Costco Wholesale Corporation

Good afternoon. Ladies and gentlemen, my name is Jerome, and I will be your conference operator today. At this time, I would like to welcome everyone to the Costco Third Quarter Earnings Conference Call. 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 questions during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Now, it's my pleasure to hand the call over to Mr. Richard Galante, Chief Financial Officer. The floor is yours.

Thank you, Jerome, and good afternoon to everyone. I will 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 uncertainties. 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 third quarter of fiscal 2019. The 12 weeks ended May 12th. Reported net income for the quarter came in at $906 million, or $2.05 per share. This compared to $750 million, or $1.70 per share last year. As mentioned in the release, this year's third quarter benefited from a non-recurring tax item of $73 million, or $0.16 per share. Excluding this item, earnings for the fiscal third quarter were up 11% year over year. Net sales for the quarter came in at $33.96 billion, or a 7.4% increase over the $31.62 billion sales figure last year in the quarter. Comparable sales for the third quarter were as follows. For the 12 weeks, on a reported basis, U.S. was 7.0%. Excluding gas inflation, FX, and RevRec, it would have been a 5.5%. Canada reported at a 1.3%. X those items, a 5.1% positive. Other international reported 1.7%. X those items, 6.9 to the positive. So total company, we reported a 5.5% comp sales figure for the 12 weeks, excluding those three items, almost negated each other, coming in at a 5.6, excluding those items. E-commerce was 22% for the quarter on a reported basis, and 19.5% X those items. In terms of Q3 comp sales, Our third quarter traffic or shopping frequency increased by 3.7% worldwide and up 3.4% in the U.S. In terms of the impacts of the items of gas, FX, and RevRec, weakening foreign currencies relative to the U.S. dollar negatively impacted sales by about 130 basis points. Gasoline price inflation impacted sales by a small amount, plus 10 basis points. And RevRec benefited comp sales by about 110 basis points. So the net of the three, about a minus 10 basis point. Our average front-end transaction, or ticket, was up 1.8% during the third quarter. And excluding the impacts from GAF, FX, and RevRec, our average ticket was up approximately 1.9%. Next on the income statement, membership fee income. We reported membership income in the third quarter of $776 million, or 2.29% of sales. This is up $39 million, or 5.3% from last year's $737 million. FX had a negative impact on that number. That impacted that $39 million increase. It would have been about just under $10 million higher than that ex-FX. Reported membership fee revenue, again, was up to $39 million, or 5.3%. In addition to FX impacting that to the negative, it does have the benefit of the fee increases we took almost two years ago, really the last fiscal quarter of that. Those are increases that we took in June of 2017 in the U.S. and Canada. We now have effectively completed that 23-month cycle it takes to recognize the incremental benefit from the fee increases. The benefit to our P&L in Q4 will be very small, less than $1 million. In terms of renewal rates, at Q3 end, our membership renewal rates remained strong. In the U.S. and Canada, membership renewal rates came in at 90.7%, the same as it was a quarter ago. And worldwide, the rate was 88.3%. That figure also the same as of Q2 end. In terms of number of members at Q3 end, the number of member households we had was 53.1 million at Q3 end. That's up from 52.7 million 12 weeks earlier. In terms of total cardholders, we came in at 97.2 million, up from 96.3 million 12 weeks earlier at Q2 end. During the quarter, we opened three new warehouses, one each in the United States, Korea, and Australia. At Q3 end, in terms of paid executive members, they stood at $20.4 million, which was an increase of $406,000 during the quarter, or $34,000 per week. Korea was actually a very small piece of that increase, so we've had good continued increases in executive member penetration in other countries as well, most notably U.S. and Canada. Going down the gross margin line, our reported gross margin in the first quarter was lower year over year by six basis points, coming in at 10.99% versus last year's 11.05%. Now, excluding the items that I've excluded before, FX, REVRAC, and the like, the six basis point lower number would be actually plus five basis points, excluding gas, inflation, and REVRAC. If I'd ask you to jot down a couple of numbers here, Two columns, both reported and then X, gas inflation and revenue recognition for the third quarter of 2019 as compared to a year earlier. The first line item here would be core merchandise on a reported basis year over year in the quarter. It was reported one basis point lower. X, gas and rev rec, it was nine basis points positive. Ancillary businesses, minus three and minus one basis point. 2% reward, minus two and minus three. And summing all those up, you'd have the reported number six basis points lower, and that's gas and REVREC, five basis points to the higher. One thing I'll note compared to the second quarter, in the second quarter we had a big increase in ancillary business margin, as we pointed out last quarter's earnings release. The core merchandise component here, again, lower by one basis point. If you look at the core merchandise categories in relation to their own sales, core on core, if you will, margins year-over-year were higher in Q3 year-over-year by 21 basis points. The subcategories within the core, all four main subcategories, food and sundries, hard lines, soft lines, and fresh foods, were all up year-over-year in the third quarter on their own sales. And that's a trend that we've seen last quarter. It was up less than that amount in Q1, down a little bit year-over-year. Ancillary and other business growth margin, again, lower by one basis point on the X gas and rubber rack. Nothing really to speak of in terms of things there. Moving to SG&A, our SG&A percentage Q3 over Q3 was lower or better by six basis points, coming in at 9.92% of sales this year. This compared to 9.98% reported last year. X gas inflation and REVREC, it was higher or slightly worse by five basis points. Again, to jot down a few numbers here, the two columns reported in the second column without gas inflation and REVREC, gas inflation and REVREC. Core operations on a reported basis was better by seven basis points, so plus seven. X REVREC, minus two. Central, minus one and minus two basis points. Stock compensation, zero and minus one. summing up those two columns, again, on a reported basis, SG&A was lower or better by plus six basis points, and X, those other items, worse by five basis points. Now, the key thing here is within the seven basis points of improvement, or rather the minus two basis points, X, gas, and rev rec, that's notwithstanding the fact that we're still facing pretty big headwinds from the U.S. wage increases to our hourly employees that went into effect in June of 2018 and as well as additional wage increases implemented in March of 2019. Both of these wage increases negatively impacted SG&A during the quarter, represented about 10 to 12 basis points of the year-over-year variance. In Q4, the estimated impact will be about minus five to six basis points, which is the residual impact from June of 18 plus the March 2019 increases. And then we'll tick down to three to four basis points of detriment, we estimate in Q1 of 2020. Central, nothing to speak of there. It was higher by two basis points on X gas and REM rec basis. Stock compensation, flat year over year, and then again minus one. Next on the income statement is pre-opening expense. Pre-opening expense came in at $14 million this year in Q3, up $6 million from a year ago. We had one additional opening, three openings this year versus two last year. There was also about $2 million of pre-opening expense in the number. related to the chicken plant that we plan to start the beginning of production later this summer. Additionally, some of this quarter's expense relates to our higher number of openings we have in Q4. In Qs 1 through 3, in the first 36 weeks of this year, we will have opened a total of 10 new locations. In Q4, we have 11 planned. So there are some remnants at the beginning of some of the pre-opening there. All told, reported operating income in Q3 was up 5%, coming in at $1,122,000,000 this year, compared to $1,067,000,000 last year. Below the operating income line, reported interest expense was $2,000,000 lower or better year over year, coming in at 35 versus 37. That's just a slight difference in capitalized interest amounts. Interest income and other for the quarter was lower by $5,000,000 year over year. Interest income itself was actually higher by $11 million year-over-year. However, various FX items in the amount of a minus $16 million negatively impacted the year-over-year comparison. Overall, pre-tax incoming Q3 was also up 5%, coming in at $1,123,000,000 this year versus $1,071,000,000 last year. In terms of income taxes, our reported tax rate in Q3 fiscal 19 was 18.5% compared to 28.8% in Q3 last year. As was mentioned in today's release, this quarter's earnings and our tax rate benefited from a non-recurring $73 million item. Excluding the $73 million item, our third quarter tax rate would have been 24.9%. We estimate that our effective total company tax rate for fiscal 2019 for Q4 fiscal 19 to be more in the 26.5% to 27% range. A few other items of note. In terms of expansion, as I mentioned, we've opened through the third quarter to date a total of actually opened 12 units. I'm sorry, opened 13 units, but that includes three relocations, so a net of 10. In Q4, we'll open 13 locations, which includes two reloads, so a net of 11, which would put us in terms of net new openings for the fiscal year at 21. the same number that we had in fiscal 18. About three-quarters of the openings this year are in the U.S., and about a quarter internationally. This also includes our anticipation of opening our first Costco in China, in Shanghai, tentatively scheduled to open on August 27th, right before the fiscal year ends. As of Q3 end, total warehouse square footage stood at 112 million square feet. In terms of CapEx, while our new warehouse openings remains in the low 20s, the CapEx spend is in line with prior years. Excuse me. It's in line with prior years. We've got a lot of money being spent on fulfillment, both e-commerce and grocery, expansion and automation, the chicken plant, which is what we mentioned, as well as ongoing expansion in depot and infrastructure, as well as IT modernization. In terms of stock buybacks in Q3, during the third quarter, we expended $44 million, repurchasing 192,000 shares at an average price of $226.57. To date, we've expended $195 million for 903,000 shares at about a $216 per share price. As a reminder, at the last board meeting, the board approved a a reauthorization of a stock repurchase program, and authorized a new $4 billion program that will remain in effect through April 2023. In terms of e-commerce, overall, our e-commerce sales increased, as we mentioned, on a comp basis 19.5%, reported 22%, 19.5%, XFX, and yes. I might point out, by the way, that these numbers do not include the increases that we're we're seeing with Instacart. Instacart comes into our warehouses and purchases, and that goes into warehouse sales. The top growth categories in the quarter were electronics, health and beauty aids, furniture, small appliances, automotive, and optical. New brands and items online during the quarter include high-end televisions from Sony and Samsung, as well as the latest generation Apple products from AirPods to iMacs and the like. Other things would include things like Bare Minerals Beauty Cosmetics. Sales highlights during the quarter included some significant diamond ring purchases, one in the $400,000 range, and big-ticket items like golf simulators that sold for $14,000 each, which we sold during a five-day period. We also continue to improve our online and inline cross-marketing initiatives. A lot of push notifications for start and end of warehouse promotions, emails featuring hot items and suggestions for Mother's Day and other holidays like Cinco de Mayo. During the quarter, we also completed the rollout of six regional grocery distribution centers located within our existing depots. You'll recall that previously we had fulfilled since late 2017 when we began the two-day grocery. We did that through our business centers. As it expands, we pushed it into our depot operations, and we'll also have, in those cases, regional assortments. An update on terms of our buy online and pick up in store. In the quarter we began rolling out additional pick up lockers. Over the last several months we've had ten locations, but we're in the process of rolling that out to an additional hundred locations over the next four or five months before the September through December holiday season. Continued growth in the Costco app use among our members. We continue to experience that with new features recently added, like pharmacy orders and pick up notifications. easier shopping ability on member savings events, photo center, and various push notifications, and expect several additional new features are planned for July and the upcoming months thereafter. We continue to focus on getting merchandise to customers faster. Some of that has to do with where we locate the merchandise in these depot and other ancillary operations. As discussed last quarter, we will begin e-commerce operations in Japan – later this summer, and Australia, late summer, early fall. The next thing I want to touch on for a minute is the whole question of tariffs. I'm sure we'll be getting some questions on that, so a few comments. As we indicated a couple of quarters ago in our earnings release, there continue to be a lot of moving parts, although some of the moving parts are getting bigger, but it is still pretty fluid. The actions that we took then and we continue to take Where we were able to, not in a big way, we're accelerating shipments before certain tariffs would go into effect or would be increased in the percentage of the tariff, although there's limited ability to do that. We've worked with suppliers. We've gone potentially to every supplier on every item, as you might expect, to see what we can do to both reduce costs and figure out how to do that. In some cases, we've reduced order commitments on certain items. We've looked at alternative country sourcing where possible and feasible, although, again, there's a limited amount of the ability to do that. And we've taken advantage of lower pricing on certain U.S. items that have been impacted the other way. In summary, we'll continue to see how customers and competitors react to this. What's interesting is, as you know, this list three, which is the biggest of the three lists of potential tariff items, those were listed back in September of 2018. at 10% tariffs, and we're going to go to 25% as of December 31st of 2018. That date has continued to move, although it's now moved and it's in fact at 25% for items that I believe are exported after May 10th. So we're just starting to see some of those impacts. As you might expect, it's all over the board in terms of every item and every vendor is different. In some cases, it's being passed on. In some cases, we're able to work to figure out how to move merchandise. And then the impact of when the price increase does go through, it has a different impact of how it affects sales. We think that we're in a good position in terms of our size and our ability and our relationships with our vendors, and we'll keep you posted how it goes. This last piece, again, includes – it's the biggest list of the three lists – It includes things like furniture, luggage, bikes, vacuums, grills, and more items like that. That's pretty much it on our side. And lastly, in terms of upcoming releases, we will announce our May sales results for the four weeks ending this Sunday, June 2nd, next Wednesday, June 5th, after the market closes. And with that, I will open it up for Q&A and turn it back to Jerome. Thank you.

Ladies and gentlemen, at this time, if you would like to ask questions, simply press star, then the number one on your telephone keypad. And if you would like to withdraw your question, press the pound key. Now our first question comes from the line of Michael Lasser from UBS. Michael, you are now live.