Costco Wholesale Corp (COST) — Q3 2016 Earnings Call Transcript

Thank you, Karen, and good morning to everyone. Before I begin, please note that these discussions will include forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. These statements carry risks and uncertainties that could lead to actual results differing materially from what has been indicated. These risks include those outlined in today’s call and other risks noted in the company’s public statements and SEC filings. Forward-looking statements are only valid as of the date made, and we do not commit to updating them except as legally required. Last night’s press release covered our third-quarter and year-to-date fiscal 2016 operating results for the 12 and 36-week periods that ended on May 8. For the quarter, we reported earnings per share of $1.24, which is a 6% increase from $1.17 in the third quarter of last year. When comparing our third-quarter results to the previous year, there are several notable items. As is typical, foreign exchange rates compared to a year ago showed that currencies in the countries we operate in weakened against the US dollar, especially in Canada, Mexico, and Korea. This led to a decrease of about $15 million, or $0.03 a share, in our foreign earnings for Q3 when reported in US dollars. Gross margins on a reported basis were higher by 34 basis points, which included a $19 million benefit from one-time legal settlements, representing a margin improvement of 7 basis points, or about $0.03 a share. Regarding our co-branded credit card transition in the United States, we stopped co-brand AMEX credit card sign-ups late last year, around October-November, as we prepare to move to our new co-brand Citi Visa card next month. The short-term negative earnings impact from these lost co-brand credit card sign-ups year-over-year was approximately $11 million, or $0.02 a share. We expect our new co-brand Visa cards to reach our members by late May or early June, with the transition date set for June 20. In terms of wages, we usually implement a top-of-scale increase every March, which we did again this year. Additionally, we raised our bottom-scale hourly rates in the US and Canada, which encompasses about 80% of our workforce. Effective March 14, we increased our starting wage by $1.50 an hour to $13 and $13.50. This change resulted in an additional payroll expense of approximately $6 million, or $0.01 a share for the quarter. We estimate a similar impact of $0.01 to $0.02 in each of the next three quarters, depending on rounding. Our IT modernization efforts led to a negative impact on SG&A expenses in Q3, causing an incremental year-over-year increase of about $16 million, equating to 5 basis points or $0.02 a share. In the first and second quarters, the year-over-year expenses from modernization averaged around 5 basis points each quarter. In Q3, we recorded a pretax LIFO credit of $13 million, up from the previous year’s $7 million, marking a $6 million, or a penny a share difference. Turning to our third-quarter sales, total reported sales were up 2%, while our 12-week reported comp sales were flat. Sales were negatively impacted by gas price deflation and weaker foreign currencies, with gas price deflation contributing nearly 2 percentage points. Excluding gas deflation, the flat US comp would have shown a plus 3%. In Canada, the reported Canadian comp would have been plus 8% in local currency, excluding gas deflation. Similarly, the reported minus 2% from other international segments would have shown a plus 3% with flat year-over-year FX. Overall, excluding gas and FX, our reported comp for the quarter would have been a plus 3%. We opened 7 new locations in the quarter and completed one relocation, making a total of 19 new warehouses and 3 relocations year-to-date. For the entire year, we plan to open 29 new locations, with more than two-thirds, or 21, being in the US; two in Canada; two in Japan; and one each in the UK, Taiwan, Australia, and Spain. I will also cover e-commerce activities, membership trends, renewal rates, and further information on margins and SG&A for the quarter. Going through our performance, total sales were up 2%, with reported comps flat but up 3% excluding gas and FX. The flat comp on a reported basis resulted from an average transaction decrease of just under 3%. On an ex-gas and FX basis, the average transaction increased by 0.5%. The average shopping frequency rose by 3% during the quarter. In the US, areas such as Texas, the Midwest, and Southeast regions performed the strongest. Internationally, Mexico, Canada, and the UK led in local currencies. In merchandising categories, within food and sundries, performance was generally flat year-over-year, with sundries, foods, and meat showing the best results. Tobacco sales decreased in the low teens as we continue to phase it out in various locations. Hardlines performed in the mid-single digits, with notable strength in sporting goods, toys, seasonal items, automotive, consumer electronics, and garden/patio departments. Among softlines, single-digit comps were seen in small electronics, men's apparel, and home furnishings. Fresh foods posted low single-digit comp sales, with produce and deli performing the best. We continue to see low single-digit food and sundries deflation in the US, along with some deflation in other sectors, including electronics. Moving down the income statement, membership fees increased by 6%, totaling $618 million compared to $584 million last year, reflecting a 7-basis point gain as a percentage of sales. Foreign exchange rates impacted this number, but without FX, the total would have been up $7 million, resulting in a 6% year-over-year increase and a similar number of basis points. Renewals were strong, with rates above 90% in the US and Canada, and 88% worldwide. New member signups increased by 15% year-over-year, particularly strong in our new openings in Taiwan and Japan, which typically see outsized sign-ups. At the end of the quarter, we had 46.9 million member households, up from 46.1 million at the end of Q2. Total cardholders rose to 85.5 million, with an increase of 1.5 million from the previous quarter. Our executive membership count stands at about 17 million, reflecting an increase of 402,000 over the 12-week period, or an increase of about 33,000 per week during the quarter. Executive members now comprise approximately 36% of our member base, contributing to two-thirds of our sales. In terms of renewal rates, business members were at 94.4%, down slightly from 94.5%, while Gold Star members were at 89.6%, a minor decrease from 89.7%. Overall, the renewal rate for the US and Canada was 90.4%, slightly down from 90.5%, and 87.6% worldwide, down a bit as well. The slight dip in Canada relates to the recent credit card change, requiring all existing members to reapply. As for gross margin, our reported gross margin increased by 34 basis points to 11.43% this year, compared to 11.09% last year. In summary, we reported an operating income of $858 million for the quarter, reflecting a 5% year-over-year increase from $821 million last year. Interest expense remained steady at $30 million, while interest income and other figures decreased slightly to $7 million. Overall, our pretax income was up 4.5%, reaching $835 million. The tax rate improved slightly to 34.2%, down from 35.0% in the previous year. Our reported net income was $545 million for the quarter, compared to $516 million last year, marking a 5.5% increase. As a final note, we plan to change the timing of our earnings release and conference calls beginning with our fourth quarter. We’ll now issue results after the market closes Thursday, September 29, followed by a live conference call that afternoon. This change aims to respond to requests from analysts and should enhance the reporting process. Additionally, next week, we will report on sales for the four weeks ending May 29, noting that Memorial Day falls on day one of the June retail calendar, providing a slight timing benefit compared to last year. I will now open the floor for questions and turn it back over to Karen.

Hi. Good morning. This is Steven Zaccone on for Oliver Chen. Thanks for taking our questions. Just two questions from us. Firstly, we wanted to get your take on the health of the customer base for you. There has been some different trends among retailers reported thus far in earnings. Wanted to just get your sense, have you seen any changes in trends or spending habits? Second question, just wanted to get your thoughts on progress with some of the third-party partnerships in grocery delivery. How has growth in those channels performed relative to expectations and then just thoughts about expanding into new markets? Thanks very much.

So far, we're seeing our customers remain healthy with no significant changes in their behavior. While there have been concerns about traffic dropping from the 4% growth we’ve seen over seven years, we're confident in our numbers. Interestingly, we've observed some strength in non-food categories, such as furniture and electronics, compared to nondiscretionary items like food and sundries. This helps alleviate any worries some may have. We are experiencing good renewal rates despite the minor effects from credit card transitions. Overall, we're pleased with our merchandising efforts. Recently, I've been asked if our sales indicate deflation or weakness in various channels. Looking at the 12-week quarter year-over-year for the U.S. alone, the average number of items per basket increased by 1.4%, while the average basket value grew by 0.4%. This suggests we may be facing around 1% deflation, but there could be other sizes and pack impacts to consider. Generally, we tend to opt for larger sizes in our products. Regarding our third-party partnerships, we maintain solid relationships with companies like Google for Google Shopping Express and Instacart, which has expanded into over 15 markets. We aim to be the anchor tenant in these joint ventures, providing a variety of products beyond just Costco items. Although this segment is still small, it is growing and offers some support. As for our expansion plans, we're targeting around 30 new openings for next year, like we have historically. We've had success entering markets where our competitors have been established for years, such as Mobile, Tulsa, Toledo, and Rochester. We could see a few more openings in these areas, including challenging locations in the Puget Sound and LA. If I had to speculate, I would guess that about 50% to 52% of the new openings next year will be in these regions.

Thanks very much.

Good morning. Simeon Gutman. Richard, the Visa transition besides the timing that started a little later, anything else to think about? Interchange fees probably start to go down when it happens, but are there other costs that make your SG&A or any other line items elevated temporarily?

No, it's the same issues we've discussed, such as not having signed up new co-branded cards since last October or November. These equations involve different sources of income, including new credit card sign-ups, which have been about 4 to 5 million per month. This was once significant, but now it's nothing until June. Other than that, we have many people on both our side and the issuer side working hard to ensure everything runs as smoothly as possible, and we are looking forward to it. It's a substantial improvement for our members, and we will retain some benefits ourselves through a reduction in merchant fees. Currently, cards are being mailed out, and they will keep coming because we're sending out over 10 million pieces in a few weeks. They have just started being sent, so everyone should receive their cards within a few days to a week before the June 20th deadline. We will provide more updates in late September during the fourth-quarter earnings call, but we are prepared and excited about the progress.

The marketing expenses, including in-store kiosks and mailings, should not significantly impact the SG&A dollar run rate. There is nothing unusual expected as we proceed with this.

Absolutely.

Okay. For my follow-up on gross margin, I believe you mentioned that the gasoline and optical business showed a year-over-year increase. If that's accurate, can you clarify how you are managing this? I thought we were passing the peak of some of the strongest gasoline gross margin quarters from last year. It could be related to the optical mix, but gasoline is a larger input.

Yes, it will happen in Q4. This quarter was unusual. In the early part of the quarter, it performed better than we expected, but with fluctuating gas prices—currently rising—it has been somewhat weaker in the last couple of weeks. However, it was likely stronger at the beginning and into the middle of the quarter than we anticipated. There are two main factors at play. The primary one is that when there are daily price fluctuations in procurement costs for us and other gas station operators, we tend to maintain a better margin when prices decrease. This happens because our competitors do not pass savings back as quickly as we do. While we return more to customers, this practice gives us a slight advantage. Overall, I think this new normal, which has developed over the past couple of years, is somewhat better on average.

Okay, thank you.

You will see it in Q4. I say that today. Day-to-day, things can change. Just when we think we have it figured out and it's safe to move forward, it can go the other way. But so far, I think it will impact us in Q4.

But in Q4 being the hump and then it gets easier after that?

Yes.

Thanks a lot. Good morning, Richard. My first question relates to margin. Can you just talk about the degree to which moving food prices, I guess a deflation issue, and/or FX would've contributed to margin rate in any way?

Well, the only thing that foreign exchange does is that in most other countries, some of their goods are sourced from the US or payable in US dollars. In Canada, this impact is significant. We manage that by securing natural hedges during the quarter once the buyers are comfortable with the exchange rate and their pricing strategy. However, my estimate is that there is still pressure, especially considering that in Canada, the Canadian dollar is 17% weaker year-over-year and has weakened by 5% from the previous month alone. This situation contributes to margin pressure, although overall, margins have increased slightly. Generally, we try to lower prices during deflation, which might affect us sooner than others, but that’s about it.

Got it. And then LIFO, I guess, it's I think the seventh consecutive quarter where this has gone your way, and I know you market to the best of your expectations at the end of every quarter. How much of this is food, and if we think about commodity prices, I know once again this should be zero in a normative environment. Any sense of whether there's more momentum that could prove helpful to you here?

We don't know. If you talk to our fresh foods buyers, they are continuing to expect some deflation. I get different answers from some of the non-foods buyers. Mind you, when we look at fresh foods year-over-year, those margins were down slightly in the low double-digit basis points year-over-year, so again not a big impact there. It's the other categories where it was up a little bit, and so the net of all those four main categories, it was up 16 basis points. I don't think there is lots...

Do you have any thoughts on how your food market share might change in the long term, particularly if prices decrease and consumers start seeing prices at other retailers that they previously only saw at Costco?

We continue to believe that we will see increasing penetration of our products in fresh foods. We maintain strong quality levels and values, and our initiatives in global sourcing, poultry plants, and organic products are yielding positive results. While our beef volumes are up, there is deflation in beef compared to other protein categories. We tend to be the first to reduce prices in these deflationary scenarios. This deflation can mask the strength we have in terms of volume or unit sales, whether it's protein or produce. While I wouldn't claim that we're untouchable, we have strong initiatives in global sourcing and partnerships with vendors. Our produce business is approaching $6 billion, which is comparable to our protein business, and few retail food outlets achieve those numbers. We believe our performance is more influenced by our efforts than by broader market shifts. There are new entrants in the market, such as 365, offering health and organic retail formats, but we excel in this area as well. We see fresh products as a key area for increased sales penetration and ongoing growth for our members.

Thank you so much. Appreciate it. Thanks, Richard.

Thank you for taking my question. Richard, you estimated that the credit card transition will impact the P&L by $11 million. I assume this is primarily due to lost credit card sign-ups. Can you provide insights on any changes in spending related to this transition? For instance, some cardholders may not realize they can still use their cards and might alter their spending behavior as a result.

There's always going to be some confusion. As for the lack of new co-branded credit card sign-ups, I believe that not many people who are considering a Costco membership have decided against it because they can't sign up for the new AMEX card. If they already have an AMEX card, they can use that. However, for those who don't have an AMEX card, or for those who haven't signed up for one in the past 16 years due to credit eligibility decisions made by the issuer, it may vary. That said, I don't believe that many people left because they couldn't get an AMEX card; they can use a debit card, cash, or check instead. On a broader scale, does this affect some larger purchases? Yes, it likely does, although our TV sales have remained quite strong. So, I can see both sides of this issue.

So does that mean that some of the comp slowdown just may be a function of the law of diminishing returns mass taking over?

It could be. Again, we look at the ones we can easily quantify. We can drive ourselves crazy with this. We know that, to be honest, in April sales were about everything. It's deflation, a bit of the AMEX influence. Maybe we're getting closer to maximizing marginal gains. Ultimately, we are still rolling out gas stations, expanding some ancillary businesses, opening new warehouses, and increasing our fresh foods offerings as we have over the past several years. People ask us about our new areas, including ticketing and executive member services. We've even been surprised by wine and spirits. These are all small factors, small movements that do impact us, but I've always said there are many little elements that contribute to our success.

And my last question is, to the extent that you've already seen some of your existing AMEX cardholders clip up their card and switch to Visa, and it's having an impact on your sales, do you think that's going to only intensify as you get closer to the June 20 transition date? So for example, are you seeing even slower trends in base so far?

Well, first of all, I don't think anybody's clipped up anything. They still have to use that co-brand AMEX card through June 19, and nobody can actually use the new card even if you got it in the mail until June 20. That's part of our original agreement with our previous service provider. And that's fine. So all stuff will happen June 20 and beyond. And rest assured there's going to be a lot of stuff happening in terms of our continued communication, of course, to our members, but there's a lot of members out there that don't have chance. About a little over 40% of our US sales were done on AMEX with I think over two-thirds of that, a little over two-thirds to half of that being on the co-branded card. Some people tend to want Delta points or Starwood points, so they are using a different one. The same thing will happen with Visa. Our goal is to get that co-branded card, as we did successfully with the AMEX co-branded card, that to be your top-of-wallet card. We think that there's going to be a lot of things that drive that, including the people out there on blogs independently and others that look at what is currently a 3, 2, 1 is going to be a 4, 3, 2, 1, that's huge. So my personal view is it'll be something that's not going to all hit on day one. Let's get through day one and the transition first, but it'll be something that will continue for a couple to several years.

Okay. Good luck. Thank you.

So Rich, do you think this annual target of 30 openings is feasible? You certainly have the resources and capital to pursue more. Is there a limitation in real estate, or do you feel confident at that level? Are you able to exceed that? Additionally, when looking internationally, especially outside of North America, there seems to be potential to achieve 15 to 20 openings a year comfortably. Is that a possibility for you?

First of all, it's not a question of capital; we have plenty of it, perhaps too much. Our challenge lies in people. In the past, I didn't recognize this as much, especially in certain countries. For example, in Japan, we experienced a significant jump from 9 to 20 units over an 18-month period a few years back. We're not just sending experienced warehouse managers from other countries; we do that occasionally, but primarily we focus on developing local talent. This can pose challenges, as things tend to take longer in some countries due to zoning laws and restrictions that apply to all large retailers. Going forward, I believe we can aim for more than 30 openings annually. We're targeting low 30s this year and mid-30s next year, with a long-term goal of reaching 35 in five years. We may fall short or exceed that, but we currently have the most real estate presence in both the US and internationally. While it may take longer, we could certainly open more locations, but we're comfortable with our current approach. We believe we are the preferred choice in the market, and even if it takes us a bit longer to enter a new market, we find that people are willing to wait for us. We're confident in our strategy.

As traffic in the US has slowed down, are there internal discussions about whether this is a natural moderation or a response to the 16 basis point improvement in margin? Are there proactive steps you can take to give more back to members, and could that impact traffic? Is there a conversation about balancing earnings with the desire to increase traffic?

First of all, in the first quarter, we are a top-line company focused on driving sales. We're pleased to see that year-over-year margins in those categories are up 16 basis points. While we're continuously seeking to improve our margins, we prioritize giving back most of any savings to our customers. Looking at our competitive pricing stance, we’ve never been in a stronger position relative to our direct competitors. We have the opportunity to increase our profit margins, but we choose not to. We’re always aiming to enhance our offerings. Historically, when we adjust membership fees, we strive to give some benefits back to our customers. Factors contributing to our margins include private label products, strong fresh food sales, and other ancillary businesses. We remain committed to improving without being overly concerned about minor fluctuations in frequency or comparable sales. We're always asking ourselves how to do better, even in challenging situations, and we will keep pursuing opportunities without focusing excessively on slight declines in margins.

All right. And then, lastly, is KS having any kind of real impact that you can see on basket size or not really?

I don't know. We keep adjusting our KS items, so they are evaluated using the same metrics. If an item isn't performing well, we discontinue it. However, we don't have any major items like toilet paper, water, or disposable diapers as we did in the past, but we do have many smaller ones. I believe we will continue to see increased penetration, albeit at a slower growth rate in the future for similar reasons.

Okay, thanks.

I don't think, getting back to your question, I don't think that's a big reason of why the basket size has changed. If anything, many of those items, it's a lower price point. If we are doing brand only and we brought in the – prefer next to it, in many instances, it may be the same because we go to a bigger pack size. In many instances, you've got a lower price point on the same number of units.

Hey, this is Mike Montani filling in for Greg. Thank you for taking my question. Richard, you mentioned noticing some extra strength in discretionary versus nondiscretionary categories, which gave you confidence that consumer behavior hasn't changed significantly. Can you share any updates? While it's still early, have you observed any improvement in traffic in May compared to the trend in April?

We can't discuss anything regarding May yet, and there are no significant surprises in either direction. At the end of the day, I was responding to inquiries from institutional investors and analysts about their concerns. When we reviewed April sales, we noted that the numbers were a bit weaker, but one point of reassurance was that some discretionary categories are actually performing better than expected given the overall figures. That's about all I can say on that.

Okay, thank you.

We will tell you next Wednesday for May.

And if I could, just to follow up on gas a little bit, could you provide the price per gallon for the quarter and also the comp gallon trends and if there was any material impact to EPS that I may have missed?

The price per gallon was down for the quarter 19.7%, basically $2.59 a year ago and $2.08 this year. And what was the last part?

Just asking about what was the comp gallon percentage change and then also was there any material EPS impact on this quarter and if you could help us size up exactly what we are up against in next quarter?

I think year-to-date we are up in the low single digits in terms of comp gallons. Again, the big comparison was it was a year ago when it was really outsized comp gallons up 7%, 8%. I know in April I think a year ago it was 8% in the US, and so that was part of that impact of why sales, in our view, sales were a little weaker particularly in California in April.

And just the EPS impact, Richard, I'm sorry, on per gallon…

It was within a penny or two, really no change year-over-year. I think it might have been a penny.

Hey, Richard. Thanks for taking the question. One on gas and another on a different subject. You've been adding 20 to 30 gas stations a year the last several years. I think your penetration is like 70% across the clubs. How do we see that going forward, is that pace of growth going to continue? Where do you think you can get the penetration of gas stations call it a few years out?

In the US, every new unit we establish includes a gas station when feasible, and we're also introducing a few in countries like Japan and Australia, where we hadn't done this before. We relocated some units in the US, including moving Hackensack to Teterboro. Hackensack became our 11th, 10th, or 12th business center, while Teterboro features a large new Costco with a gas station, improved parking, and other advantages. I believe if we relocated three or four units this year, at least three would have gas stations while the others wouldn't. We're reaching the maximum capacity for gas stations. By the end of the quarter, we had 420 gas stations across 481 warehouses in the US and 55 out of 90 in Canada. I expect there's still some potential for growth in Canada since we started there later. In the UK, we went from having none a couple of years ago to 4 now. In Japan, we have 5, in Spain, 1 out of 2, and in Australia, 5 out of 8. While the pace of adding gas stations isn't as rapid as five years ago, it still makes a significant impact.

Okay. That's helpful. And then can you take a minute and discuss the senior management ranks at Costco? There's been some turnover lately. Doug, I think his last day may be tomorrow I guess, but just talk about what's going on in terms of transition, future transitions, and maybe what changes, if any, these new leaders have implemented. I understand it would be only marginal, but just curious your thoughts on all that?

You mentioned that shopping frequency has remained at 4% for seven years. Some people have been with us for 30 years, myself included. Yes, there is some turnover. In recent years, we've seen team members retire in their early 70s who started together at FedMart in San Diego over 55 years ago. However, I believe we've managed the merchandising and operations aspects well. The initial major concern was what would happen when Jim left. Internally, we felt confident, and Craig has demonstrated that the transition has maintained our culture seamlessly. In merchandising, we've made changes, such as promoting two individuals who have separated hardlines and softlines, following the retirement of Dennis Knapp, a senior executive who previously managed those areas. In operations, we've also seen several promotions, and we've typically advanced individuals who have been with us for 20 to 25 years to Senior VP positions. Currently, we have about 16 Senior VPs of Operations in the US. Regarding Doug, who has been leading US merchandising, he is leaving for positive reasons, and there's no internal or personal issue involved—it's something we all somewhat envy. Doug is one of the younger members of the senior management team. Craig has a plan and is currently reviewing some options, and we will make announcements on any changes in the coming months. We have capable people in position, and we don’t foresee any issues. In Asia, Richard Chang, who has been with us since the Price Club era over 25 years ago and previously managed operations in Taiwan, has been promoted to Senior VP over Asia. We've also welcomed some existing Costco employees from the US into new roles there. Overall, I think we are in a good position with these changes. Our growth is accelerating from a previous halt. Over the past couple of years, we've seen a gradual increase in changes, and I believe we're well-prepared moving forward without significant alterations to our approach.

Okay, great. Thanks, Richard.

Good morning. I was wondering if you could comment a little bit more around some of the geographic trends that you are seeing and just update us on your thoughts around the trends in California?

Last month, we highlighted California for April because, while the overall US performance was slightly weaker than before, California stood out. California accounts for about a third of our operations in the US and likely has a higher level of gas penetration. A year ago, we were comparing gallon sales, which not only influence gasoline sales but also significantly drive foot traffic, as approximately 52 or 53 out of every 100 customers visit our stores. This created a distortion when comparing California with the rest of the US. I believe there was a notable difference in performance; to reach a score of 1, other US markets were at 2, while California was at around minus 1, though I may be slightly off on those figures. This situation was somewhat unusual. I can't predict the implications for the future, but there are positive signs in some new medium-sized markets. Recently, we experienced the highest number of new sign-ups in years, particularly in Tulsa, which outpaced any previous opening day. This does not include Asia, where sign-up levels are a different matter. Overall, things appear quite promising. Aside from the issues we mentioned regarding California, I don't anticipate many geographic changes and I believe much of this relates to gas supply challenges.

Got it. I noticed you are working on a pickup truck with GMC, and are other vendors approaching you for marketing opportunities given your business success?

In the car business last year, we sold just under 500,000 new cars in the US. When car manufacturers launch new models, we can significantly boost sales during the following weeks by showcasing those vehicles at our locations and offering additional incentives. We've considered creating a KS vehicle for several years and have spoken with various manufacturers about it. This would be an appealing vehicle that offers great features and better value than what our Costco members or executive members typically receive. We've made some progress, having started and paused discussions with a few manufacturers. Overall, we're pleased with the direction it's taking, and we believe the manufacturer and dealers are as well. There may be more opportunities like this in the future, but we'll have to wait and see.

Great. Thank you very much.

We back those with auto products too. We just keep bringing it to a different level. Why don't we take two more questions?

Hey, good morning, Richard. Just want to clarify a few things, if you don't mind. First, on the new member sign-ups, I think you said up 15%, certainly international store openings have a lot to do with that, but you are also seeing success in the US. If you can maybe just give us a little bit more detail around what's driving that.

Well, I don't know what's driving it. We do a pretty good job of getting people in the door, opening in some of these new markets help. It's just been overall strong. If the US is 15% and the whole company is 15%, where was it down? It was up relative to the 15% of course in the end, and places like Taiwan and Spain of course was huge, but it's huge on a base of one. And then it was a little lower in Canada where we had very few new openings. And Mexico same thing. Mexico last year we had a huge opening on a base of about 34 or 35 units, a huge opening, which had outsized numbers, so we are comparing against that with no new openings this year, the same thing in Canada. We had a huge opening in a location there a year ago in the quarter versus none.

Got it. And then on core merchandise margins, just wanted to make sure the 16 basis point gain you are referring to, that's kind of the true core merchandise margins on the four categories that compares to the 11 basis points. Is that correct? And then also you made a comment earlier in the call regarding AUR. Is your view of total store deflation around 1%?

Well, looking at my LIFO index, which represents 70% of our inventory according to US accounting principles, it's about a percentage point, specifically 0.9 of 1%, from the start of the year to now. When I examine the total at our US front-end registers, the number of items in the shopping basket increased year-over-year by 1.4 percentage points, and the average basket size went up by 0.4 percentage points, resulting in a 1.0 percentage point difference. This reinforces the idea of an average deflationary trend of approximately 1%. However, this is more of an educated estimate rather than an exact science. The margins of 16 refer to sales in each of the four categories individually.

Good morning, guys. Scot Ciccarelli. Thanks for getting me at the end here. Richard, can you remind us where you are in the IT modernization investment program, when some of those pressures may start to ease? And secondarily, are there any other investment bubbles we should be mindful of as we think about the next two to three years?

IT is a continuous advantage for us. We began this journey around four years ago. Looking at our current position, we anticipated that it would take about four years to achieve significant milestones, but it seems it will require six years instead. The expenses have also exceeded our initial estimates, costing 1.5 to 2 times what we expected, which isn't uncommon. We expect there may be a slight negative impact in fiscal '17, but it could also remain stable or show slight improvement thanks to the extra week in that fiscal year, so we expect it to be flat or slightly up in '17, with potential for minor increases or stability in '18, though there may be slight decreases as well. We are nearing a critical turning point, likely at the end of '17 or into '18. It's important to note that these figures are based on necessities first. We anticipate that this will benefit us in various ways, and we plan to incorporate additional elements. However, the majority of our efforts will soon be behind us, allowing us to move forward from there.

Okay. And any other incremental expenses that we should be mindful of, like you finish one program and typically there's another one waiting or lurking right behind it?

I don't see anything significant on the horizon. We recently implemented a slight increase that’s not substantial, roughly $0.06 annually. There are no major changes expected in healthcare. We continue to offer excellent health, medical, dental, and vision benefits to all employees. If we enhance our sales efforts outside the US, certain structural costs will benefit us. Healthcare expenses in the US are considerably higher, by 20 to 60 basis points as a percentage of sales, compared to other countries. Therefore, expanding our operations internationally will improve that figure somewhat, which also applies to labor costs. We provide competitive wages relative to local standards, but wages in the US and Canada are higher than in some other countries. These factors will provide some assistance. However, I don’t foresee any major disruptions occurring.

Got you. Thanks a lot, guys.

Thank you, guys. We will be around. Have a good day.