Costco Wholesale Corp (COST) — Q3 2015 Earnings Call Transcript

Thank you, Britney. Good morning to everyone. Last night’s press release presented our third quarter operating results for the 12 weeks ended May 10, 2015. Before I begin, please note 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 we do not undertake to update these statements except as required by law. So to begin with, our 12-week third quarter fiscal 2015 operating results for the quarter, earnings per share came in at $1.17 a share, a 9% increase over last year’s third quarter earnings results of $1.07 a share. A couple of factors that impacted our third quarter earnings comparison year-over-year. First, FX; as compared to a year ago, in the third quarter this year, the foreign currencies where we operate weakened versus the U.S. dollar, in fact in all countries, but primarily in Canada, Mexico, Korea, and Japan, resulting in our foreign earnings in Q3 when converted into U.S. dollars being lower by about $33 million pre-tax or $0.06 a share than these earnings would have been had FX rates been flat year-over-year. Second item of note, IT modernization. As with the past many quarters, our major IT modernization efforts are ongoing and will continue to negatively impact our SG&A expense percentages through this fiscal year and certainly into next year, especially as new major systems are placed into service and depreciation on those begins. And in Q3, on an incremental year-over-year basis, these costs impacted SG&A by an estimated $19 million pre-tax or 5 basis points without gas deflation and FX. A third note, LIFO. Last year in Q3, we recorded a $12 million pre-tax LIFO charge. This year in Q3, we had a $7 million pre-tax LIFO credit, which benefited Q3 this year by $0.01 a share. And last item of note, while we enjoyed the benefit of strong year-over-year gross profits in the first half of the fiscal year, both Q1 and Q2, in Q3 it was additive, but only by $0.01 a share, so pretty much back to normal this quarter although the next quarter will be a little bit of a tougher comparison. In terms of sales for the third quarter, total sales were up 1% and our 12-week reported comparable sales figure came in at down 1%. For the quarter, sales were negatively impacted as you all know by gasoline price deflation. That represented about 350 basis point negative impact and by weaker foreign currencies relative to the U.S. dollar year-over-year. That impact was a little over 300 basis points. So excluding gas, the reported plus 1% U.S. comp number increase in Q3 would have been a plus 5% and the reported minus 6% international comp figure excluding gas and FX impacts would have been plus 7%. Such that the total company comps reported at minus 1% for the quarter excluding gas and FX would have been plus 6% for the company. Next week kicks off a very busy fiscal fourth quarter expansion, which includes openings next week in Wichita, Kansas, Mobile, Alabama, and Rochester, New York. These are the first three of 14 planned new locations for the fourth quarter, including four additional new U.S. locations, one new location in each UK, Taiwan, Korea, and Mexico, and three new warehouses opening in Japan this August. We will most likely end the fiscal year with 24 net new openings and 687 Costcos worldwide. Also this morning, I'll review with you our e-commerce activity, our membership trends and renewal rates, our recent common stock repurchase and dividend activities and of course additional discussion about margins, SG&A and other items in Q3. So for our third quarter results, in terms of sales, sales for this year’s third quarter for the 12 weeks ended May 10 were $25.52 billion, up 1% from last year’s third quarter results of $25.23 billion.

So, Richard, two questions about gross margin. Number one, so the guest benefit moderated, but you still had a pretty good performance out of ancillary, so were there some other non-gas ancillary departments that were particularly robust, really up quite a bit in gross? That is number one. And then two, if you look at sort of core merchandise right ex deflation, so you are still down there, I know you are making – I think you're making some investments. Can you talk about how you think about tying gasoline windfall or gasoline benefit or ancillary benefit to investments in price and is one of those the idea of pass along less meat inflation because you’ve got some gas wind at your back?

First of all, all the ancillary businesses were good this quarter. They generally have been good. I mean sometimes one is a little lower year-over-year but it hit all, we are up. Gas was a very small benefit year-over-year this quarter of gas profits versus the first two quarters as we mentioned in those first two quarters. And again that will cycle over the next three quarters when we had strong Q4 a year ago and strong Q1 and Q2 earlier this year, so those could be tougher comparisons. In terms of investing in price, I mean that’s what we do. It’s not a scientific function here. It’s an art form and we are always going to be competitive.

Well, just curious about meat, meat in particular has been very inflationary. It is a big category for you. That strikes me that that is one where you may have delayed putting some pricing through.

Yeah, well, but that’s such a front and center category, when you see ads in the paper every week particularly holiday weekends for Memorial Day or July 4th or Christmas or Labor Day, you name it, and so we are always going to be tough on that. Historically when commodity prices are going up, we are the first to not have them go up as much and when they are coming down, we are going to go down as fast as we can.

All right. And then just lastly again on the topic of mix here, so if you think about KS, just remind us the margin spread and I know it will vary by item, but margin spread KS versus a branded product, KS penetration and then is the KS margin itself staying pretty flat over time as you get a benefit you pass it along or is KS margin actually getting a little bit better?

Yeah, of core merchandise, Kirkland Signature is about a quarter of our sales and increasing. Hopefully, it will continue to increase to some higher level. I would say again if I think back of some of the big volume items, paper goods, we have some KS on order, we have some KS items that are several hundred million dollars or more of sales a year.

Thanks. Good morning Richard. One follow-up on gas, this quarter it looked like there was a slightly different dynamic at play where wholesale prices were rising different from the prior to, you got retail prices went up a bit – national prices, right I don't know how your prices trended, but you still eked out a little bit of a benefit, did you do anything different to manage it, did you typically lag, I guess the market, but where you more cognizant of the interplay between wholesale cost and retail prices this quarter?

Nothing out of the ordinary, no.

Okay and then my follow-up is on investments in SG&A spending, I think we asked this once a quarter, regarding the timing in terms of when investments crest and when we should start to see those investments dwindle?

In terms of IT? Yeah, I think if I go back two and a half years ago, we felt that probably sometime in early 2016, maybe I’m off by half a year or a year, so maybe still longer, but good news is the denominator in that calculation keeps getting higher to the sales denominator, but we're just starting to see some of those big projects and we've got several of them. The installed and that's when you start that amortization of those items. So we will still see it eke up a little bit over the next – certainly the next four quarters maybe six, it's hard to predict maybe it’s seven, I don't know yet, but it’s going as planned.

Hi Richard, I was wondering if you could talk a little bit about what you are seeing in terms of inflation in chicken and eggs because of avian flu?

No I don't know completely, I do know that there was requirement in California in terms of something related to eggs that caused egg prices to come up.

Can you talk also just more generally about food inflation both in the U.S. and outside the U.S.?

On the protein side it’s been involved for various reasons, pork was volatile because of a virus that reduced the supply. The beef was, as I understand in an 18 month transition where grain prices when feed prices skyrocketed, certain part of that 18 month cycle of growing cattle was reduced as people, as farmers sent them to process sooner because it was too much, it cost too much to feed them.

Looking at international, can you provide an update where you guys are versus your long-term potential, you know currently international is about 30% of your star base, could that get to 50% over time and then we understand you know France is the next country you guys are going to enter, any other new markets you are looking to consider?

Well international is going to be most likely continue to grow if you think about it on a base of about 480 U.S. we are opening 12 or 14 year this year and about half in the US half International where that number of openings internationally on a smaller basis of total international right now is a lot bigger and that will continue and I think even the percentage of annual openings each year will continue to grow outside of the US as we, as that is limited.

I guess can we dig into the core margins by category a little bit and I mean it seems like the 10 basis point improvement as a percentage of owned sales is the best in a few quarters. So kind of what drove that performance I guess in the food and sundries and softlines categories?

Yes, well, again food and sundries, softlines was bigger improvement year-over-year than food and sundries. In fact, I don't remember if it is because it was a weak comparison to last year. Foods has a much bigger penetration mind you. Food and sundries is our biggest core category. And there is nothing specific. Again I think that we feel that we are able to make a little more margin mostly by buying better and keeping a little of it but passing more of it on. When we look at our competitive landscape versus our direct competitors if anything the gap is improving, it is getting bigger a little bit, not a lot. So it is not like – and so in our view we are as if not more competitive while still showing some improvement in the core. For fiscal 2015, again, these 24 will represent about a little over a 3.5% unit increase, so probably about a 4% square footage increase. And at Q3 end, we ended with total square footage of 96.7 million square feet. So overall, we think margins are in good shape. Moving to reported SG&A, our SG&A percentages in Q3 year-over-year were higher by 25 basis points coming in at 10.1% of sales this year, compared to a 9.86% in last year’s third quarter, but again better or lower by 10 basis points excluding gas deflation.

Good morning, Richard. Thanks a lot for taking my question. You have been putting up such great traffic trends for so long, I think some of it has been due to the improvement in your fresh, rolling out more gas stations. How long can that continue? What is your expectation on the sustainability of the recent traffic performance?

Well, you know, we cross our fingers and hope it will continue. I mean we are out there every day trying to get new items and new exciting stuff and lower some of our prices. And organics has helped, gas helps. We are still certainly as many new locations that can get gas gets it which is more than the company average. But at the end of the day, that is what we do. So fresh – in my view, fresh foods, gas, executive membership, opening in new geographic markets outside of the United States, all those things are net positives. We had originally planned to be closer to 30 for the fiscal year. However, several of these have been pushed into early fiscal 2016 due to timing and construction issues. I think overall, looking just down the list of the most deflationary and inflationary items in the last month, you've got some beef items on there for sure and that's 8% to 20% range year-over-year. Overall, reported net income of $516 million this year in the third quarter represented a 9% increase as compared to the $473 million net income figure last year in Q3. We will most likely end the fiscal year with 24 net new openings and 687 Costcos worldwide.

Your next question does come from the line of John Heinbockel with Guggenheim. Can you provide an update on some of the digital initiatives you guys are doing like e-commerce, Tmall with Alibaba, Google Express and Instacart?

Sure. Well, pretty much the same as a quarter ago. We are certainly testing in six markets with Google and probably a few other merchants with Google, the Google Express Shopping. Instacart has expanded to more cities with their announced capital raise a few months ago. And there's a couple of other smaller ones in some regional markets and so that is good. We are agnostic. We are working with all of them. We like to sell merchandise and we will see where it goes. Overall, we think margins are in good shape. Moving to reported SG&A, our SG&A percentages in Q3 year-over-year were higher by 25 basis points coming in at 10.1% of sales this year, compared to a 9.86% in last year’s third quarter.

First of all, any initial thoughts on the transition process as you move away from AmEx to your new credit card deal whether there is any friction in the process?

Right. Well, there is not a lot we could say at this point. Needless to say we are excited about it.

What should we expect in terms of your operating margin in the upcoming quarters?

We are up against – Q4 of last year was the first in a while outsized gasoline profitability, should be pretty good this quarter, but I don’t know if we get all the way, I don’t think we get all the way where we were last quarter.