Costco Wholesale Corp (COST) — Q1 2019 Earnings Call Transcript

Thank you, Liz, and good afternoon to everyone. I’ll start by stating that these discussions will include forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties that may cause actual events, results, and performance to differ materially from those indicated. 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 the Company does not undertake to update these statements except as required by law. In today’s press release, we reported our operating results for the first quarter of fiscal 2019 and the 12 weeks that ended this past November 25th. Net income for the quarter came in at $767 million or $1.73 a share, a 19.3% per share increase compared to $640 million or $1.45 per share last year in the first quarter. In comparing year-over-year operating results, there were three items noted in the release. First, this year's first quarter benefitted from a $59 million income tax benefit related to stock-based compensation. Last year, the benefit was $41 million in the first quarter. Second, the Company recognized an additional tax benefit this year of $27 million related to the 2017 Tax Act. Third, this year's first quarter results included a charge of $43 million pre-tax, or $31 million after tax, for an adjustment to our estimate of breakage rewards for the Citi/Visa co-branded credit card program, which will be discussed in our gross margin section. In terms of sales, net sales for the quarter were $34.31 billion, a 10.3% increase over the $31.12 billion reported last year in the first quarter. For U.S. comp sales during the fiscal first quarter, reported basis was up 11.0%. Excluding gas inflation and FX, the 11% would be 8.3%. Canada reported 2.4%, and when excluding gas, FX, and revenue recognition, it would be plus 5.5%. Other international reported 4.0%, and ex those items would be plus 5.8%. Overall, total company reported 8.8% and ex gas, FX, and revenue recognition impact was 7.5%. E-commerce for 12 weeks reported an increase of 32.3%, and again ex those items plus 34%. In Q1 sales metrics, shopping frequency increased 4.9% worldwide, with a 5.2% increase in the U.S. Weakening foreign currencies relative to the U.S. dollar negatively impacted sales. Gas price inflation and revenue recognition benefited Q1 comps. Together, these three items contributed approximately 130 basis points, accounting for the difference between the 8.8% reported and 7.5% I mentioned. Cannibalization weighed on the comp by approximately minus 70 basis points. Our average front-end transaction or ticket was up 3.7% during Q1, and excluding impacts from gas, FX, and revenue recognition, the average ticket rose about 2.4%. Next, membership revenue rose by 9.5% or $66 million, totaling $758 million in the first quarter compared to $692 million last year. FX had a negative effect of approximately $6.4 million, so the 9.5% increase would have been about 10.4% if excluding FX. Reported membership revenue was up 9.5%. About half of that increase is related to membership fee increases made in June 2017, which takes about 23 months to fully reflect in the income statement. Our renewal rates increased in Q1, with U.S. and Canada membership ending at 90.5%, up from 90.4% just 12 weeks earlier. The worldwide rate improved to 88%, also up a tenth of a percent from 87.9% at Q4 end. At the end of the first quarter, Gold Star membership reached 41.3 million, compared to 40.7 million 12 weeks earlier; business primary membership was 7.6%, remaining steady; and business add-ons stayed at 3.3%. Overall, we started the fiscal year with 51.6 million members and ended Q1 with 52.2 million. Total cardholders increased from 94.3 million at year-end to 95.4 million at first quarter end. We opened six new warehouses during the quarter. At first quarter end, paid executive memberships totaled 19.7 million, an increase of 442,000 or 37,000 a week since 12 weeks earlier. This is one of the largest weekly increases, influenced by various activities to encourage members to upgrade as new members sign up. The 23-month cycle for recognizing the incremental benefit from the fee increase means the benefit will diminish in the remaining three quarters of this fiscal year. Our reported gross margin in Q1 was lower year-over-year by 50 basis points at 10.75% compared to 11.25% a year earlier. Excluding gas inflation and revenue recognition, the decrease would have been 26 basis points. If you jot down two columns of numbers for core merchandise and ancillary businesses, on a reported basis, the core merchandise year-over-year in Q1 saw a decrease of 43 basis points. Excluding gas inflation and revenue recognition, that decrease would be 22 basis points. Ancillary businesses reported an increase of 5%, while excluding those items, it would be an increase of 11%. Key categories within core gross margin showed that food and sundries and hard lines were up, while soft lines and fresh foods were down. The net effect was a decrease of 6 basis points. The pre-tax charge of $43 million related to the Citi/Visa co-branded credit card affected revenue and sales, impacting gross margin percentage. Over recent months, we decided to increase reminders for members to redeem outstanding rewards, which saw a rise in redemption rates. The $43 million adjustment relates to increased redemptions and adjustments in breakage estimates for rewards from calendar year 2018. Moving to SG&A, our Q1 percentage improved by 23 basis points on a reported basis and remained flat without gas inflation and revenue recognition. Q1 came in at 10.13% compared to 10.36% last year. If you jot down numbers for operations, core operations reported improvements by 23 basis points and 4 basis points when excluding certain items. Central expenses improved year-over-year by 4 on a reported basis and 2 on an ex-items basis. Stock compensation, often impactful in Q1 due to annual grants for employees, led to a reduction of 4 and 6 in those categories. Pre-opening expenses were $5 million higher in this year's first quarter, totaling $22 million due to one additional opening and other operational expansions. Reported operating income for Q1 was $949 million compared to $951 million in Q1 last year. The previously mentioned charge related to the Citi rewards program and the hourly wage increases influenced the year-over-year comparison. Below the operating income line, reported interest expense decreased by $1 million year-over-year, totaling $36 million. Interest income was flat year-over-year but rose by $8 million due to higher interest rates and a greater invested cash balance, offset by negative FX items of about $9 million. Total pretax income was $935 million compared to $936 million a year ago. Our reported tax rate for the first quarter was 15.9%, down from 30.4% last year. This quarter benefited from the lower federal tax rate following recent changes and favorable discrete adjustments. Notably, the $59 million tax benefit related to stock-based compensation and a $27 million benefit from the 2017 Tax Act were significant contributors. For fiscal 2019, we anticipate that our effective total company tax rate to be in the range of 26.5% to 27%, slightly lower than our previous estimates. A few additional notes on warehouse expansion include the opening of eight locations this fiscal year, including two relocations, resulting in a net of six in Q1. We expect to open about 23 net new warehouses and four relocations for the entire year. Furthermore, we are under construction for our first Costco in Shanghai, with an expected opening later in 2019. As of the end of Q1, total warehouse square footage was 111 million. Regarding stock buybacks, in Q1, we repurchased $34.5 million worth of stock, equating to 150,000 shares. E-commerce sales continued to grow at healthy levels. For the quarter, e-commerce reported an increase of 32.3%. Excluding FX and revenue recognition, the increase was 26%. Last week, we shared strong performances for the four-week November period, with records established for orders and sales during the Black Friday through Cyber Monday weekend. Top growth categories during the quarter included grocery, consumer electronics, and various other segments. Our website enhancements, especially in home categories, improved the shopping experience significantly. We now offer same-day grocery delivery to members within a 20-minute drive of 99% of U.S. locations, and two-day grocery delivery is available nationwide. We also introduced several interesting new merchandise items this quarter, including high-end offerings like fresh white truffles and luxury cosmetics. Recently, we launched a line of Apple products online, and similar offers will soon be available in stores. Our online and inline cross-marketing initiatives have been improved as well, enhancing both online and in-warehouse sales. Lastly, regarding tariffs, there is not a lot of new information. The planned increase on many items from 10% to 25% has been postponed. We have effectively managed costs in the face of potential tariff changes by bringing in additional seasonal merchandise early, and we will continue to update you. Upcoming press releases will announce our December sales results for the five weeks ending January 6th on January 9th after market close. With that, I’ll open the floor for questions.

Within your core-on-core gross margin, it's been spending a little bit lower over the last couple of quarters. What's been driving that? Are you starting to feel the impact of your pretty rapid e-commerce sales and the margin dilution from that on your core-on-core gross margin? Then I have a follow-up.

There are two people in the room, one senior merchant represents us. There hasn't been much change. Looking back at the fourth quarter, I believe it was down two year-over-year. In one of the two previous quarters, it was in the 4 to 6 range on a year-over-year quarterly basis. We don't see it as more than the efforts we're making to drive our business. We're quite excited about driving sales, whether through Buyers’ Picks, Hot Buys, or promotional seasonal items, which reflects the strength of our business. The only thing I've mentioned in the last quarter or two is that on the fresh side, we have experienced some margin pressure due to increased retail competition, not just from supermarkets but also from Sam's. But that is part of the business.

And my follow-up question is on the expense side, recognizing that you've been investing in wages and investing some of the tax benefit that you got. But you have put up some of the best comps we've seen in a long time and expense leverage has been modest. So when can we start to see that improve?

Keep in mind that within these figures, there are about 8 basis points related to the extra rate increase we implemented in June after the tax changes. On the IT side, we have a lot happening. I believe it will fluctuate a bit, but it's essentially flat year-over-year, and we are beginning to observe that. It's all sales driven with many different factors involved. We haven't detailed all the activities currently underway, such as improvements in our depots, returns processes, and fulfillment efforts, particularly with the success of last year's rapid rollout of two-day service to our business centers, as well as the strong performance of e-commerce, including smaller ticket items. We are ensuring timely delivery, even if it incurs additional costs. There are numerous aspects to discuss, but overall, we have many positive initiatives in progress. If we can maintain sales momentum, you will notice the impact.

But should we interpret that answer as, even if you continue this rate of sales growth, expense leverage should continue to be modest?

Well, we'll see. We never want to predict where it's going to go. We are clearly a top-line company. We aren’t going to make changes to wages or healthcare costs. Over time, people have always asked us how we control healthcare costs. My somewhat casual but honest answer is to expand more overseas. Healthcare costs as a percentage of sales in the U.S. are 20 to 60 basis points higher than in all other countries. Our international pipeline has expanded, and I think you will see the U.S. versus international sales start to shift towards more international. There are actions we take ourselves based on timing. We have many initiatives in place, particularly with ancillary businesses and enhancing our fulfillment and risk management systems. I may not be being direct enough because we can't specify exactly when changes will occur. We feel confident about building our capacity to accommodate further growth in e-commerce and delivery, and we anticipate that some of those costs will decrease as a percentage of sales. However, we cannot provide a specific timeline for these changes.

Okay. Thank you, Richard. I wish you a good holiday.

Last one, Michael. I mentioned earlier, the stock compensation. Stock compensation is not just to a few people of this company, it's over 5,000 employees. And in many cases from warehouse manager above and buying managers and above and certainly the senior people, it's 60% to 80% of compensation. Because of our annual grants that invest currently over five years are granted in October, which is Q1. The fact that our stock price has increased as well and acceleration related to 25, 30 and 35, that was 6 basis points of it. You're not going to see that thing forever. If you look back in the last couple of years, you'll see that typically in the first quarter and that will ease off in the next three quarters.

Richard, I missed some of the prepared remarks, so I didn't catch what the core-on-core merchant margin was. My question is, if margins came in a bit lighter than expected, could you discuss whether the cost of business is rising? Is it due to reinvestment, or external factors? Also, I understand you prefer not to comment on the reinvestment rate, but has it changed this quarter considering the strong sales and increased revenue?

We're not particularly scientific in our approach; we're merchants at heart. When we notice something is working, we pursue it. Regarding the core-on-core performance, it declined by 6 basis points year-over-year. As I've mentioned over the last few quarters, we've faced slightly more competition in the fresh segment, which we’re managing well. Our fresh sales numbers are strong, but like our competitors, we’re operating with slightly lower margins in that area, and we intend to maintain our position. However, that's just a small factor in the overall changes. There are several other elements at play. Some of this is tied to our fulfillment processes, where we're experiencing marginal dips as we quickly implement new initiatives. Nevertheless, we don't increase our investments based on available funds; we do so because we believe in what we're implementing, regardless of our financial situation.

And then just two quick ones. Can you tell us what the e-com penetration is, either the quarter or just e-com stands? And then the other piece is just cents per gallon or the gas margins, I don't know, but I'm sure you spoke about what they were in and of itself. But has the margins widened out?

Gas margins have increased. It seems that everyone is earning more in the market. As they profit more, we also benefit slightly, especially since we sell a significant amount of gas. In recent quarters, while overall U.S. gallon consumption has been very low, we've experienced high single-digit growth in gallon consumption from customers filling their tanks. That's a positive development. What was the other part of the question regarding e-commerce?

The e-com benefit, yes.

I think it's approximately 4.8%, so somewhere between 4.5% and 5%. It had about a 60 to 80 basis points impact on the comparable figure, including revenue recognition.

Richard, just on the other grosses again. I think you said overall down 50 ex rev rec and gas discount 26. Can you quantify what the actual rev rec impact was for 2Q, and how we should think about over the upcoming quarters?

I can’t provide the exact figures, but overall revenue was down about half. However, I can give you a hypothetical example. In the past, what we referred to as a curated travel package involved us committing to different components of that package, such as hotels or cruises. This typically generated a brokerage fee, which I’m completely fabricating for illustration—let’s say it was a $500 brokerage commission. If there were no sales, you would still have that $500 in brokerage commission and essentially no cost of sales, resulting in a very high margin percentage. If we consider that alongside a hypothetical $5,000 or $5,500 cruise package, then you would have $5,500 in sales with $5,000 in cost of sales. While this is a small portion of our business, it accounted for $700 million in revenue recognition for the year. Therefore, there are many moving parts to consider.

We thought it maybe could be about 10 to 12 basis points, I don’t know…

Yes, qualitatively, I’m hearing a little less than half of it, so 10-some, like it's a little less than half of 22.

And then just again here just on the model and there is 2017 tax impact that you had. Was that just a one-time item in the first quarter, or is that going to repeat? It doesn’t sound right, doesn’t sound it will based on your 26% to 27% tax rate for the year, but just wanted to…

It was one-time. It relates to the tax act, but some of it relates to things that it started for us in fiscal 2019. And by the way, there are still some moving parts to the tax act. I mean, it's hundreds of pages. Some of things don’t work completely outlined. There may be a little pluses and minuses. This was a little bit bigger than a little plus, which was good.

I'm curious if, after a year of experience with cost of grocery and Instacart, you think you might be losing some in-store traffic as customers substitute their shopping trips with online purchases through either CG or Instacart, especially considering how strong November was.

I believe the overall impact is positive, although it's difficult to determine how significant it is given the strong in-store traffic. We haven't conducted extensive surveys to assess whether this change is truly incremental. However, it seems we are experiencing less of an impact than we initially anticipated, which was already minimal regarding any potential reduction in in-store frequency. While it cannot directly increase store traffic, it has allowed us to enter new or broader markets. I've heard from many friends who express their appreciation for the convenience this service provides for their additional grocery shopping. Additionally, those living further away seem to be utilizing it more, but these observations are purely anecdotal and not based on scientific evidence.

And then just a follow up on Simon's question about the e-commerce margins, might have saying historically it's been a margin accretive category for you where it garners the higher margin than the store margins. I just want to make sure that that still in fact correct?

No, that's never been a higher margin. It’s been a little lower margin. You've got competitive categories like a lot of things which nominates the penetration and then there is cost of shipping. And so it's a little lower margin. It's a little lower margin and a lot lower SG&A, so it's a higher P&L if you will in terms of the earnings, recognizing that not every expense is allocated back to it.

Did you see any hardest pressure from the port congestion, either having to pay to prioritize fly product in? And are you seeing any of that today as we go into '19?

Nothing more than usual this time of year idea, again anecdotally, I know that when we had very strong produce sales on the few items like watermelons around Labor Day. When you have to get an extra container somewhere fast not shipping across, I'm just talking about truck containers or the side trailers, something you paid $1500 for might cost $3500 for that last truck. But again, these were anecdotal stories I heard. My understanding is there was a little backup in China and Shanghai, but not a heck of a lot there. And plenty of part of that is every extra container goes out there merchants like Costco were filling them to bring in things in anticipation of certain tariffs going to 25% on January 1st.

In terms of the supply chain, thinking back to calendar 2019, is the chicken plant the only significant issue? That plant is still expected to open in 2019. Will we actually see any financial impact from that in the profit and loss statement? Also, are there any other significant issues that could specifically affect the supply chain in 2019?

The plan is to begin processing by early summer, though not at full capacity. It will take around six to eight months to reach full capacity, which means we’ll likely be operating smoothly by mid fiscal '20. We have other projects that are less significant and not as variable. Last year, we launched a bakery commissary in Canada, which isn’t yet at full capacity. We’re adding more items for sale and expanding our offerings there. Similarly, we’ve had a meat plant in Tracy, California, for over 20 years and recently opened a second meat plant in Morris, Illinois to serve the Midwest and East Coast, which also isn't operating at full capacity yet. These facilities have been in operation for over a year or so, contributing to the variability in our supply chain. Regarding SG&A challenges mentioned earlier, there are several smaller factors to consider, including the ramp-up for e-commerce fulfillment and other two-day delivery services. The major project influencing our operations will be the chicken plant, which will involve additional pre-opening activities and possibly some more depreciation.

And then just lastly, are you seeing any early signs of pickup in fresh inflation meat produce? It might be percolating a little bit. But have you seen that yet?

We haven't. One of the merchants here is shaking their head.

Thanks. Good evening. So, first of all, on rev rec. So as we think about that gross margin pressure that you experienced in this quarter, is that something you expect for the rest of the year, essentially, there's no recapture or pressure all year because of the change in accounting? And then also on the top-line front, I know you mentioned that there was a benefit to this month on the top-line in November, but that has pressure in December and January. So over the year, is the rev rec impact to the top-line neutral?

That latter question is related to income. Now rev rec will be for the year, I think in our September sales release, we talked about the fact that throughout '19 we estimate that this new standard will benefit sales by about 1%. So 1 point something billion dollars. Some other things have more margin percentage in fact. But at the end of the day, it has no impact on the bottom line.

So you experienced a significant advantage in November during this quarter due to e-commerce, correct? Is that reflected in revenue recognition? It seems like this advantage will balance out over the rest of the year, or could it go the opposite way?

Relatively speaking, there's a bigger benefit at the end of Q1 and into December because of the holidays and the strength in e-commerce.

Okay. And then the gross margin, I know it's up and down to the SG&A line, but the gross margin impact persists over here?

Yes, typically will be an 8 to 10 basis point headwind.

Understood. And then, in terms of the e-commerce strength in the month of November, you got a lot of stuff on the website, you're advertising it more. Were you more I guess aggressive with advertising or promotions because it was Black Friday or is this just a new normalized rate of like, “Hey this is what we're offering” and sort of there's some sustainability to that growth that you saw in the month of November?

We had the same amount of advertisements and marketing materials, and we are sending out more emails. Over the years, we've improved our email collection efforts. There are better values now compared to a year ago, both online and in-store, with initiatives like Hot Buys and Buyers' Picks driving higher traffic and conversion rates. Many of these improvements involve personalizing the website, building on past successes, and offering greater value. I believe we've gained the attention of suppliers, as they recognize how our efforts have positively impacted their businesses, with some products competing effectively against traditional brick-and-mortar retailers.

Yes, I purchased a snow blower, and it was about 30% cheaper than what I found at a big-box store. So in November, that was my Black Friday gift. My last question is, what percentage of e-commerce are you currently shipping versus direct from the vendor? Where do you think this trend is heading over time? What kind of cost savings do you anticipate generating in the long run?

We are shipping about 50% ourselves and that tends to be the smaller size items and small pack sizes what have you, all the big stuff and all the white cliff stuff like white goods, big electronics, furniture, Italian furniture, those typically are done by third parties.

Is that percentage getting up over time or just because the mix of small items goes up that's what drives it up?

We'll have to see. Whatever we do, we will choose the most economical option. I believe there are some tasks currently handled by third parties that we will bring in-house as we become more skilled and confident in managing them. For instance, consider our arrangement with UPS for two-day drive service; while it's not e-commerce, it serves a purpose. We are looking into what other solutions we can implement within that size category. We are collaborating with vendors, as others likely are, to identify ways to acquire certain products and reduce freight costs. Given our volumes and the predictability of specific items, we aim to improve efficiency in delivering to our customers.

Hi. A couple of questions. Just on tariffs. Can you maybe just elaborate a little on what your pricing philosophy will be with respect to tariffs? Meaning will you address price I guess increases if you need to on a SKU-by-SKU basis or are you looking at the whole box more broadly and trying to figure out how you can offset with a lower price increase across the box?

It's done on a SKU-by-SKU basis, which is much simpler when you're consistently selling 3,800 SKUs right from the start. This approach ties into our pricing strategy. For instance, I spoke with a merchant yesterday who shared examples of $40 or $50 items that have seen price increases of 15% to 20%. They noticed no change in unit volumes. If the increase is around 10%, we've successfully collaborated with the supplier to minimize the impact or find alternative suppliers. There are products where a 10% price increase hasn't required a change in price. Sometimes this may slightly affect our margins, but other times it doesn't impact them at all. For larger ticket items, an increase from $500 to $625 at 25% may affect unit volumes. In anticipation of such increases, we may reduce order quantities on certain items. It varies widely, but overall, we aim to manage price increases strategically without offsetting them with other adjustments.

Okay. Can you provide more details regarding your comment on fresh becoming more competitive with both conventional and Sam's? What exactly are you observing? Additionally, is there a chance that Sam's will continue to become more aggressive in other categories, potentially spreading the pressure? Are you noticing any signs of that, or is it just confined to fresh?

We respect our competitors and have been in this business for 35 years. We are committed to staying in the game and believe we are in a solid position. In the fresh category, particularly with produce and protein, we are adaptable to whatever challenges arise. It's true that fresh is slightly down year-over-year right now, though there have been times when it was up. We still feel that closing 63 Sam's units has created more opportunities for us, and we always focus on competition.

Okay. And for my last question, could you elaborate on the pick-up lockers in 10 locations? How large are they, are you planning to expand or broaden this service? Additionally, what kind of SKUs can currently fit in these lockers?

I don’t think they could accommodate a 60-inch television as an example. They appear relatively small, and we have them in 10 locations. We initially selected items that we believed customers would want. Personally, I would have purchased those items from Costco, but I can't have them shipped to my office and prefer not to leave packages on my doorstep. We believe we’ve gained some additional interest in this area. What we’re discovering is that many customers have adapted their purchasing habits; they’ve bought items this way. We have increased availability of products because we offer a wider selection. When you order online for store pickup, you're mostly limited to jewelry, some small electronics, and handbags. All our locations currently provide this service, and we are showing customers that there are more options available. However, we view this as a test and will evaluate it further. We do not plan to implement full online ordering for store pickup for groceries anytime soon for a couple of reasons: first, we lack the space for that upfront, and second, we’ve noticed that not all customers who order online actually show up to pick up their orders. Additionally, managing dry goods alongside refrigerated and frozen items is very expensive, and we currently have an alternative through the Instacart platform.

Rick, you mentioned the gas business and margins rising everywhere, we’re seeing that at other companies. Just thoughts on the reason for that and the sustainability of that?

I think the reason is that traditional retailers, like us, are focused on profitability. What we've observed is that as prices decrease, our competitive pricing has become more significant. We regularly conduct our own price studies, and based on our findings, we are saving customers more per gallon compared to nearby competitor stations, whether they are independents, supermarkets, or national chains. Currently, we are achieving the highest savings per gallon and generating more revenue than ever, partly because others in the market are also seeing increased profits. However, I'm uncertain how long this trend will continue, as there doesn’t appear to be much indication of rising gas prices. As I’ve mentioned before, our strategy is to make small profits consistently. In terms of gas, we have enjoyed strong year-over-year growth with high single-digit gallon comparisons in the U.S., while the overall population growth is just above flat to low single digits. This indicates that we are successfully capturing market share and benefiting from it while increasing our earnings, though not drastically.

I just want to take a step back and ask you a question about EBIT growth. If you look at EBIT growth this quarter and adjust for one-time items like the charge on the breakage, adjusted wage investment, remove the MFI benefit. If you do all that it looks like EBIT grew somewhere in sort of like the 3.5% to 4% range. That was about the same as it was last quarter, but yet your comp is 7% to 8%, fuel is contributing. I'm just kind of curious as we take a step back here, help us understand how we read that I guess, why that number is not better and then how do we think about going forward because you might not be comping 7% to 8% forever. Does the kind of flow through improve from here?

First of all, regarding the 3% to 4%, when you account for those two items, the impact on pre-tax is about 6% to 7%. And those two items refer to the Citi/Visa breakage and our payroll increase, which were both influenced by the income tax changes. We anticipated that some of that income tax would affect pre-tax results. As for your earlier questions, there are many factors at play here. We're less concerned about whether gross margin is 5 or 10 basis points off. It could have been better, but we focus on driving our business forward and remain committed to profitability. Our long-term perspective is about building a stronger and more loyal company. So, we are optimistic about our future, although I can't provide specific guidance on where it might lead.

Thank you.

In the first full year after the tax reform, we estimate a little over 300 million in tax benefit from our pre-tax earnings, and over 400 million in pre-tax overall. We allocated around 120 million towards wages. We consider this investment as part of our members and are committed to growing our business. We are actively reminding our members with Citi Visa cards to use them, which positively impacts our long-term revenue share as more members use these cards more frequently. All these efforts are contributing to our growth. This is especially evident in our first year of offering two-day delivery and significantly enhancing small package deliveries. We are investing in fulfillment, and we’re delivering packages to our members with two-day delivery at costs that are still higher than they will be in the future.

Good afternoon, thanks for taking my questions, so first on the tax rate housekeeping question. The tax rate that you gave, the guidance, does that exclude the benefits that you saw in Q1?

Yes, it excludes those usual things.

Okay, great. Regarding capital allocation, it seems you are not repurchasing many shares. I’m interested in the special dividend and how you plan to approach capital allocation in the future.

We regularly buy back stocks based on certain metrics, adjusting our purchases as the stock price fluctuates. If the stock goes up, we tend to buy a bit less, and if it goes down, we buy a bit more. Although the total for the quarter was small, it increased towards the end and the beginning of the quarter. We'll see what the next quarter brings. Regarding special dividends, we have not made a decision on a fourth dividend. We've been asked repeatedly about it since the three we issued in the past were spaced about 2.5 to 2.25 years apart. As for what will happen in 2.25 years from May 2017, we are uncertain and suggest staying tuned. Our previous special dividends have been successful, and we continue to generate significant cash, exceeding our capital expenditures and the annual dividend of roughly $1 billion, which has historically been about 13% per year. While it's certainly a possibility, we can't guarantee if, when, or how much we might do it.

Okay, great. Thank you.

Richard, as you guys change your accrual for the rewards breakage, is that something that will be a notable item on a go-forward basis or is it relatively minor and kind of just lost in the rush?

It was relatively minor, just to note that you're looking at an in-reward that’s slightly above $2 billion. We began implementing these larger reminders a few months ago, and this has really influenced the redemptions, particularly for those linked to calendar purchases from 2007 on that card. Additionally, we saw a net loyalty accrual for all purchases in 2018, which was significantly lower compared to the accrual from the previous year. This is part of our ongoing operations, and I believe the impact to the quarter compared to our previous results was about a penny per share.

Okay. Got it.

It was about $49 million-ish, almost $50 million. $43 million was one-time prior to Q1.

I would like to clarify an earlier question about the profitability of e-commerce. I was under the impression that e-commerce generated a higher operating profit, but your phrasing suggests it has a lower gross margin, yet it may positively contribute to EBIT.

It has a higher operating margin, even though the gross margin is somewhat lower and SG&A expenses are significantly lower. We prefer to emphasize the substantial reduction in SG&A because there are certain expenses we don’t fully allocate to it. For example, when items are purchased online and returned to the warehouse, the warehouse incurs charges for that. Therefore, we try to allocate these costs, although not completely, to IT expenses and other similar categories. Ultimately, we see it as more profitable than the overall bottom line of our company.

Got it. Okay. Thank you.

Okay. One last question.

Hey, guys. Thanks for taking my question. So I just wanted to make sure I understood the answer to the last question of the $43 million. It sounded like $6 million to $7 million of it is actually not one-time it's going to be kind of an ongoing. Did I get that right or I misunderstood?

The $43 million pertains to activities before the start of fiscal 2018. It is one-time in the sense that it relates to anticipated redemptions that were higher than what was previously reserved for purchases made from January 1 to December 31 of 2017, both within and outside of Costco using the Citi/Visa card. Since February 2018, once sent out, these have been redeemed. In recent months, we have increased the frequency of reminders to our members to redeem their rewards, resulting in increased redemption rates. Based on our earlier estimates of what would be redeemed without expiring as of December 31 of this year, we account for an annual net amount, which is slightly over a third of that $42 million. The remaining portion is from purchases made later this year, where card members will get a rewards certificate in February 2019. Each time a reward is reserved, we set aside a portion to account for anticipated breakage or slippage. With our reminders, this accrual is slightly less. This also includes all purchases made from January 1, 2018, through the end of August or September 2—whenever the fiscal year ended. We have increased our accrual for that. In Q1, based on our lower breakage assumptions and thus higher breakage accrual, that amounted to just under $7 million pre-tax. This component will continue going forward.

Okay. So I think I got that.

It was about $49 million-ish, almost $50 million. $43 million was one-time prior to Q1.

Perfect. My second question is more strategic. Many companies are experiencing this, as we've discussed, as we move further into omni-channel sales, profitability seems to drop a bit. How do you view Costco in this context? It appears Costco doesn't seem to have this issue, but perhaps we are noticing some effects as we transition to an omni-channel approach, which may slightly reduce profitability. What are your thoughts on this, and how should we consider it moving forward?

I believe we've been fortunate not to be impacted in the same way as traditional department stores that offer home delivery but see a significant return rate. For them, free returns are essential to their business model, but it may not be profitable when compared to previous methods. In supermarkets, the potential for delivery may not significantly grow market share, although any negatives could be balanced out by increased sales. We’ve been proactive with our e-commerce strategy and two-day delivery, investing around a billion dollars in delivery capabilities in partnership with UPS, which has proven effective. While we aim to expand our delivery services across the continental United States, some remote areas do incur higher delivery costs. We’ve also seen growth in categories like white goods. A few years ago, our sales in this segment were minimal, but now they've surged significantly, largely due to customer demand for delivery and white-glove service. We’ve taken advantage of the downturn in brick-and-mortar apparel sales to acquire inventory, with most of our apparel still sold in-store and a small but growing online presence. In furniture, we have a seasonal in-store display, but we've expanded our online offerings, catering to year-round buyers in certain locations. Overall, we view our item-centric business model as beneficial in navigating these changes, despite initial higher costs in areas like building fulfillment centers. The growth in online sales should ultimately help mitigate these expenses.