because you are massing out bigger quantities of higher volume stuff and you are getting rid of the stuff ultimately that you should be getting rid of.

There’s a lot of things. This is a silly example but a good example of how we can -- this has to do more with improving margin but something as simple as all the new detergents that are coming in with like Ultra Squared, or whatever it’s called now, Ultra III, that it’s half the size, half the cube. That saves thousands of trucks.

We’ve greatly reduced tobacco SKUs. I’m not talking about Canada but we recognize that some of our tobacco sales, while it’s nice because it helps SG&A a little bit, we don’t make a lot of money on the couple hundred SKUs that are not Marlboro and Winston and the like.

It’s a lot of little things. You are constantly being more efficient. I would say the biggest area is SKU reduction and that’s a seasonal thing as well. Again, I think we are doing a better job of that.

The number that Jim threw out about three or four months ago and I think I mentioned on the third quarter conference call that his goal, barring inflation or deflation, was to reduce inventories by $500,000 to $800,000 over the next couple of years.

If you look at the average inventory at Q3 end versus year over year versus Q4 end, we improved by over $400,000. If you look at Q4 end versus the first month, month over month, end of September versus end of September, we picked up another $50,000 to $80,000.

I am sure there will be months when it goes up a little and months when it goes down, but I think the trend has been that we have probably done a few hundred thousand of the $500,000 to $800,000.

Christine Kilton-Augustine - Bear, Stearns

On the CapEx guidance for ’08, if I just take the low end of the range and I think you said there’s $100 million in there for a depot expansion, it looks like it is still $200 million higher than what you spent in ’07 for basically the same net number of new clubs, so is there something else --

Richard A. Galanti

The big thing there is that you’ve got -- let’s assume -- I said eight to 10 relos. I think we have 10 in the budget, so inevitably one or two slip into the next year. They will all happen but let’s say it was nine. Nine times 26 or whatever, that’s your 200 bucks.

Now there is an offset to that disposing, my guess is without looking at the list of those that are being replaced, two or three of them are probably leases which were at the end of the lease that just go away, so there’s no sales proceeds from them. And no doubt if we are replacing them, they tend to be smaller, older, less well located facilities that have been depreciated down. Not going to be a big hit or gain either way, probably, but if we are spending let’s say 26 on average for land, building and site, my guess is we’ll pick up 10 or 15 on six or seven of them, so it’s probably some number in the mid 250 to 275 minus 125, that gets you to something in the 150 to 200 range.

Christine Kilton-Augustine - Bear, Stearns

And then, in your outlook for ’08, how much buy-back are you assuming?

Richard A. Galanti

I don’t think I can really say what we are assuming. What I’ve said in the past is our MO has been to buy daily. I’m assuming we are going to continue to buy daily. As I said, when it goes up, we buy a little less that day.

Clearly, we have shown that we bought more at 58, 59 and 61 than we did at 46 two years ago. I'm not suggesting we're going to buy more tomorrow at 68; we'll take a breath here for a minute.

My guess is we'll continue to buy back and I think you should assume on a regular basis, based on what I said about debt and based on the stock always fluctuates. In a vague way, we'll buy, but I'll let you make that decision.


Your next question comes from Mark Husson - HSBC.

Mark Husson - HSBC

First on food price inflation. You saw the Kroger numbers where they had a pretty decent gross margin on the back of being able to pass through some of the food price inflation now. Could you talk about, I think you mentioned that it was a better margin. What specifically was the contribution in the quarter from better food?

Richard A. Galanti

I'm sorry, Mark. Say that again? The question part.

Mark Husson - HSBC

The gross margin on fresh food seems to have been quite good for food retailers in the last three months. You had said there was some contribution in the quarter from fresh food in terms of margin mix. Can you be a bit more specific? Was the inflation pass-through more efficient in this quarter?

Richard A. Galanti

I assume it was, if we have a little better margin. Our margins year over year in the quarter in fresh foods were up I think about half a percentage point. Again, some of that is our own improvement in operational; throwing away less.

I think the answer, like what you're hearing from the other types of food retailers, I'm sure that we can do that as well, recognizing, we don't play exactly in the same game as them. But yes, margins in fresh foods were fine. I'm willing to bet that the 0.5% plus was at least half -- if not more of it -- was operational. I don't have that detail in front of me.

In terms of inflation, just looking in the first month down the list, there are two items that were inflationary versus a year ago; lamb, grapes. Interestingly, when I look at this list, usually the list is tobacco and gas, and of course, that's not the case here.

I did hear at the budget meeting yesterday that we're hearing from lots of the paper people --and paper is everything from towels and tissue and toilet tissue to diapers to copy paper – to expect to see some increases in the low to mid single-digits there in cost.

Mark Husson - HSBC

Two other questions. Could you talk about California and what you're seeing and what the outlook is there in terms of demand?

The second question is on our sourcing surveys, we noticed that your percentage of China importing has gone up about 300 basis points year over year to about 38%. Is that one of the initiatives?

Richard A. Galanti

Not particularly. I would be happy to look at some of your data and see if I can get some answers. I haven't heard anything as it relates to that.

In terms of California, I think I mentioned earlier that if you just look at the delta, the U.S. went from a 1 to a 4 in August versus September, or 3 percentage points higher. That delta was the same for California -- not from a 1 to a 4, but from a slight minus to a slight positive; but again, 3 percentage points. So it was pretty much in line with the company, although the Northwest and a couple in the Northeast were a little better than that.


Your next question comes from Robert Drbul – Lehman Brothers.

Robert Drbul - Lehman Brothers

I have a question on the consumer electronics. Can you just talk about your expectation on the return policy in terms of the margin impact as this year progresses, versus what you have already experienced in the fourth quarter?

Richard A. Galanti

What I have done for everyone in the past is simply talk about the fact that over the last four or five years, our realized gross margin in that department has gone from the very high single-digits to just below 5%; or well in excess of 400 basis points, closer to 500 basis points. If it's a department that's 6% or 7% of sales, times mid $60 billion in sales, you're talking about $4 billion plus, times 400 or 500 basis points is $160 million to $200 million.

All I've said is -- because I don't know yet, we don't know exactly -- if we could get half of $160 million back over two or three years, it's accumulated about 10 or 12 basis points; four or five, four or five, three or four. That's a guess. We'll have to see.

As I mentioned, it was 7 in Q4 but part of that may be relative to my guesstimates there, just a little bit more front-loading. It doesn't take three years; it takes one-and-a-half years, so we'll have to see.

Clearly, there's some real dough there. We have not seen any negative impact from customer responses. If anything, for every negative blog or email I read, there were ten people out there congratulating us -- and I don't think it was you guys. I think it was just customers who like us and agree that it was being abused.


Your next question comes from the line of John Jabb.

John Jabb

To stay on that topic of electronics, if you look at HDTV specifically, I'm curious what kind of trend you're seeing there.

In addition, I was in your store probably in late August, early September and saw you setting up a very large Vizio display. Vizio has gotten a lot of good press lately. I'm just curious how they're performing.

Richard A. Galanti

Well, in terms of HD, I don't know the exact issue there. I know that LCDs are outperforming plasma, but I think that's everywhere. In terms of Vizio, it's been a good relationship for longer than anybody else. We pretty much helped them get to where they are. We still have a good relationship. We're working with them to continue to provide high end stuff at great value.

We don't typically go out and request exclusives, and we feel good about what we have in that department, TVs, as well as what we have Vizio relative to others and the types of things that we're bringing in.

John Jabb

Do you feel good about the sell-through of Vizio then as well?

Richard A. Galanti



Your next question comes from Thomas Forte – Marquis Investment.

Thomas Forte - Marquis Investment

Can you indicate if traffic was positive in California in September?

Richard A. Galanti

You know what? We didn't run it. We ran it last time because we were trying to figure out reasons why the darn thing was so low. I haven't seen it. If you want to call and leave a message, we'll try to figure out.

Generally speaking, we're not going to try to give out states. We were trying to explain the negative. My guess is that given California, comp-wise, was up from August to September like the company as a whole, that we saw a similar improvement in the components; that being average ticket and average traffic. So traffic, if it had gone from 0.5 to down -- like in July it was I think 0.5, we said and August it was like minus 4.5 -- my guess is it's flat to down slightly, but not back to plus 0.5.

Thomas Forte - Marquis Investment

Can you tell us where we stand at the end of the fiscal year on private label penetration?

Richard A. Galanti

Last time I saw some numbers in a budget meeting, we were about 17. Now, that had a little spike last year because the private label diaper helped by a few tenths. Again, I think the way to look at it is more like the penetration goes up 0.5 to 1 point a year.

Thomas Forte - Marquis Investment

Third and lastly, can you give us an update on if you're seeing anything different in competitive pricing from either Sam's Club or BJ's?

Richard A. Galanti

BJ's has gotten more aggressive since their management changes, back to some of their original management several months ago. Frankly, for a few years there I don't think we were doing a lot of comp shops. We were doing them but they didn't mean a lot because there was, in our view, a big delta between our competitiveness and theirs.

To their credit, they've gotten more competitive. We still feel that we are more competitive, recognizing in some instances we're selling different merchandise or a different level of merchandise.

With Sam's, really from the get-go four years ago when they announced a management change and that they were going to be more aggressive on pricing, they have remained more aggressive on pricing. I wouldn't say there is any difference today than there was three, six , 12 months ago. It's still very competitive.


Your next question comes from the line of Michael Exstein - Credit Suisse.

Michael Exstein - Credit Suisse

Congratulations. For those of us who were skeptical on the gross margin, it's really very impressive to see what you can do when you put your minds to it.

I guess the next question we all have is, how high is high in terms of the gross margin? What do you talk about internally, that you are capable of doing without losing the competitive juices? Thanks, Richard.

Richard A. Galanti

That's more of an emotional question. What I dream about and what is reality are two different things. The reality is, rest assured, we're not going to crazy. If anything, when I first saw the last few months of the year, the first order of business is I hope it's not so much that the feeling is we need to come back a little bit.

How high is high? I would guess is only as much as we need and just recently I saw us lower the price on those – and some of you have heard me talk about them -- these Spanish almonds, these Marcona almonds that sell at Trader Joe's and Whole Foods at $26 and $30 a pound and we had them last year for $8.99 a pound. We now have them for $6.99 a pound.

We're still going to go and try to wow people with things and we're still going to do that. I think the issue is I don't know where the number is. I don't want to imply that it's way up there. If anything, I'm trying to temper the expectations based on what you saw in Q4. It will be good. So how vague can that be?

Michael Exstein - Credit Suisse

Following up, four years ago you talked about a five year goal of 100 basis points. Has that goal changed? We're now in year 5.

Richard A. Galanti

Well as you know, the good news was is for five or six quarters we did just that -- 20 basis points a year for a year-and-a-half. The bad news, for the next six quarters we went right back to where we started, if not a few basis points under.

First of all, the 100 basis points did not assume stock buyback, so you might temper the 100 with 70; I don't know what the exact number was. Then the question is: I think what we've learned is you don't know what is going to happen. Clearly, I think there's been a little more emphasis on focusing on it to try to get some of that. My guess is a safer number to look at is something in the mid-3s versus again, using 70 basis points from three years ago, so something like 40 or 50 instead of 70 over the next few years. We'll have to see.

As history would show, we'll be a year late and a basis point less; but still, I think we do feel that over the next two to three years we've got some good wins here and we can do some things.


Your next question comes from the line of Sandra Barker - Wachovia.

Sandra Barker - Wachovia

I was wondering in September, certainly it was a nice rebound and I know that the iPod was not in for the whole month and the seasonal stuff was still trickling in. Was there any meaningful impact from those? Would it have been better if you had those for the full month? Was it meaningful?

Richard A. Galanti

I think we're back on target. When we were in New York at the Goldman conference the Wednesday after Labor Day, I think by that time which was, if you will, three weeks since mid-August, when Jim said the second half of August we didn't look very great, very good in terms of starting to bring in seasonal, I think by the first week we were starting to see the trend going in the right direction; to be not all the way there but closer to there than not there. I don't want to build in any extra until we see how the next month comes out.

Sandra Barker - Wachovia

Could you talk about big ticket trends, generally?

Richard A. Galanti

Well again, majors continue to be good. Not crazy good like it was a couple years ago, so it's been still better in the company. Jewelry has probably softened a little bit in terms of big ticket items. What was amazing to me is diamonds as an example in '07 in carats was up 5% so I'm sure in dollars was up a little more than that. Those are really the two big ones.

Again, majors being up better than the company of course and let me just look at camera. Sporting goods, sporting goods includes everything from a 24-pack of tennis balls to golf clubs and $600 and $800 exercise machines, so I guess there's some big ticket items there. Sporting goods was actually up double-digits in September. The two big ones, jewelry was down slightly and again, majors was fine.

Sandra Barker - Wachovia

What percentage of your sales are now done on some kind of coupon? I know you've been giving out more and more coupons over time.

Richard A. Galanti

I honestly don't think I've ever seen that number. Maybe we don't want to look at it. But it's still a small piece. I'm just thinking aloud here. Based on just the amount of coupon savings, the dollars saved on those coupons that are actually transacted, I'm guessing probably something about 5%, maybe 4%, maybe 6%.


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

Adrianne Shapira - Goldman Sachs

Richard, just back on guidance, you shared a wide range for guidance and it sounds as if there's a reason to be encouraged on the gross margin. Just help us understand your top line expectations. In other words, if comps continue in this 4% to 5% range, could we be closer to the higher end of the range? Thanks.

Richard A. Galanti


Adrianne Shapira - Goldman Sachs

So towards $3 you need 4% or 5% and we get closer to $3?

Richard A. Galanti

Yes, as the higher end assumes an assumption, something that has a 5 in front of it and something that averages to 5, it might be 5 point something. Again, there are all kinds of other things you have to assume though, good and bad.


Your next question comes from the line of Teresa Donahue – Neuberger Berman.

Teresa Donahue - Neuberger Berman

Good morning, Richard, a great quarter. I'm curious with respect to Todd's question earlier on the gross margins, if you add up what you indicated were contributions from initiatives as well as the change in CE, it looks as though maybe two-thirds of the year-over-year increase you've got might be sustainable; and therefore, I'm wondering what that does to the operating model as far as the level of comps you need to get operating margin leverage and get earnings growth?

Richard A. Galanti

I think when you're saying two-thirds, you're adding my estimate of the initiatives plus the sales return.

Teresa Donahue - Neuberger Berman

Yes -- am I double counting?

Richard A. Galanti

No, you're not. Also in the model of the day, expenses were a little higher in Q4 than we thought. While I think we can fix some of that, again, nothing happens overnight. Some of that detriment is probably a little -- my guess is we came in certainly better on margin and came in certainly a little worse on SG&A, some of which is sustainable as well.

Teresa Donahue - Neuberger Berman

My question is the net bottom line result was that you showed a really strong increase in operating earnings on just a 5% comp, even with the SG&A being higher. So I'm wondering if a comp leverage point has been lowered from what you might have once said a couple of years ago?

Richard A. Galanti

If anything, Terri, it probably has gone up. Keep in mind that we also had the anomaly in membership fee income which half of that 26 is an anomaly, just on having the unusual thing a year ago in the quarter with the extra week.

Again, I try to share with you all these components, simply to recognize that we're going to do fine, but Q4 was a little crazier than that. I'm going to take one more question and I've got to go into a meeting downstairs.


Your final question comes from the line of Neil Currie - UBS.

Neil Currie - UBS

I just wanted to ask about what we used to call existing markets and new markets. I don't know whether you still call them that, in terms of what the units in the new markets are doing in terms of sales per square foot comparisons or sales per store comparisons against the existing markets. Also in terms of the store opening program for '08, what's the balance of stores looking like in terms of existing versus new?

Richard A. Galanti

I don't have that data right in front of me, Neil. If you think about new markets, and recognizing some new markets are two or three years old now, but generally speaking, those would be somewhere probably in the $75 million to $90 million range. Existing markets, the equation for the existing markets, the company average was 130. My guess is they're 150. So let's say 80 and 150; so there's a pretty big difference there.

Neil Currie - UBS

What's the difference in customer?

Richard A. Galanti

In what?

Neil Currie - UBS

Blend of acquisition costs in terms of existing and new? So trying to compare returns.

Richard A. Galanti

I think it varies. Certainly when Chicago was new that was as high an average as anything. Certainly when we do a Boise 2 or an Albuquerque 2, it's less. I guess I'd have to look at it. Feel free to call me and we can talk general numbers, but generally speaking, new markets take a little longer. We look at a threshold when we do a new market of five to six years of getting to a threshold return and we look at up to three years on an existing market, recognizing existing is easy.

Neil Currie - UBS

Just a second question. I know you talked about Australia earlier. Are there any other markets outside of that in the next five years that you're looking at, thinking of South America or Asia?

Richard A. Galanti

Within the next two or three years, probably not. We are constantly looking at other markets. My guess is it's more likely Asia and Europe versus South America.

Thank you, guys. I think Jeff and Bob will be available and I'll be available this afternoon. Thank you very much.

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