FOOL ON THE HILL
An Investment Opinion

Costco Q4 Conference Call, Part 1

By Dale Wettlaufer (TMF Ralegh)
October 7, 1999

The following is the first part of a multi-part summary of Costco Wholesale's <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COST)") else Response.Write("(Nasdaq: COST)") end if %> Q4 fiscal year 1999 financial results conference call. You can listen to the conference call by hitting this link (RealPlayer plugin required) or heading to Costco's investor relations homepage.

Presentation of Richard Galanti, Chief Financial Officer

Comps for the fourth quarter were up 12%. For the fiscal year, comps were up 12%. That's on top of 1997 comparable store sales increasing 7% and 8% in 1998. Despite the fact that the company has continued to open new units each year, average sales per warehouse, which were $87 million average annually in 1998, will finish this year at $94 million.

Geographic and merchandising breakdown of comps for Q4; FY 1999; and September, fiscal 2000:

Merchandise category

-- Food and sundries (including dry and fresh foods and institutionally packaged foods; including candy, snack foods, health and beauty aids, tobacco, alcoholic beverages, soft drinks and cleaning and institutional supplies): +9%; +8%; +8%. Despite huge tobacco price increases over the last year, tobacco comps accounted for only 9% of sales increase. Tobacco hasn't driven these comps in the last year and in September of this year.

-- Hardlines (including major appliances, video and audio tape, electronics, tools, office supplies, furniture and automotive supplies): +14%; +12%; +15%. That's driven by what the company calls "majors," which includes TVs, VCRs and camcorders, PCs and peripherals, and white goods such as the Whirlpool washers, dryers, refrigerators and freezers. Within that 15%, the majors category (which is about 23% of hardlines, was up 26%. Other strong categories included hardware and toys.

-- Softlines (including apparel, domestics, cameras, jewelry, housewares, books and small appliances): +7%; +6%; +9%. Apparel has been the strong point there, both men's and women's, back into the mid-teens comps. That's driven by branded goods and merchandise the company is able to procure, both directly and indirectly. Several of the new Kirkland Signature items have done well, such as men's and women's cashmere sweaters at 60% to 70% discounts to retail brands, as well as Kirkland Signature men's dress shirts, which sell for $17-$18 versus $40-$50 in the retail market.

Media was only up 3%. The company has been asked many times about how the book sales are doing. Media being up 3% is more a reflection of the lack of strong movie titles. Book sales have been quite a bit stronger than that. Housewares has been flat, as it has been for the last few months. Fresh foods has continued to have a better showing near year-end. Comps were up 12% for the fourth quarter, +10% for the year overall, and for September, +13%. All aspects of fresh foods are fine and growing. Probably the strongest area is the bakery as the company continues to roll out new products and offerings, as usual.

Ancillary businesses (including pharmacy, optical, one-hour photo, print shop, hearing aid and gas stations): +37%; +33%; +36%. Gasoline sales have driven this category, but even without gas, this category would be up 20%+.

Geographic category for Q4; FY 1999; and September, fiscal 2000

Northwest: +12%; +10%; +10%.
California (about 38% of company): +13%; +12%; +13%.
Northeast: +9%; +6%; +8%.
Southeast: +14%; +12%; +18%
Midwest (a reflection of the five Detroit units opened a year ago May): +14%; +14%; +22%
Overall United States: +12%; +11%; +12%
Canada (in $US): +4%; -1% (reflects FX translation early in year); +9% (about +5% in $C)
UK (seven units): +35%; +31%; +33% ($37 in pounds sterling)
Taiwan (one unit - second unit just opened in Taipei): +68%; +37%; +97%.
Korea: +31%; +31%; +24% (12% in terms of the won).

Total company: 12%; 10%; 12%

Mexico numbers, which are not consolidated (in $US): +13%; +9%; +32% (+21% in pesos)

On earnings, Q4 and the year turned out a little better than estimated about a month ago.

Adjusting EPS for an apples-to-apples comparison after taking into account the accounting change for membership income to an accrual basis rather than a cash basis. Also, adjustment for Q4FY99 closing costs:

                        Q498  Q499  FY 98  FY99

Reported EPS           $0.66 $0.66  $2.03 $1.73
Membership change
    in accounting                         $0.50
Membership pro-forma  -$0.01       -$0.07
Q4 closing costs             $0.13        $0.13
Total                  $0.65 $0.79  $1.96 $2.36

Membership

Q4 membership fees were $155 million, up $18 million, or 13% from last year's Q4 fees of $137 million (cash basis). Pro-forma for Q4 1998 just under $133 million, so the pro-forma increase in membership fees would be about 17%. In terms of basis points, membership fee income as a percent of sales was up four bp year-over-year on a pro-forma basis.

9.6 million Gold Star members
3.9 million primary business members
4.2 million business add-on
17.7 million households
Including free spouse cards, just over 30 million cardholders
A member is still counted as a member for about six or seven months after expiration, as many people don't renew right away. After that, they aren't counted for membership tally purposes. About 1.5 million in that count right now.

Renewal rates have inched up again, a trend that has been going on for about five years. Business members renewing at a 91% rate and Gold Star members renewing at an 83% -- weighted average renewal rate is 86%.

Executive Membership

Executive membership is counted as paid-only now. This is $100 per year rather than $35 or $40 per year. At fiscal year end, Costco was a little under 125,000 paid members, implying that if you took the extra $65 per member in fee income, this accounted for a little under $8 million in incremental membership fee income. Incremental fee income in 1998 was around $2 million. By next August, the company hopes to be over 300,000 Executive members. If that happens, incremental cash fee income would be in the high teens (millions of dollars).

Pricing

In terms of gross margin, both for Q4 and the year, gross profits margin showed good increases notwithstanding the company's stated objective (starting four or five months ago and going into fiscal 2000) that it will become even more aggressive on pricing. Costco is enjoying strong results and it believes now is the time to do so. Gross margin in Q4 was up 9 basis points and up 12 basis points in Q4.

Gross margin change by category, in basis points:

                           Q3    Q4   FY99

1. Core warehouse         -11    -6     -5
2. Ancillary businesses   +13    +4     +9
3. International           +8    +5     +8
4. LIFO                    -1    +6     +1
5. Other                   -3     0     -1

Total                      +5    +9    +12

1. This was a programmed reduction in pricing, the effect of passing along savings on merchandise sales to offset the 1998 membership fee increase.
2. The decline in contribution to gross margin was a reflection of gasoline costs.
3. This is the effect of pricing as if the company were sourcing directly in new markets such as Japan.
4. An inventory workdown in cigarettes following a manufacturer's announcement of price increases brought about a breach of a LIFO pool.

The budget for FY 2000 has gross margin up 5-6 basis points. They hope to do better than that, but that's where the budget is starting. The gross margin reflects a conscious effort on the company's part to remain aggressive on pricing.

Galanti said: "The gross margin message sounds like a broken record. We'll continue to drive prices down and we'll only improve gross margins if prices are able to go down. I see no letup in our ability to continue to do that. We have continued improved purchasing power. Our depot operations continue to increase the penetration of stuff that goes through there.

"Probably the biggest area of change over the year and going into this year is increasing penetration and opening up some new depots and cross dock operations to consolidate refrigerator and frozen items, increased penetration of some of the higher-margin ancillary businesses, and even hopefully shrink. I don't know how much more we can get out of shrink. As I reported to you a year ago, we had in our history our best year in shrinkage results. In fiscal 1998, it was 21 basis points�in fiscal 1999, it was 19 basis points."

One area the company thinks offers margin improvement possibility is in the "damaged and destroyed." But even so, the company thinks it can improve this by 10 basis points over the next couple years.

Due to space constraints, I'll continue with this in tomorrow's Bore Port report, which will come up under the following URL tomorrow after 7:00 p.m.: http://www.fool.com/BoringPort/1999/BoringPort991008.htm