Costco Wholesale Corporation

Good afternoon. My name is Vincent, and I'll be a conference operator today. At this time, I would like to welcome everyone to the Q2 earnings call and February sales. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. And if you would like to withdraw a question, press the pound key. Thank you. I will now turn the call over to your speaker today, Mr. Richard Galanti, CFO. Sir, you may begin.

Thank you, Vincent, and good afternoon to everyone. I'll start by stating that these discussions will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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. Forward-looking statements speak only as of the date they are made, and the company does not undertake to update these statements except as required by law. In today's press release, we reported operating results for the second quarter of fiscal 2019. The 12 weeks ended February 17th, as well as February retail sales for the four weeks ended this past Sunday, March 3rd. Note that the first two weeks of February fell into this second fiscal quarter, with weeks three and four of February are the first two weeks of our fiscal third quarter. The reported net income for the quarter came in at $889 million, or $2.01 per share, a 27% increase compared to the $701 million, or $1.59 per share, last year in the quarter. In terms of sales, net sales for the quarter came in at $34.63 billion, a 7.3% increase over the $32.28 billion reported last year in the second quarter. Comparable sales for the second quarter, as shown in the press release, for the 12 weeks on a reported basis, U.S. was 7.4%. Canada was minus 0.3%. Other international, 0.7%. For the total company of 5.4%. As well, e-commerce for the 12 weeks on a reported basis was 20.2%. Excluding gas deflation, the impact of FX and some weakening foreign currencies relative to the dollar, as well as revenue recognition, which is an impact this year, the 7.4% reported in the U.S. would have been a 7.2. The minus 0.3% in Canada would be a plus 6.0%. Other international, instead of being 0.7% reported, would be plus 4.8%. With total company, the 5.4 reported would become a 6.7. And again, e-commerce reported at 20.2. X-Gas, FX, and RevRec, 25.5% plus. In terms of Q2 comp sales metrics, second quarter traffic or shopping frequency increased 4.9% worldwide and 5.2% in the United States. Weakening foreign currencies relative to the U.S. dollar negatively impacts sales by approximately 140 basis points. and gasoline price deflation was another minus 50 basis points of impact. RevRec actually benefited comp sales by about 55 basis points to the positive. These are the three factors that we adjust for and that are presented in today's release as the adjusted column. In addition, weather conditions adversely impacted Q2 sales by around a half a percentage point, and cannibalization weighed in on the comps by about minus 70 basis points. In terms of front-end transaction, or what we call tickets, Average front-end ticket was up 0.4% during the quarter. And excluding the impacts from gas deflation, FX, and RevRec, our average ticket was up approximately 1.8%. Going down the income statement, membership fee income reported came in at $768 million, or 2.22%. That's up $52 million, or 7.3% from a year ago. Again, with weak foreign currencies, if you adjusted for flat FX, That would make the up 52 another $9 million up 61 million year-over-year FX. Reported membership revenue of the plus $52 million amount, that's a little more than half of that, a little more than $20 million of that related to the membership fee increases taken in June of 2017 in the U.S. and Canada. We're now nearing the end of that 23-month cycle to recognize the incremental benefit of the increases, what was known as deferred accounting, into our P&L. The benefit to our P&L will be fully recognized in the next two quarters by the end of the fiscal year, but as with this last couple of quarters, it diminishes each quarter. In Q3, we'll have about half the benefit recorded in Q2, and in Q4, there'll be a very small benefit. In terms of renewal rates in the second quarter, our U.S. and Canada member renewal rates in Q2 came in at 90.7%, up from 90.5% 12 weeks earlier at Q1 end. And worldwide, the rate improved to 88.3%, up from 88.0% at Q1 end. So improvement in our renewal rates. In terms of the number of members at Q2 end, member households and total cardholders, we ended Q1 12 weeks earlier with 52.2 million member households. At Q2 end, it was 52.7 million. And total cardholders increased from 95.4 million at Q1 end to 12 weeks later at Q2 end, 96.3 million. During the quarter, we had one new opening in Carl Springs, Florida, and we also relocated a Miami location. At Q2 end, our paid executive membership base stood right at 20 million. This is an increase during the quarter of 341,000, or about 28,000 per week since Q1 end. Now, this includes the recent introduction of the executive membership in Korea, which is our fifth country offering executive membership. For Q2, Korea contributed a little over half of those increases. Going down to the gross margin line, reported gross margin in the quarter came in at 11.29%, up 31 basis points from last year's Q2 18 of 10.98%. The 31 basis point improvement, X, gas, FX, and REVREC would be plus 30 basis points. I'll give you the chart. There's not a whole lot to it given that the adjustment column is not that different than the reported column. In terms of core merchandise, year-over-year in Q2 was up one basis point on a reported basis as well, X, the gas, deflation, and the REVREC up one basis point. Ancillary businesses up 33 on a reported basis and up 32 on an adjusted basis. 2% reward, minus 3 and minus 3 basis points year-over-year. And then total, up 31 basis points, as I just mentioned, on a reported basis, and up 30 basis points, X, gas, deflation, and rev rec. The core merchandise component, again, was higher by one basis point here. Looking at the core merchandise categories in relation to their own sales, what we call core-on-core, margins year-over-year were higher by eight basis points. Within the four key subcategories, both food and sundries and fresh foods were up a little, and soft lines and hard lines were down a little. But the net of the four departments on their own sales was up eight basis points. Ancillary and other business gross margin was up 33 basis points, up 32, ex-gas, deflation, and rev rec, primarily driven by gas and also benefiting somewhat from e-comm and a few other things. Moving to SG&A, our SG&A percentage Q2 over Q2 was lower or better by two basis points, both with and without the adjustments, coming in at 10.0% of sales this year compared to 10.02 last year. In the chart that I normally give out, there really is not a whole lot to tell you. Operations was an improvement of two basis points in both columns. The other two line items that we usually point out, central and stock compensation expense, were zero and zero. So the total remained at two basis points, so overall two basis points better. In terms of that two basis points better, we feel it was a pretty good result given that we're still facing the headwinds from the U.S. wage increases to our hourly employees that went into effect last June 11th of 2018. As mentioned in the past couple of fiscal quarters, those wage increases negatively impacted SG&A by about seven to eight basis points during Q2 year over year. And it will continue to impact SG&A comparisons through Q3, which ends May 12th, and into the first month of our 16-week fiscal fourth quarter to anniversary on that June 11th. Additionally, this past Monday, we began our new three-year employee agreement. With the new agreement, we announced that we're taking our starting wages from $14 and $14.50 up to $15 and $15.50 per hour in both the U.S. and Canada. In addition, we're also increasing wages for supervisors and also introduced paid bonding leave for all hourly employees. These items are incremental to the usual annual top-of-scale wage increases that are typically done each March. Collectively, these additional items will add about three to four basis points to SG&A over the next four quarters. Now, again, this is on top of that seven-day basis point impact I just mentioned that will impact SG&A through this coming mid-June. Otherwise, pretty comparable year over year in terms of central and stock comp and other various SG&A expense line items. Next on the income statement is pre-opening. Pre-opening expenses were actually lower by $3 million, coming in this year at $9 million compared to $12 million last year. This year, again, we had two openings, one net opening and one relocation. Last year, we actually just had one opening. There's other activities that relate to pre-opening as well. Year-over-year, primarily the difference was due to the $4 million in Q2 last year related to our opening of our new meat plant in Morris, Illinois, slightly offset by higher warehouse pre-opening this year due to the additional opening. All told, reported operating income in Q2-19 was up 18.4%, coming in at $1,203,000,000 this year, compared to $1,016,000,000 last year. Below the operating income line, reported interest expense was $3 million lower or better year-over-year, coming in at $34 million this year and Q2 as compared to $37 million last year. The actual interest expense quarter over quarter each year is about the same, a little delta in improvement in capitalized interest amounts. Interest income and other for the quarter was better by $39 million year over year. Interest income itself was higher by $17 million year over year in the quarter, a combination of higher interest rates being realized and also higher invested cash balances. also benefiting year-over-year comparison with the various FX items in the amount of $22 million. Recognize that much of this is essentially an offset to the lower reported operating income and earnings in our foreign operations due to the strength of the U.S. dollar versus many of the foreign currencies in the countries where we operate compared to last year. Overall, pre-tax income in Q2 is up 23%, coming in at $1,215,000,000 this year compared to last year, $986,000,000. In terms of income taxes, our income tax rate was a little better than we had anticipated. It came in at 25.8% effective tax rate during Q2 2019 compared to 27.7% in Q2 last year. For all of fiscal 19, based on our current estimates, which, again, are subject to change, we anticipate that our effective total company tax rate for this fiscal year to be approximately 26 to 26.5%. This figure is about a half a percentage point lower or better than we had previously estimated a quarter ago. This is primarily due to a Q2 tax rate that now includes a one-time benefit for certain foreign tax credits. This one-time tax benefit will continue through the end of this fiscal year, but we do not anticipate a similar type of benefit beyond fiscal 19. A few other items of note. Again, we opened a net one unit during Q2, opened two including a re-roll. In Q3, we have three new openings planned and no reloads. We actually opened this morning in Bayonne, New Jersey. In late April, we plan to open our 16th location in Korea, and in early May, our 11th location in Australia. The big expansion quarter for us this year is Q4. We plan to open a net of 12 units, 14 openings, including two reloads, including our first opening in China, in Shanghai, in the city of Munhong. and also our third unit in Spain, which would be our second in the Madrid area. Any of these could slip a little bit, but our current best guess right now is 14 openings, including two reloads, so a net of 12. As of Q2N, total warehouse square footage stood at 112 million square feet. I might also add that in terms of CapEx, we continue to allocate more CapEx to grow and support our operations. including, as you know, over the last year, year and a half, we'd opened a second meat plant, the first one in California many years ago and then in March, Illinois. Also, a little while ago, our Canadian bakery commissary in Canada. We are under construction with the big chicken plant in Nebraska. We plan to start initial processing and production later this year. Depot expansion, we're doing that in many areas around the world. Also, we just – Just a month ago, I believe, we started up our first what we'll call fulfillment automation operation next to our – as part of our Mira Loma depot. This is for small packages for e-commerce, and we plan to do two more of those this year at other depots. In terms of two-day grocery, which, as you know, we started in October about a year and a half ago, we did that out of 10 or 11 of our business centers around the country, We're in the process of moving these operations out of the 10 to 11 business centers to six of our depots over the next several months. I think we've done our first one, and we've got several more planned right around the end of spring, beginning of summer. In terms of stock buybacks, in Q2, we expended $117 million to repurchase 561,000 shares at an average price of $208.72. The $117 million, of course, is significantly higher than the Q1 purchases of $35 million. In terms of e-commerce, overall, again, e-commerce sales increased during the quarter on a reported basis 20.2% and FX and RevRec up 25.5%. Continued increases in e-commerce in terms of orders and sales and profits and other metrics. Top growth categories in the quarter, quite a few actually. Grocery, consumer electronics, what we call majors. Hardware. health and beauty aids, tire automotive, toys seasonal, and apparel. We've now passed our one-year anniversary on the grocery launch, which was, again, a year ago, October. Same-day grocery delivery is now available to members within a short drive of 99% of our U.S. locations. Two-day grocery is available anywhere throughout the continental United States. And while still these are small pieces of our total business operation, they're growing nicely. We now have grocery shipments to all 50 states. In terms of e-commerce, in terms of new brands and items online during the quarter, we're now offering a much broader selection of Apple products, including the recent addition of MacBooks and iMacs. And, yes, you'd expect good values to our members. Also, the first of what we expect, several products from Sony. They've just started to arrive. In terms of health and beauty aids, new names like Living Proof Shampoo and Conditioner, Mirad Skin Care, and Kate Somerville items. On the exercise front, NordicTrack is a new name. And finally, I had to point out the now somewhat famous 180-serving, 23-pound, 20-year shelf life macaroni and cheese for $89.99. If interested, you can find that online under emergency supplies and in a few of the Costco locations. We continue to improve our online and in-line cross-market initiatives, and we think that's continuing to drive our business. In terms of buying online and pickup in-store, In the quarter, we expanded our selection within the same categories, jewelry, some electronics, and handbags, and continue to test pickup lockers in 10 locations for this program. Lastly, this calendar year, we will begin e-commerce operations in Japan early summer, likely, and in Australia late summer, early fall. Finally, I'll turn to our February sales results. The four weeks ended March 3, 2019, compared to the same period a year ago. As reported in our release, net sales for the month came in at $10.72 billion, an increase of 5.0% from $10.21 billion the year earlier. In terms of comparable sales, U.S., on a reported basis for the four weeks, was 6.0%. X, gas, FX, and RevRec, that 6.0 would be 5.7%. Canada, on a reported basis, 0. X, gas, FX, and RevRec, plus 4.8%. Other international, reported minus 5.9%. and again adjusted with X those things, minus 1.2, such that total company came in at a 3.5 reported and a 4.6 X those items. In terms of e-commerce, reported for the four weeks, 24.2%, and X those adjustments, appropriate adjustments, 21.6% up. February sales were negatively impacted by weather throughout the U.S. and Canada in a big way. We estimate that negative impact on the total company was approximately 1%. and a little more than the 1% figure in the U.S. and Canada. In addition, Lunar New Year, Chinese New Year, occurred in February, the same as last year, however, 11 days earlier this year. This is an important holiday in terms of sales strength. The holiday shift negatively impacted February's other international sales by, we estimate, 450 basis points or 4.5 percentage points, and total company sales by about a half a percentage point. Looking at January and February combined, effectively eliminating the impact of that holiday shift. The comp for other international for the eight weeks was 0.2% reported and plus 4.9% FX gas deflation and rev rec. U.S. regions with the strongest results in February were Midwest, Northeast, and Southeast, and internationally the strongest results were Mexico, Japan, U.K., and Spain. Spain, of course, is relatively new with two locations. Foreign currencies year-over-year relative to the U.S. dollar hurt Fed comp sales. by February comp sales in Canada by approximately 460 basis points, other international also by about the same number of basis points, about 4.5 percentage points, and total company by an estimated 130 basis points. The negative impact of cannibalization was about 50 basis points to the negative in the U.S., 80 in Canada, and 120 in other international for total company of minus 70. Within ancillary businesses, Hearing aids, optical, and food court had the best comp sales in February. Gas price deflation negatively impacted total reported comps by about 75 basis points. The average selling price during the four-week month compared to a year earlier was down 6.3% year over year. The average gallon a year ago we sold for $2.74. This year, $2.56 a gallon. Including the adverse impact of weather and the holiday shift in Asia, Our comp traffic or frequency for February, even after taking those into effect, taking those impacts into effect, for February was up 2.7% worldwide and plus 3.2% in the U.S. For February, the average transaction was up 0.8% for the month. Again, this includes combined impacts from FX, gas deflation, and rev rec. So that's about it in terms of our prepared notes. Lastly, in terms of upcoming releases, we will announce our March sales results for the five weeks ending Sunday, April 7th, on April 10th, after the market closes. With that, I'll open up to Q&A and turn it back over to Vincent. Thank you.

At this time, I would like to remind everyone, in order to ask a question, please press star, then the number 1 on your telephone keypad. Again, that will be star, then the number 1 on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. We have your first question comes from the line of Christopher Horvath from J.P. Morgan. Your line is now open.