Costco Wholesale Corp (COST) — Q1 2015 Earnings Call Transcript

Thank you, Erica. Good morning to everyone. This morning’s press release reviews our first quarter fiscal 2015 operating results for the 12 weeks ended November 23rd. I’ll 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 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 first quarter operating results for the quarter, as you saw, our reported earnings came in at $1.12 a share, up 17%, or $0.16 per share over last year's first quarter earnings of $0.96 a share. Few items of note regarding looking at the comparison. Gross margin was higher year-over-year in the first quarter by 22 basis points. We benefited from strong margins in our gasoline business, which I will speak to more when I discuss our gross margins results. We also had a $17 million pretax nonrecurring loss recovery, which represented about 6 basis points in margin improvement or about $0.03 to our per share earnings. Interest income and other was higher year-over-year in the first quarter by $17 million pretax or about $0.03 a share. This increase primarily related to several of our foreign operations using FX contracts to lock in U.S. dollar denominated merchandise payables. Under GAAP, the mark-to-market gains or losses in this case, of course gains are recorded on the interest income and other income statement line. I really look at this as part of merchandising gross margin in the sense that our foreign operations buyers lock in exchange rates at prices they are comfortable being able to price their merchandise at. In the first quarter, the foreign currencies where we operate overall weakened versus the U.S. dollar, primarily in Canada and Japan, resulting in our foreign earnings in the first quarter, when converted into U.S. dollars, being lower by about $22 million pretax or $0.03 a share than those earnings would have been had FX exchange rates been flat year-over-year. Stock expense was higher year-over-year in the first quarter by $38 million or $0.06 a share. As I mentioned before, we have over 4,000 of our assistant managers and above, who receive restricted stock units as a significant part of their annual compensation. These grants are made annually each October or in the first fiscal quarter. These RSU grants then typically vest over a five-year period, with accelerated vesting when a recipient reaches 25, 30, and 35 years of employment with the company. Factors driving this increase included the appreciation of our stock price, additional levels of accelerated vesting given some employees’ long tenure with the company, and the large number of employees in the plan. Last October, our RSU grants were reduced by an average of 15%. The fifth item is IT modernization costs, as discussed in each of the past eight or so fiscal quarters earnings calls. Our major IT modernization efforts continue to negatively impact our SG&A expense percentages through ‘15 and into probably the first half of ’16, especially as these new systems are placed into service and depreciation begins. In the first quarter, on an incremental year-over-year basis, these costs impacted SG&A by $12 million on an estimated 3 basis points or $0.02 a share. Turning to our first quarter sales, our 12-week reported comp sales figures for Q1 showed a 5% increase on a reported basis, 6% in the U.S. and 1% internationally. As indicated in our release, excluding gas price deflation and the impact of FX, the 6% U.S. would have been 7%, the 1% international would also have been 7% and therefore, the 5% for the total company reported on a normalized basis would have been 7%. Our November sales results for the four-week month ended November 30th indicated that our comp sales increase, excluding gas and FX were even stronger than these 12-week figures, with total company comps on that normalized basis increasing by 8%, which included a 9% increase in the U.S. and 7% international excluding gas and FX. Other topics of interest include our opening activities and plans. We opened eight new locations during the first quarter, which ended November 23rd, six in the U.S., our seventh location in Australia and our second location in Leone, Mexico. We also relocated one location in Wayne, New Jersey to an expanded location. About six weeks prior, we experienced a severe hurricane around our Campos and Lucas, Mexico location, but that has since been reopened. We have no openings planned for Q2 for all of fiscal ’15. However, we have a current plan of 31 new locations, 18 of which will be in the U.S., three each in Japan and Mexico, two each in Australia and Korea, and one each in Canada, U.K. and Taiwan. Additionally, this morning, I will review with you our e-commerce activities, our membership trends, and additional discussion about gross margins and SG&A in the quarter, among a few other topics of interest. Our total sales were up 7.4% to $26.3 million. On a comp basis, reported a 5% increase, and excluding gas and FX, it would have been a 7% increase. In terms of comparisons by geographic region for the quarter, the Midwest and Southeast were the strongest, with the Northeast close behind. Internationally, the better performing countries were Canada, Taiwan, and Mexico. For the first quarter, within food and sundries, which was up in the mid-single digits, the categories that performed well included candy, deli, and spirits. Within hardlines, there were also up in the mid-single digits for the quarter, with electronics performing positively as well, coming in the high-single digits range. Other better-performing departments within hardlines included hardware, sporting goods, and tires. Moving to line items in the income statement, membership fees were up 6% or $33 million to $582 million. That was about a 3 basis points decline. Excluding FX, the 6% dollar increase, assuming flat year-over-year FX, would have been up 8%. We continue to benefit from strong signups at existing and new warehouses, continued increase in penetration of the executive member, and strong renewal rates both in the U.S. and Canada, as well as worldwide in newer markets. New membership signups in Q1 year-over-year were up 4%. There were fewer locations opened; we opened nine locations in Q1 this year versus 13 last year. At the end of Q1, we had 31.6 million Gold Star members and the number increased to 32.1 million, so up about 0.5 million. Our primary membership remained at 6.9 million, while the Add-On Business remained at 3.5 million. Therefore, we went from 42 million member households to 42.5 million. Including additional cardholders, went from 76.4 million at fiscal year-end to 77.5 million at the end of the first quarter. At Q1-end, paid executive memberships totaled 15.2 million, which was an increase during the 12 weeks of about 420,000 or about 35,000 a week during the quarter. Executive members represent more than a third of our membership base and over two thirds of our sales operations. Renewal rates continued to be strong. At the end of the fourth quarter business memberships were at 94.4%, which increased to 94.5% at Q1 ’15, Gold Star remained at 89.8%, giving a total of 90.6% at fiscal year end and 90.7% at Q1 end. Worldwide we remained at 87.3% in the fourth quarter and at Q1 end saw a nice increase from the year earlier, ending with 86.5% worldwide. As I touched on last quarter’s conference call, we continue to try new things to drive sales and membership signups. I mentioned that in this fiscal quarter, but on the last call in early September, we ran a nationwide promotion for new members on LivingSocial. It was a good value and we felt it worked pretty well, but we will continue to look and see what we want to do going forward with no plans at this point. Moving on to the gross margin line, as you saw, gross margins were quite strong, up 22 basis points to 11.03%. Our four columns, the first two columns are for the entire fiscal year ’14, both reported and without gas deflation, and the first quarter of ‘15 would be columns three and four reported and without gas deflation. The core merchandise for the year was up 6 basis points on a reported basis and up 3% excluding gas deflation. For the quarter, it was down 6 basis points and down 13% without gas deflation. Reports show that ancillary, plus 6 and plus 6 in both columns for all of last fiscal year in Q1 ‘15 reported plus 22 and without gas deflation plus 20. 2% reward reported decreases were consistent across four columns. Finally, other adjustments were minus 2 and minus 2 in all of fiscal ‘14, and plus 6 and plus 7 without gas deflation for Q1, which includes that one-time nonrecurring lawsuit recovery mentioned earlier. The total reported was up 22 for the quarter and up 14 without gas deflation. The core merchandise was down 6 and down 13 excluding gas; a lot of this again is driven by the success in the gas business, both in volume and margin contribution, where gas margins were up when gas prices go down typically. Core gross margins as a percent of sales were slightly negative, down a couple basis points year-over-year, with food and sundries, and softlines showing year-over-year improvement, and hardlines and fresh foods gross margins being lower year-over-year in the quarter, which has been pretty much as planned. Ancillary and other business gross margins, as mentioned, were up 22 or up 20 without gas deflation. With the exception of pharmacy margins being slightly lower year-over-year, most of the other ancillary businesses, starting with gasoline, but also including optical, hearing aid, and travel business centers all showed higher margins year-over-year in the quarter. For SG&A, our SG&A percentage year-over-year in the quarter was higher by 4 basis points, at 10.26 this year compared to 10.22 last year. Again, I will quickly go through those same four columns for all of fiscal ‘14, both reported and excluding gas deflation. Going across the line items, operations were a minus 2 and a plus 1 for the year, and a plus 8 and plus 16 for the quarter. Central expenses were reported as minus 3 and minus 3 for the year, and minus 1 and minus 1 for the quarter. Stock compensation was minus 2 and minus 2 for the year and minus 11 and minus 11 for the quarter. Total reported SFGA for fiscal ‘14 SG&A was higher year-over-year by 7 basis points, without gas deflation higher by 4%. For the first quarter of this year, it was higher year-over-year by 4% reported and lower by 4% without gas deflation. The core operations SG&A was lower year-over-year by 8%, while lower with functional gas impact of 16%. Payroll SG&A was 9 basis points better year-over-year, while benefits to workers comp-related expenses were about 4 basis points worse year-over-year. The increase in central expense resulted from increased IT spending as we continue to modernize our systems, but was partially offset by improved payroll. SG&A related to stock compensation increased year-over-year by 11%. I should point out that the year-over-year basis points variances for the next two quarters will vary significantly less compared to Q4, but not as big negatives. Last item on the income statement, pre-opening expenses were lower or better improvement by $9 million this year, totaling $15 million. We opened nine units this year compared to 13 last year. Reported operating income for the quarter totaled $668 million last year and $770 million this year, marking an increase of 15% or up $102 million. Below the operating income line, reported interest expense was roughly the same year-over-year with Q1 ‘15 coming in at $26 million versus $27 million last year. Interest income and others showed a significant increase year-over-year, rising to $35 million this year from $18 million last year. The other component of equity earnings within this line item increased as well. Overall pretax income was up 18% from last year’s quarter from $659 million to $779 million this year. Our effective tax rate this quarter came in at 35.2%, higher compared to last year’s first quarter rate of 34.6%. Overall net income was up 17% from last year’s first quarter, rising from $425 million last year to $486 million this year. Regarding the balance sheet, depreciation and amortization for the quarter came in at $254 million. In terms of accounts payables as a percent of inventories, the reported number this year was 101%, up about two percentage points from 99% last year. We took everything together and reported merchandise payables as a percent of inventory as well, last year in Q1 it was 89%, showing an increase to 92% this year. Average inventory per warehouse last year in the first quarter ended at $14,453,000, this year came in slightly lower at $14,372,000. Excluding FX, we are also seeing a small increase of about $169 million, reflecting a 1.2% increase on a normalized basis compared to the 7% plus sales increase. There are no real issues with inventory levels going into the calendar year and Christmas holidays. We’ve received questions about possible inventory issues due to the work slowdowns and shipping along the West Coast. Overall, it was not a significant issue for November and December. Looking ahead, it may present some small issues from seasonal furniture and other types of items, but no big delays were expected. In terms of CapEx for Q1 ’15, we spent $555 million, while our fiscal ‘15 CapEx is estimated to be in the $2.5 billion to $2.6 billion range. This compares to last year’s estimate of around $2 billion. We’ve seen significant growth here due to ramp-up and expansion alongside the relevant IT expenses associated with it. As for dividends, our quarterly dividend stands at $0.355 a share or $1.42 annualized, amounting to approximately $625 million annually with stock buybacks featuring in Q1 at $18 million at an average price of $126.43. Costco Online is now active in four countries: the U.S., Canada, U.K., and Mexico. For the quarter, sales and profit were both up over the previous year. E-commerce sales experienced a 20% rise, a 19% rise on a comp basis, and a 21% rise excluding FX. E-commerce represents about 3% of our total sales. We've improved the timing of shipments and expanded our product offering categories over the years. Internationally, we may expand to at least one additional country by the end of fiscal year '15, as well as possibly by the end of calendar '15. In terms of a couple of other things discussed in the past, Google Shopping experience is currently in six U.S. markets. There is increasing overall spend and positive developments in partnership with Google. Instacart is now active in 13 markets, and the program is expanding. Lastly, I’d highlight that we are dispatching about 125 to 130 items, primarily food or sundries items from our Taiwan operations in collaboration with Alibaba. In terms of expansion, we have nothing planned for Q2 but expect five openings in Q3, two being relocations, netting to three, and 20 planned for the 16-week fiscal fourth quarter. Assuming we add the 30-31 units on a base of 663, it would be about a 5% square footage growth. As for the total square footage at Q1 end, it stood at 96,437,000 square feet, marking an increase over the last fiscal year.

So Rich, I want to drill on a little bit on growth by category. So two were up, two were down, the two that were down are some fresh food and hard line. Fresh food was solely passthrough of inflation and was hard line’s entirely mix?

Fresh food was certainly inflation in U.S. holding prices, like you know, we do. Things I know again soundbite anecdotal. Butter and milk is way up and so therefore cheese. And so you’ve got those types of items. On the other side, some of it’s electronics, that's more competitive and we’re part of that. And so a little of it is mix but quite honestly, I don’t think anything is really out of the ordinary.

And then when you look at the two that were up, I think they were not up a lot, is that solely mix and where is Kirkland? I guess, Kirkland would have the big impact in food and sundries. That’s what would show up. Is that primarily driving the better mix?

Honestly, I don’t have that level of detail in front of me. None of the ups or downs were significant, basically in the 10 to 25 basis point range. So there wasn't much fluctuation either way. My guess is that it's a little bit about mix. Kirkland Signature contributes, but the significant increase in its penetration from 0 to 25% over the past couple of decades means those increments are smaller now. Yes, it provides some benefit, but it doesn't have the same impact as during the times when yearly growth was one or two percentage points.

All right. Lastly, regarding FX and inventory, aside from those factors, inventory is clearly well managed. Is the inventory situation more related to in-store practices, or does it involve more backend processes between your vendors and the stores?

Keep in mind, if we are turning our inventories more than 12 times a year, everything is quite fast-paced. Whether you're in Canada, Japan, or elsewhere, buyers are utilizing foreign exchange contracts because most of their inventory payables are denominated in U.S. dollars. They lock in based on their incoming shipments and what they need to pay in dollars. They are comfortable with the conversion rate and the price at which they will sell in their local currency. It's fairly simple. In some quarters, year-over-year, this could result in a $10 million gain or a $10 million loss. This time, it was slightly better. I believe this is partially due to the fluctuations in the strength and weakness of the dollar and how quickly it has strengthened, especially in a couple of countries.

It’s not about anything you are doing structurally to remove inventory working capital from the system.

No, we do that. It's one of the principles we try to follow. That's just how it operates. For instance, around 20 years ago in the tobacco industry, which has a high volume, though not as high as before, it continues to be a fast-moving business. A few years back, the major companies offered various terms, like a discount for payments made within seven days. They even sweetened the deal with an extra half a point if you paid one day early. The 0.5% for settling six days in advance seems obvious, especially in a high-volume scenario, where it shifts from a significant amount payable to nearly nothing. That serves as an extreme example. Conversely, in gas, accounts payable can range from 600% to 700%.

Okay. Thank you.

Good morning. This is Joshua Siber on for Simon Gutman. Just curious looking back how our customers reacting to lower gasoline prices and have you seen any trade up from regular to premium?

I think we observed an increase in premium, but I don't have exact figures at the moment. Our customers' shopping frequency remains strong. Historically, we've noticed that significant changes like gas prices spiking towards $4 a gallon in early to mid-2008 did have some impact on us, though likely less so than on discount stores or those targeting lower demographics. While we do gain some advantage from it, we don't see it having a substantial effect on our overall performance.

Okay, so.

It’s got to be helpful.

Sorry, what was that?

It’s got to help a little.

Okay. And then looking forward, if gasoline stays where it’s at right now, is there a change in profitability or have we seen the most of it in Q1?

Well, I’ll say what I know. I mean, this is a volatile business as we know. Generally speaking, when gas prices are declining, it’s the best in terms of profitability. It is more profitable at any level than it used to be a little bit. It’s a profitable business. Overall, just the specifics probably changes quarter by quarter.

Okay. Again, if you don’t mind, if I could add just one more, if you could discuss if there has been a mentality or strategic shift on e-commerce front. If you feel you’ve gotten more aggressive over the past 6 to 12 months?

I think the things that I mentioned have probably been ongoing over the past 6 to 18 or 24 months, but certainly we have added a few SKUs, expanded some categories, trying to get people to think of it, not just as the place that I can buy patio furniture or a big TV but also some regular higher-velocity items. Last year, it was in the high teens, and this quarter, it continues in the very high teens, low 20s. I think that’s a reflection of the things that we've done, but nothing new and dramatic in the last six months and just a continuation of that.

Okay. Thank you very much.

Good morning, Richard. Just to clarify on the gross margin grade, did you say that ex gas, the quarter was down 13 basis points?

The quarter is down; but again, it’s also like it's under the phrase, no good deeds go unpunished. Over the years, as I’ve tried to explain this in a little matrix, you almost need a three-dimensional matrix given the gas was strong and gas gross margins were very strong relative to a low gross margin business. That disproportionately rated those two lines in that little matrix. That’s why I pointed out if you could adjust food and sundries, hard lines, soft lines and fresh foods. Those four core areas, which represent over 80% of our business, those were year-over-year down two basis points. Two of those sub-departments were up 10 to 25 basis points, two of them were down 10 to 25 basis points. The core business is pretty much flat year-over-year.

Okay. So the up two basis points were more or less compared to, say, that up six or seven basis points that you posted in the third and fourth quarter?

Yeah. But it was down two and not upside.

I’m sorry, down 2. Yeah, okay. I got it. And then on CapEx guidance, you had a big acceleration from this year versus last year, yet store growth was pretty consistent. Just wondering if you could speak to the delta. Is it IT spend? What’s driving the increase?

We are also considering former locations and relocations. International expenses have increased. This year, we are likely spending more on depot-related costs. Year-over-year, depots may have increased by 100 to 150. Last year, the increase was probably around 75 to 100 in IT, not counting the leap year. For the year, the projected figure of 25 to 26 was initially set slightly higher. We anticipate some shifts and assume that land acquisition will take place in the early part of next year. We are definitely spending more on certain international locations with confidence.

Okay. Just last question on the balance sheet. Roughly, $70 per share in cash, any updated thoughts on getting a little bit more systematic on the buyback, as opposed to setting up a grid and any thoughts on the current dividend 1% yield is lot lower than some of your consumer stable peers?

Yeah. Our Board discusses it in every quarterly Board Meeting. Again, I guess I learned that the metrics work when stocks move slowly in either direction. We have had that high-quality problem that we put the makers in place, and in some cases, we are locked in for five or six weeks due to blackout, and then it moves well above several dollars of accretion we gave it. I think we want to be more systematic, but I can’t say when it will be.

All right. Thanks a lot. Good luck.

As it relates to the dividend, again, that’s the conversation we continue to have. We look at all options. We recognize that our first priority is CapEx, and then tied for second, a few other things that we’ll continue to look at. I’m sure we will just do things over time but beyond a timetable that we feel comfortable with.

Hi. Good morning. Nice quarter. A couple of questions. I mean, first off on gross margins. If you look at that, you may have discussed it in the prepared remarks, but the ancillary gross margin benefit you saw beginning here in Q1, can you just discuss the drivers of that and how should we think about sustainability over the next two quarters?

Well, I mean, the bigger hurdle was gas. I mentioned that five or six, or six or seven of our ancillary businesses all had higher year-over-year gross margins, particularly gas. Is that sustainable? No. It’s never sustainable. You see where gas prices are now, so it's continuing. But it could be fleeting. We've been asked the question, well, when do you get these outsized profits? Are you more aggressive in pricing? We don’t sit down and say let's use these many dollars, but certainly we are going to be aggressive and that’s what we do for a living. So I think that buffers a little bit as well.

It actually goes to my next question. I think, Richard, you already answered it. In the marketplace, if we look at Costco gas right now, I know from a competitive standpoint Costco gas typically prices below. Are you saying that when prices are doing what they’ve done, you've essentially kept the competitive relationship the same in various markets?

We’ve improved the competitive relationship in our minds.

Okay. All right. Thank you.

Hi. It’s Dan Binder. Congrats on a good quarter. Just want to follow-up on the gas discussion, with all the movement in the gallon comps and the pricing, where are we now as a percentage of sales for gas?

I’ll have somebody calculate it right now for you. Hold on a second.

Okay. My other question, if you want to focus on that first, is on consumer electronics. You talked to a lot of strength there. Any color you can give us around, sort of the breadth of that strength?

First of all, as you know, we introduced several Apple products over the last year. That's a very competitive business for retailers and for us as well. We know that. Mobile products have been trending well in terms of sales and we tend to be the outlier in terms of driving sales. But still, it is a smaller scale relative to the entire category. Appliances are showing strength, along with the various categories. So generally, we are pleased with the strength of the comps in that area.

And then on your cannibalization rate, I know it hasn’t really changed much. What you're seeing, does it come back to sort of historical volumes within a year or two?

Generally, yeah, it’s a year, or maybe slightly over a year. Generally when we open it, when we cannibalize our own units, you might take anywhere as much as 10% or 15% from nearby units. A year or a year and a half later, that rebounds pretty much to where it was. Moving forward, it’s more unpredictable for us.

Great. Thanks.

It's Meredith Adler. I was curious about the areas where you see the most potential for growth. I understand that you don't have many locations in Continental Europe, and it seems challenging to open warehouses there. In terms of Asia, do you believe there's still significant growth potential in those markets? What about in the U.S.?

Well, if you had asked me five years ago where we would expect to be now, I would say our goal is to get up to about 30 locations a year by this time, and probably, we’ll be right at that middle point of trending from majority in the U.S. to less than half in the U.S. If you look at this year or next, it’s roughly 30 a year, still a little over half in the U.S. I think we added 16 last year, and I think I mentioned 18 out of the 31 this year. So that’s a function of our continued success across different markets. We will still continue to expand in the U.S., but progress is slow. As for outside the U.S., we’ve got 10 or 11, I believe, in each of Korea and Taiwan, maybe 12, and we think that market can expand to the mid-to-high 20s over time.

Okay. Great. Thank you very much.

Hi. Good morning. A slightly different question on gas prices and my historical recollection is that when gas prices were high, more consumers might go out of their way to drive to Costco, which was viewed as a historical benefit to traffic. But the inverse does not appear to be happening. So I’m wondering if there is a risk of gas prices staying lower that you may not get quite as much of a lift in terms of traffic to the stores as in the past?

You are correct about the upward spikes back in ’08. Gas prices rose towards $4, which brought our customer base into our stores. Theoretically, as oil prices drop, there could be less incentive to visit. I would stress that the value proposition for membership also drives that traffic. When gasplay.com reports we are the lowest priced nationally by $0.14 or $0.16, that reacts positively as well. Our strong offerings in fresh foods, pharmacy and overall good customer service are all things that play positively into that. Once our members come for gas, they typically return for the extras, driving loyalty and building frequency.

Got it. Thank you.

Thanks. Congrats on the performance and thanks for the details. Regarding a bigger picture question on online, where do you think the mix should go over time? Will it remain a little bit more modest as a percentage of total? What factors do people want to see you implement over time?

Our expectation is online will continue to inch up, and over the last couple of years, we've gone from about $1.4 billion to close to $3 billion in organic sales. It’s high-value customers who return to us, and we want to improve offering across all our categories, whether it’s health, beauty, sundries, and so forth. And our site will certainly evolve over time. However, we don’t see ourselves in the game of quick delivery of low-priced, everyday essentials. We aim to be the supplier to those companies rather than be directly in that consumer space, but we do want our site to be more integrated with our broader offerings.

Okay. Thank you.

In the fresh food category, we expect to see some price fluctuations due to inflation, particularly driven by some shortages in production in other areas. We will continue to price competitively while ensuring quality in our offerings.

Thanks again. Best regards for the holidays.

Thank you.

Thanks a lot. Good morning. It’s Matt Fassler. My one question at this stage relates to IT modernization. Richard, if you could just talk about qualitatively what you've gotten done and what is still on the common? How you would expect those additional investments to further enable the online in e-commerce effort? Thank you.

Well, first of all, for those of you who noticed for long time, it’s going to keep us alive and growing. Our view is, as we've told internally, we were at the top of our game in terms of keeping systems and old legacy systems as long and as cheaply as possible. Modernization started in earnest about two years ago. The goal is to double the company in size. We certainly need systems to facilitate that growth. The front-end membership system is in; we are looking at improved onboarding for systems, and thus far we’ve secured better efficiency across multiple areas. When it comes to our depot and truck fleet operations, these systems improvements can lead to significant operating leverage.

Thanks so much.

Good morning, everyone. Richard, you may have said it, but I’ll double check on this regarding the gas. What was the year-over-year decrease in the gas price?

The average price per gallon was down 7.3%.

Okay. Thank you. And I’m curious about the buying or having merchandise shift ahead of a little bit ahead of sales plan because of some of these slowdowns on the ports? Where is the extra merchandise being stored? Is it in the clubs or your depots?

Well, Costco, it's not offsite. It's mostly in depots or the clubs. We stack tall, but we turn it pretty fast too. It wasn’t a huge issue, it was not an issue, but in terms of logistics of handling it. But mostly depots had a bit more for a few weeks.

Okay. Thanks.

Hey. Good morning, guys. This is Mike Otway in for Scott. Thanks for taking the questions. I think, first, Richard, you had said that outside of pharmacy, all the other ancillary businesses and their gross margin rates were up in the quarter? So, outside of gas, which is obviously transitory? How should we think about your ability to get some slight margin improvement on these other businesses over the course of the year?

Most of them were up year-over-year. I mean, a lot of it’s particularly in some of the business like Optometry and Hearing Aid. The actual markup on the goods is higher than our range because we included our own cost of sales calculation, the impact of the Hearing Aid tax or of the Optometrist and things like that. But essentially, they're driving operating leverage that favors growth, while we look to bring prices down. Over the last couple of years when we did introduce those KS products at a higher quality and lower price point, we really drove that business.

Okay. That’s helpful. Thank you.

Sure.

And then, I guess, just switching gears on the international side, you guys obviously continue to fare pretty well given the headwinds? But just kind of looking at profitability of the other international business outside of Canada, stepping back, over the last few years, you saw EBIT margins come down slightly in that portion of the business versus the middle part of last decade.

Our goal is to improve profitability every year. There are lots of moving parts and some of these ancillary businesses help Costco travel. That’s growing nicely, along with the business centers which remain in motion. With our international sourcing strategy, we're finding ways to maintain quality while controlling costs and ensuring that profitability follows.

Okay. Great. I appreciate it. Thanks again.

Hey Richard, another gas question, I know you love these. Historically, when moving into a lower gas price environment, big declines year-over-year at the pumps like we are seeing and could see more of. What do you guys tell the buyers to do then? What categories tend to do better when you're having a pretty dramatically falling gas pump prices?

I don’t think we are smart enough to sit around and say with this extra profit what we can do. I spoke to Doug Shaw, the head of U.S. merchandising, the other day. His view was that we are doing everything we typically do. This helps; do we do more? Sure, it gives us a little extra cushion. All in all, we will continue along our path.

All right. Thanks.

Hi. Thanks. Rich, I thought we had a couple of questions left here but could you update us on inflation across the store both in COGS and at the retail level?

Basically, there was very slight deflation for the first 12 weeks, with food and sundries having very minimal inflation. Apparel is also very slight inflation, similar to that, less than 10 basis points. Grocery costs have risen marginally around 3.5%. For the first quarter, we are overall seeing costs down less than half a percentage point since the start of our fiscal year, compared to being up in the previous fiscal year.

That’s helpful and that’s at the COGS levels and same with retail?

Yeah.

Okay. The second question is regarding the switch of your card partner in Canada that took place in September. Could you explain how this affects the sales or profits of the business? Also, could you remind us when your Amex deal in the U.S. is set to expire?

Sure. We basically had long-term agreements in Canada and we have one here. We don’t really talk about our current contracts. We’ll let you know when and if anything happens. But in Canada, we made the switch for a couple of months back to both, and we will continue to do so. We made the switch to MasterCard, so we’re now seeing an uptick in transactions using that card. The transition is challenging, but it is manageable, and we are working with our new partner positively.

That’s great. Thanks a lot.

Yeah. Hey guys, good morning. Thanks for taking the question. I wanted to ask something related to the food side of the business. If you could talk about opportunities within food like new products, maybe organic or natural, any updates there?

I think we can do a lot more. The supply chain is improving every day, not just for us. In two years, we've moved from about $1.4 billion to close to $3 billion in organic. Our view is there are positives there, as some of these items are being added without being substitutes. Organic items can carry a higher margin as well. Ultimately, we add value for the customer and a higher margin for us.

Thank you. I wanted to follow up on the LivingSocial deal that you've mentioned a couple of times this quarter and last quarter. Should we expect more updates or similar initiatives in the future?

Well, it worked, but we don’t want our members to get used to waiting for the next deal. So we will do things on a sporadic and irregular basis. We will keep trying things out. They typically work well.

Got it. Thanks and good luck with this quarter guys.

Thank you.

Thank you. Just to add a follow-up, has there been any synergy or new developments that the Alibaba relationship could bring?

Certainly, we are shipping about 125 to 130 items to different parts of the trade offer, and we are seeing positive pushbacks, especially from what we’ve sent. It’s great to get our name noted there again, and we will continue to assess future opportunities.

Thank you.