Costco Wholesale Corp (COST) — Q2 2017 Earnings Call Transcript

Thank you, Frederica, and good afternoon to everyone. I’ll start by saying 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. In today’s press release, we reported three things to discuss: our second quarter and fiscal first half 2017 operating results for the 12-week and 24-week periods ended February 12; our monthly sales results for the four-week reporting month of February, which ended this past Sunday, February 26; and our plans for a membership fee increase in the US and Canada effective this coming June 1. For the 12-week fiscal second quarter, earnings came in at $1.17 a share or $0.07 below last year's earnings results of $1.24. Some items of note: First, our co-branded credit card and how it impacts our results. Similar to what we reported in our first-quarter results, the Citi Visa co-branded credit card program, which went live last June 20, partially impacted our margins by 16 basis points, our SG&A expenses by 24 basis points as compared to a year earlier, and our overall bottom line in Q2, benefiting earnings by $0.16 a share. A more detail on that later in the call. Second, gas profitability: our profits from gasoline during the quarter compared to last year's second quarter were lower by 42 million pre-tax or $0.06 a share. This was primarily a function of last year's very strong second quarter gas profit results and is consistent with the impact of gas profitability that rises in gas prices which will cause our earnings to fluctuate. Third, IT expenses: our IT activities impacted SG&A in Q2, on an incremental year-over-year basis by $26 million pre-tax or 7 basis points or - SG&A of $0.04 a share compared to last year. This reflects both the direct expenses for the quarter, as well as increasing levels of depreciation and amortization on major completed projects that are now in service. Fourth, stock compensation expense. This one is getting less of a negative impact each year, so it is a little smaller than expected. It was 10% higher year-over-year. So $10 million higher or about $0.015 impact to the P&L. Fifth, FX: there are two FX items to point out. The first one is how the impact of changes in foreign currencies relative to the US dollar year-over-year. As compared to a year ago during the second quarter, many of the foreign countries and locations where we operate began to strengthen during the quarter versus the US dollar, most notably in Canada, resulting in our foreign earnings in Q2, when converted into US dollars, being slightly higher by about $4 million pre-tax or about $0.01 a share than if the exchange rates had been flat year-over-year. The second FX impact during the second quarter was related to FX losses on forward contracts and US dollar holdings by our international subsidiaries used to pay US dollar-denominated merchandise payables in those countries. Losses on these exceeded the gains on the related US dollar-denominated payables. This year in the second quarter, it was roughly $20 million pre-tax hit. Last year in Q2, the gains on those payables exceeded the net losses on forward contracts at US dollar holdings by $6 million. So year-over-year, that's a $26 million year-over-year swing, impacting the P&L negatively by $0.04 a share. I might add that this year-over-year swing typically runs within a small range of plus or minus $0.02 a share, but with all the volatility out there, it was a little bigger this quarter. On LIFO - there was no LIFO charge or credit in this year's second quarter results. Whereas in last year's Q2 results, it had a LIFO credit of $15 million, reflecting deflation in our LIFO indices positively impacting last year's Q2 by $0.02 a share. While we did have some deflation in the quarter, as we did in Q1 with the switch over to a new accounting system and platform at the beginning of the fiscal year, we had no associated previous inflation or LIFO charges historically taken. If you will, there is a buildup of credit that will offset future LIFO charges to the extent that there is inflation in the future, but again year-over-year that’s a $0.02 hit to the quarter. Regarding income taxes, our effective income tax tax rate last year in Q2 was 34%. Due to a discrete tax item this year in Q2, as well as small changes in the profitability mix by country, our effective rate this year came in at 35.6%, effectively impacting our Q2 EPS by about $0.03 a share. Turning to our second quarter sales, reported sales were up by 6% and our 12-week reported comparable sales figure came in at up 3%. For the quarter, the 3% plus comparable sales figure was helped by gasoline price inflation to the tune of about 84 basis points, while the impact from FX was a very slight detriment, again, as currency strengthened during the quarter, the net over the quarter was still a slight detriment of about minus 9 basis points, yielding total comps for the quarter at plus 3% excluding gas and FX. For our four-week month of February, which included the last two weeks of the fiscal second quarter and the first two weeks of February, comps came in at plus 4. Reported figures were plus 5 for the US and minus 2 for other international. I also want to point out the calendar shift of the Chinese lunar New Year, which happened 11 days earlier compared to last year, positively impacted January's reporting period and negatively impacted February. We estimate that this shift was a detriment to February comps of about three-quarters of a percent on the total company and 650 basis points on the other international segment. Sales in February were positively impacted by both gasoline inflation and overall strengthening in foreign currencies relative to the dollar. Ex-gas inflation, the reported plus 10 in Canada would have been a plus 2, and the minus 2 reported for international would have been a minus 1 ex-gas, and a plus 5 excluding the lunar New Year shift. Total company comps for the month reported at plus 4 would have been a plus 2, excluding gas deflation and FX. In terms of cannibalization, we do this every quarter and typically it’s somewhere in the 0.5% range or a little less. Cannibalization has become a larger factor to our comp sales results in the recent months. The cannibalization impact on February was approximately 90 basis points negative for the total company as it was minus 75 in January. For February, it was minus 300 basis points in Canada, given we are opening seven new warehouses on a base of 91 up there. We estimate that weather had a negative impact on February comps due to snow in the east and heavy rains in the west, affecting traffic. The estimated impact was about 50 basis points in the US, about 75 in Canada, and also about 50 for the total company. Regarding deflation, we've observed overall deflation in the 1% to 1.5% range in February, with departments such as foods, sundries, frozen foods, liquor, meat, and dairy showing the most deflation. In terms of new openings, we planned to open a net of eight new locations during the first quarter, and in Q2, we opened four new locations, including our 13th unit in both Korea and Taiwan, along with two new locations in the Tampa area. For fiscal 2017, we have plans for 29 net new locations, with 14 in the US, eight in Canada, and one each in Japan, Korea, Taiwan, Mexico, and Australia, as well as our first openings in France and Iceland. In terms of membership trends and renewal rates, our membership fleet plans in terms of increases in June are underway, and we will update the Citi Visa Anywhere card information and our multi-vendor mailer promotional activities. In the second quarter, sales were $29.13 billion, up 6%. On a reported comp basis, they were up 3%. For the quarter, the plus 3 reported comp was composed of an average transaction increase of a little over 1% and an average shopping frequency increase of 2% for the quarter. Geographic regions such as Midwest, Texas, and Northwest were the strongest with California not far behind. As for international performance in local currencies, better-performing countries included Mexico, the UK, and Korea. In terms of merchandise sales for the quarter, food and sundries were flattish year-over-year, spirits and foods were among the leaders while tobacco continues to be a negative with high teens losses expected to cycle by the end of June. For hardlines, results were in low to mid single-digits, best department results were tires, hardware, and seasonal with consumer electronics down in the low singles. Fresh foods comp sales were also in the low to mid single-digits. As mentioned, second-quarter deflation was in the 1.5% to 2% range, impacting both food and non-foods, specifically in TVs. For February, traffic was up approximately 2%, including a strong 3% in the US. Average transaction also was up a little under 2.5%, with much of this attributed to gas inflation and FX. Internationally, UK, Mexico, and Canada continued to lead in local currency growth. Excluding FX, categories such as food and sundries, and hardlines were in low single digits, while softlines were up mid-single and fresh foods were slightly negative. As we relate to our promotional activities, we've revamped the MVM program, creating more merchandising excitement and enhancing member values on items. In terms of member fee income, we anticipate that coming in at $636 million, representing a 5% increase, up $33 million versus last year, with minimal FX impact at the start of the second quarter. Our membership renewal rates continue strong, with rates of just over 90% in the US and Canada. In Q2, primary Gold Star members reached 37.5 million, up from 37.1 million 12 weeks prior. Total members hit 48.3 million compared to 47.9 million a fiscal quarter earlier. Regarding the membership fee increase announcement, we plan to increase the annual fee for our individual Gold Star business and business add-on memberships from $55 to $60 and our Executive Membership fee from $110 to $120. The annual reward for Executive Membership will also increase from $750 to $1,000 based on eligible purchases. Approximately 35 million member households will be impacted by this increase, with half being Executive Members. In summary, I’ll be happy to take questions now. Thank you, Frederica.

Hi Guys, it’s Simeon. So Richard, I think the big question that will come up a lot, it looks like - I'm not in front of all of the numbers - but margins in this quarter sequentially versus Q1 seemed like they got a little bit weaker? Is there anything changing as far as investment back in the business, SG&A dollars, eCommerce, or just reinvesting back into price that we aren't seeing?

Well certainly, the gas inflation does have an impact, as well as the increasing sales penetration of gas. That's probably as much of an impact. Certainly, as some of the more promotional stuff we did with everyday low pricing had an impact. If anything, we did it a little more just because we wanted to. There's been some other things going on, but nothing major though. Overall, I look at the numbers and I don't see a big change other than the factors I mentioned. Historically, we’ve generally increased fees every five years. We know it hits the membership fee income line over about two years. We also realize that it typically hits very little in the first month, one-twelfth of the renewal group. Historically, we've taken great pride in investing in many aspects, including continuing to invest in price, arguing we’ve chosen to do some of the revamping with some of the MVM and pricing initiatives now. These strategies are generally independent of if, when, and the current fee increase.

Got it. Okay. That's helpful. I guess my follow-up - just thinking about reinvestment rates in the business, you have a membership fee increase coming down the pike at some point, and now we know when. I guess, maybe the way to ask it is, is there a natural run rate of reinvestment that you as managers of this business try to put back in? And where are we running relative to that?

Good evening, thanks a lot for taking my question. Richard, presumably you're investing in price because you're seeing a more competitive environment? Can you quantify or at least qualitatively comment on how much more promotionally and competitively intense it is now than when you've seen it in the past, particularly around the time when you've raised your fees?

We really haven't seen a big change there, and certainly this was not motivated by an increase in competition. The investment in pricing we've made relates more to changes in our sales activities. We generally do this to drive unit sales, and while some of the evaluation of what we're doing with the MVM has changed, competition had little stock in driving this investment.

So Richard, when you think about the executive increase in particular, how much discussion was there? What you should do with that, in light of where your club competitors are, where prime is?

We generally start with the premise that we knew we wanted to do the fee increase. We look at many factors as we examine other codes. We value the member's experience and we always seek to enhance the value proposition for all members over time.

How do you communicate the other factors you don’t advertise to the member about road shows and new excitement or lower prices on certain key items?

It’s through our magazine and emails. We range our activities relative to different promotional periods. It's not a huge surprise to us, we've said this is our transition quarter and that traffic might be negatively impacted, but going forward we expect improvements. The upcoming quarters will have a more fluid number of promotional events.

Can you help us understand a little better as we're lapping quite a significant deleverage in core SG&A, excluding gas?

At the end of the day, it's mostly payroll and benefits. Healthcare is inflationary, and we look continuously at labor in the warehouses and controlling overtime hours. The underlying comp also factors into that and is impacted more or less depending on our product mix.

So just to be clear... are we looking at a gross margin dollar growth that slowed relative to where you were last quarter? Is that primarily fuel?

Yes, we’ve had lower margins. When prices go up, we make less per gallon. That’s directly impacting the growth rate this quarter. The larger factors contributing to that shift remain gas profits. This year is less favorable historically for us than the year before, but we can't predict future rates heavily.

Can we discuss your digital infrastructure in terms of online sales and delivery services?

We are improving our distribution logistics and expanding partnerships with third-party delivery services. Our focus remains on enhancing member experiences and delivering products efficiently. Expect more developments this year as we continue evolving our offerings.

Can you provide insights into gross profit? How is it trending for gasoline?

Regarding gasoline profits, yes, we view our gross profits are reduced. We're experiencing a lower margin environment which presents challenges compared to previous profitable years. This will continue to impact margins quarter over quarter.

What are your thoughts on border taxes and how they might impact Costco?

Our stance on the border adjustment tax is clear. It would raise prices for consumers and we are concerned about the possible impacts it may have on our growth. We're aligning with industry concerns but are primarily focused on delivering value and avoid negative impacts we can control. Thank you all for your questions and I look forward to speaking with you again post the next earnings release. Goodbye.