Costco Wholesale Corp (COST) — Q3 2019 Earnings Call Transcript

Thank you, Jerome, and good afternoon to everyone. I want to begin by noting that today's discussions will contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties that could lead to actual results differing significantly from those projected. The risks and uncertainties encompass those mentioned in today's call as well as other risks noted in the company's public statements and reports filed with the SEC. Forward-looking statements are valid only as of their date, and the company does not commit to updating them except as legally required. In today's press release, we disclosed our operating results for the third quarter of fiscal 2019, which ended on May 12th. Our net income for this quarter was $906 million or $2.05 per share, compared to $750 million or $1.70 per share from the previous year. As indicated in the press release, this year's third quarter benefited from a one-time tax item of $73 million or $0.16 per share. Excluding this item, our earnings for the fiscal third quarter increased by 11% year-over-year. Our net sales for the quarter reached $33.96 billion, marking a 7.4% growth from last year's $31.62 billion. For comparable sales during the third quarter, the reported figures show U.S. sales at 7.0%. When excluding gas inflation, foreign exchange, and revenue recognition, the growth was 5.5%. Canada’s sales were reported at 1.3% and 5.1% when adjusted for those same factors. Other International saw 1.7%, which adjusted for the same items resulted in 6.9%. Therefore, we reported a total company comparable sales figure of 5.5% for the 12 weeks, and excluding those three items provided a figure of 5.6%. Our e-commerce sales for the quarter stood at 22% on a reported basis and 19.5% excluding those factors. Regarding traffic for Q3, our shopping frequency increased by 3.7% globally and by 3.4% in the U.S. The impact of gas, foreign exchange, and revenue recognition weakened foreign currencies against the U.S. dollar and negatively impacted sales by about 130 basis points. Gasoline price inflation had a minor positive impact of about 10 basis points, while revenue recognition improved comparable sales by around 110 basis points, resulting in a net effect of roughly minus 10 basis points. Our average front-end transaction or ticket increased by 1.8% in the third quarter. Excluding gas, foreign exchange, and revenue recognition adjustments, the average ticket rose approximately 1.9%. In terms of membership fees, third quarter income was reported at $776 million, or 2.29% of sales, up by $39 million or 5.3% from last year's $737 million. The increase was partly offset by foreign exchange, which impacted that increase by just under $10 million. We also reported a consistent renewal rate of 90.7% for U.S. and Canada memberships and 88.3% worldwide. By the end of Q3, we had 53.1 million member households, an increase from 52.7 million 12 weeks earlier, while total cardholders rose to 97.2 million, up from 96.3 million. During the quarter, we opened three new warehouses, one each in the United States, Korea, and Australia. By Q3's end, the number of paid Executive members grew to 20.4 million, an increase of 406,000 during the quarter. In terms of gross margin, we reported a decline of six basis points year-over-year, now at 10.99%, down from last year's 11.05%. When accounting for gas inflation and revenue recognition, the adjusted figure showed a slight increase. Moving to SG&A, our percentage improved by six basis points to 9.92% of sales compared to 9.98% from last year. However, excluding gas and revenue recognition, it increased slightly by five basis points. Regarding preopening expenses, we reported $14 million this quarter, an increase from $6 million last year due to additional openings. Our reported operating income for Q3 increased by 5%, totaling $1,122 million compared to $1,067 million last year. Interest expenses decreased by $2 million year-over-year, totaling $35 million, while interest income was lower by $5 million due to various foreign exchange impacts. Nonetheless, pre-tax income rose by 5%, amounting to $1,123 million this year. Our tax rate for Q3 stood at 18.5%, down from 28.8% last year, benefiting from a nonrecurring item of $73 million. Without this item, our effective tax rate would have been 24.9%. We project the effective total company tax rate for fiscal Q4 to range between 26.5% and 27%. Regarding expansion, we have opened a total of 13 units through Q3, and we plan to open 13 locations in Q4, which includes relocations. Consequently, our total innovation in warehouse square footage is currently at 112 million square feet. In terms of e-commerce, our sales increased significantly. The top growing categories included electronics, health and beauty, and furniture. We also rolled out new brands online, such as high-end televisions and new Apple products. We are enhancing our online and in-store marketing efforts and have plans to introduce features like pickup lockers at an additional 100 locations before the holiday season. As we continue to invest in customer service and convenience, we are also adapting our strategy around tariffs and supplier relationships. Lastly, our Q4 expansion efforts remain on track, and we anticipate positive growth outcomes moving forward. Following this overview, I will now open the floor to questions and hand it back to Jerome. Thank you.

Good evening. Thanks a lot for taking my question. Richard, how are you going to comp the $400,000 diamond ring? It's going to be tough next year.

Well, do you have an anniversary coming up.

Even if I did, I can't afford it. My question relates to the comp. The traffic’s been moderating a bit, should we think about this as just more reversion to the mean? Or do you think that there's something else going on?

Every time we see a slight moderation in traffic, it reminds me of a few years ago when we thought this might be the new normal. At that time, we didn’t really know what was happening. However, we know that we have many exciting initiatives in buying. The various revenue streams we've discussed over the past few years—like increased membership fees, the switch to credit cards, and tax reform—remain in play and actually tend to grow each year. We believe we are in a strong position to continue driving this growth. Regarding future developments, we’ll have to wait and see. Our value proposition appears to be as robust, if not stronger, than ever. We also face some challenges, including recent weather issues and tariffs. While these tariffs invoke ongoing questions, we noted that with previous tariffs, which were mostly in the 10% range rather than 25%, we actually gained some market share. While the future is uncertain, we believe we are well-positioned from a buying power perspective and are capable of driving sales effectively while providing good value.

My follow-up question is your core-on-core gross margin expanded rate that accelerated quite a bit from the last couple of quarters. Is that because of what you are doing proactively? Or is it just that the market becoming a little less competitive and as a result you're able to earn a little bit more in your sales?

I think it's a combination of factors. We've got strong internal controls in place, and we're effectively managing spoilage, inventory, and negotiations with vendors. This process is much easier due to our significant buying power, as we manage over 4,000 different items with a total value of $150 billion. Additionally, we have access to other resources that enhance our overall performance. Our vendors are experiencing a substantial increase in unit sales, which has ultimately worked to our advantage.

Okay. Thank you very much.

Yeah, hi Richard. I wanted to ask you about margins. Just the performance on the core margin and then the core-on-core, which obviously was even better. Any additional color on the puts and takes there? And then how we should maybe be thinking about that for the remainder of the year particularly as tariffs starts to accelerate?

We have been asked about when prices and costs will increase, and our goal is to be the last to raise prices and the first to lower them when costs decrease. We're willing to invest some of those funds to drive our business forward. Several factors worked in our favor this quarter, and just when you think you've got us figured out, we’ll surprise you again. However, we do not provide specific guidance on future movements. Currently, we feel confident about our competitive standing both in-store and online, as well as the value we offer. In fact, some market weaknesses, whether related to tariffs or other issues, may actually give us an advantage by allowing us to purchase large quantities at favorable prices. Though these comments are anecdotal, overall, we are optimistic about our competitive position and our upcoming merchandise offerings and pricing.

And just maybe a follow-up on the tariff side. As we think about this three and we think about 25% your philosophy I guess generally you've always been a bit more of a customer-first organization. Is there a margin risk associated with that? And then as we think about any potential for list four, how strategically would you think about that?

There is always some level of risk involved. Eventually, we won't be able to absorb all the tariffs. We collaborate with our vendors and have made some limited switches to other countries when possible, although we are not the only ones trying to do this. Ultimately, prices will increase. It's challenging to predict the exact impact. We've observed that patio furniture sales have remained strong despite certain tariff increases, partly due to a slowdown from bad weather in January and February, which affected our early seasonal sales. Each situation is complex and difficult to assess. We are particularly mindful of key price points. For example, moving from $9.99 to a new price of $10.49 is not ideal, but if we face a 25% increase on $9.99, we must reconsider prices above that threshold. We believe we have taken all necessary actions and will see how things develop. A significant factor is how long this situation will persist. If tariffs extend to list four, it would significantly alter the landscape, affecting a wide range of products including electronics, apparel, phones, and televisions. On the patio side, we were a bit surprised but cautiously optimistic, considering there was some accumulation of sales due to the weather conditions. However, if we start facing 25% tariffs on list four, we have yet to see that impact and hope that the dynamics of international relations improve.

Hi, this is Josh Kamboj joined for Simeon. Thank you for taking our question. The expense leverage that you saw in the quarter was encouraging especially against the wage headwinds that you're facing. Can you maybe go into a little bit more detail about what's driving those specifically? And then ignoring the benefit from lapping that wage increase next year, can you continue to drive expense leverage in the same areas for the foreseeable future to offset tariffs?

Look the biggest – depending on the level of tariffs, if it's lot, no. But as we've always said, we're – the biggest thing is driving sales. If we can drive sales, we're not very good at leveraging expenses of sales or weakening relative to others perhaps because there are things we're not going to do. We're not going to postpone a wage increase and things like that. And we work on expenses every day and every week and every month at our budget meetings literally, and I think we – again, there will be a little reduced headwind in each of the next few quarters with the big increase as we saw in hourly wages both in June of 2017 and now in March – sorry in June of 2018 and now in March of 2019 as those – that 10 to 12 negative goes to six or seven goes to four or five or whatever I said earlier. Beyond that, there's also – I mean, there is basis points here and there that go both ways. A lot of the things we're doing like this – the new fulfillment centers, the automation, none of this stuff goes completely smoothly. And we don't point out each one of these things, but I'm sure there's some extra hits of half basis points here and half points there and there are other things that improve. At the end of the day sales is paramount. The other thing is that as – I think not over this next year, but over the next several years to the extent that we have a higher increase of openings outside the United States that tends to help the overall percentages on things like healthcare. Healthcare is 30 to 70 basis points higher in every other country than in the U.S. things like that.

Okay. Thank you. And just as a quick follow-up following up on some of the other questions a little bit more directly. Do you think over the next few quarters your merch margin can continue to expand if it's the core-on-core one as tariffs have a greater impact on your business?

Well, first of all, we don't guide. That's why – I should say stop. But look tariffs to the extent that we want to be the last to raise prices, it doesn't mean we're going to wait and not do it at all. We've had to be pragmatic about it, but net-net those that would be a drag a little bit of a drag. Now hopefully, it's a grab from a plus – a drag from a plus 20 not a minus 5.

Good afternoon, guys. Scot Ciccarelli. I was curious, if you guys have considered providing a click-and-collect kind of process for your grocery offering given the success that Walmart had with their grocery pickup?

Not at this time. The click and collect initiative we are currently implementing is primarily aimed at small, high-ticket items such as electronics, jewelry, and handbags. We are continuously evaluating this approach and considering the significant financial investments made by others in this area. Over time, much like other operations at Costco, we will develop a method that suits our needs while still being effective. Our partnerships with services like Instacart and smaller scale shipping options in the Southeast, along with Google, are strategies that allow us to operate in this space without making a large commitment. If a customer wants something within an hour, they probably won't be turning to us. However, our customers still prefer to visit the warehouse. Thus far, our efforts this year, including one-day grocery services through third parties and two-day grocery options, have provided a slight benefit. While there is some impact on warehouse business, we are still experiencing an overall increase in sales. These insights are based on limited data collected over a brief period, so we will need to monitor them further. Nevertheless, we are confident that we will continue to find a way to operate that aligns with our strategy and hopefully achieve positive results.

Got it. So, really nothing in the near future. Okay. Thanks guys.

Hi, good afternoon. Thanks. Richard, just in light of the trade war, rhetoric and market volatility and some of the concerns, I’m just wondering if you've seen any change in the consumer behavior particularly in some of your more important market such as California. PVH was out saying some things last night. Curious if you're seeing anything on your consumer?

No. We really haven't.

No? Okay, great. And just thinking on Ed’s question about operating margins, they are much stronger than a decade ago. And frankly, not many in retail can say that. I’m just curious when you look ahead, you think bigger picture about some of the puts and takes what do you think about operating margin dollar growth in the future?

I guess, more, more. The slides that have been shown at our international managers meeting every year for that three or four-day event from the beginning of time and through Craig Jelinek's tenure over the last eight years, we're a top-line company. And as long as we can keep driving sales all those other things fall into place. The fact that we have been successful longer than I thought and continuing to get more people to convert to Executive Membership, the benefit that we have with great value on a credit card, all those things drive loyalty and will drive sales and everything else will take care of itself. And we feel pretty comfortable right now with the recognizing the value is not just price, the price is still the biggest piece of value on what we do.

Hi, good evening. Can I just ask in terms of competition on the consumable side, are you seeing anything notable in terms of change on pricing, whether it be greater aggression or maybe a greater willingness to pass on overall cost inflation? And I guess I am definitely curious about categories like eggs and pork where we've seen some significant deviations on pricing?

Pork has generally been steady. Regarding your overall question, the answer is not really. If I use gasoline as an example, most gasoline retailers have been willing to raise their margins, which has given us a larger value gap and allowed us to earn a bit more. We're fortunate that many price wars among traditional retailers have affected them more than us. We've been paying attention to supermarket ads for a long time and continue to do so. We have improved our offerings in private label, organic, and specialty items. For example, we're now selling premium cheeses rather than just basic ones. Across all our products, we've enhanced quality, whether it's organic, antibiotic-free, or other options. These improvements allow us to show significant savings while still maintaining a reasonable margin.

Okay. And you brought up fuel. I guess I'm curious that the comments on being able to capture maybe a little bit more margin all while expanding the gap relative to competition. Is that broad-based across the country? Or is it more so confined to areas like state of California? And then can you just speak to growth on gallons in the quarter?

As I understand it, the only geographic region in the U.S. where that's not the case is parts of the Midwest, and it fluctuates there. Everywhere else, it's been quite healthy for us. When looking at some of these third-party websites that compile pricing from millions of people nationwide, we continue to be recognized as the best value available.

And anything on the comps for gallon growth?

They are still at high single digits in gallons this quarter, while U.S. gallon consumption is in the low single digits. We're attracting more customers to the parking lot.

I'm curious about the core growth margin. Is there any advantage to core-on-core possibly from timing related to faster delivery of items that may be experiencing some price increases? It seems like this could be somewhat more structural in nature, although I understand you may not want to fully commit to that. I have another question as well.

Not really because in our mobility we kept of the cost down. Even as costs went up and we had it sooner we held it off. We held off raising price until we were into a higher cost unit or product.

Okay. And then I guess then that would lead us to think that there may be something more structural in terms of what we saw on core-on-core? Or are you reluctant to go down that path?

We aim to be practical here. We're not focusing on the past quarters where core-on-core dropped a few basis points year-over-year, then increased last quarter, and now it's risen again. This wasn't part of a strategic plan. It stems from our buying power. During challenging times, especially in categories like apparel, we can purchase large quantities when other merchants have reduced their orders, allowing us to offer great value that customers appreciate. Private label products also play a role in our overall mix.

Okay. If list four is implemented, what percentage is imported from China in total? Or what will be the increase in direct imports from China? Or do you have no way to calculate that?

There's really not an easy way to calculate it. First of all, list four is somewhat titled everything else, but who knows what everything else is once it goes through that few months' process of exceptions and people appealing the process. And look it's more significant in the sense that there's some categories that are arguably discretionary in nature. Apparel to some extent, electronics certainly, and more people put that off. Again getting back to patio furniture, we didn't see it, although, we believe part of that is related to just the season starting a little later this year.

Hi thanks. Richard can you give us a little more on the e-commerce front? Specifically, is it still more profitable from a margin standpoint than retail globally? And how could that change as you know roll out into Japan and Australia, how should we think about that?

Overall, U.S. stores are more profitable than Canadian stores, which reflects the size of our company. We don't charge back every item, and there are costs associated with the warehouse accepting merchandise. We believe this results in slightly higher profitability, even with lower gross margins. A significant category for us is white goods. Four years ago, we had around $50 million in sales of items like refrigerators and washers in the U.S. Last year, we achieved over $500 million, and we expect to surpass $700 million this year. This category has become essential as customers are not picking up these items elsewhere anymore. Additionally, we see strong seasonality with patio furniture sales peaking from January through April and regular furniture sales primarily after Memorial Day. However, we are also selling patio furniture online year-round, particularly in sunny regions.

Got it. And so is it fair to say that still that e-commerce business is very general merchandise-heavy? And can you update us on what vendor direct is as a percentage of that business or just – and how big it is as a percent of sales?

Well, vendor direct, yeah. When we first started years ago, it was mostly all vendor direct because it was big ticket. It was solely big-ticket items being shipped – drop shipped. That's a lot of smaller percentage today than it's ever been. First of all, in addition over the last few years, where we have gone as to, one, improve the site greatly itself, whether its search, returns, you name it. But we've added categories to create more velocity and more reasons for you some of you to think about the going to costco.com, whether its health and beauty aids or food and sundries and things like that. And so I think you'll see that continue, one of the reasons that we're doing some of these automation fulfillment for small packages. If you will and that's the natural progression of how we do things. And I was reading an article just this morning about – the writer was suggesting a small percentage of our members shop online at Costco. That's in this small relative to others, but it's increased each year and has increasing at a greater level now. And we're getting better at it. But again, we still want to use the Internet to get to the end of the store as well, and we think we've done a pretty good job of both of those.

Great. And just a clarification on the tariffs, it sounds like – if just pick a number let's say 15% a year COGS came from China. List three would be less than half of that and list four theoretically would be bigger if it went on everything it. Is that fair?

Yes, absolutely.

So Richard, let me start with the sequential improvement in core-on-core, I'll beat that horse again. Is that fairly broad based right the 8 to the 21? And then secondly, I don't think you guys don't spend a lot of time thinking about item-by-item elasticity or do you? And a real good sense where – where the – where some of that can be given back productively?

It is broad-based, and we certainly don't focus much on price elasticity. We do consider price elasticity in one direction, meaning that if we lower the price, we sell more. A couple of years ago, when we restructured the MVM, which had worked well for over 15 years but had become a bit stale, we introduced a few higher-value items. We found that in some cases this worked and in others it didn’t. However, we don't really contemplate the scenario of raising the price and selling 2% fewer units.

I'm considering whether lowering the price and investing some of our core benefits could help us gain more market share, or if we're just focusing on our existing strengths.

We do that. And I think we tried the most extreme example of saying can we drive more value out of more volume. And if we can't, we don't stubbornly push on a string in every case.

All right. And then secondly, where do you think we stand gross and net openings for next year right? So I know you probably have wanted to get up both of those right. Gross openings probably in the high 20s and maybe a you get a bit higher than it's been. And obviously you open Shanghai, but what's going on with China? Does that give you any pause for additional openings beyond Shanghai? Or no you're still looking for real estate?

Currently, we have two locations planned, with one set to open this late summer and the other expected to open in about one and a half years after the first. This timeline is similar to what we have achieved in other countries, such as Australia where we opened three locations in the first four years, Japan where we opened five and later six in five years, and Spain where we opened two in four years. Therefore, this approach is consistent with our past experiences. Our team, including Craig, the real estate team, and Jim Murphy, our Head of International, along with local country managers, are actively exploring other sites. However, we acknowledge that China presents its own unique challenges, particularly with current tariff issues, which we hope are not long-term. Each item must be registered individually, but we are fortunate to bring key personnel from our successful operation in Taiwan. Our strategy focuses on hiring internally, starting with a small core group of expatriates and progressively expanding our internal team. Additionally, if this new market proves successful, we are open to establishing a few locations within the first two to three years, aiming for a total of four or five units within five years of opening our first one.

And your thoughts on opening this coming year?

Excuse me?

This coming year, 2019 or August of 2020, early thoughts on gross and net? Where would that go to this year?

Yeah, I think the next year we’ll look about the same amount as this year.

All right. So like mid-20s growth and low 20s net?

Yes.

Hey, guys thanks for taking my question. I got two questions. Richard, you talked about driving top line sales and that's the key – the company everything else takes care of itself. And if you look back over the last I guess five years did a huge expansion, even blew out a number of centers to add to the fresh, so I think that helped a lot. The credit card helped a lot. When you look out over the next year or two or three, what do you see pretty substantial? What do you see as similar type of sales drivers potential?

I believe we are continuing to see growth, particularly in fresh foods, which is evolving and expanding. Specialty items in both food and nonfood, including organic options that are fresh and shelf-stable, are performing well. There are multiple factors contributing to our success rather than one major element. We are also increasing the number of gas stations in countries beyond the U.S. and Canada, and it's proving effective. This year, we expanded e-commerce into two more countries, and these efforts work in synergy. Historically, we've excelled at bringing items from the U.S. to other markets and, to a lesser extent, some items from Canada. We are now testing and successfully introducing high-end specialty unique items from other countries. While this is still in the early stages, we are proficient in scaling these efforts. We remain focused on being the best value merchants. We are enhancing our membership offerings by improving conversion rates to executive memberships and seeing strong credit card sign-ups. As the rewards grow, we expect to build even greater loyalty. The good news is that we are addressing past concerns about moving quickly in areas like e-commerce, and there are numerous opportunities that we are starting to capitalize on. During budget meetings, I listen to our merchants discuss the exciting initiatives we are pursuing. We are now positioned in such a way that we can produce high-volume Kirkland items and goods in other countries at the same quality but with significantly reduced freight costs. While this isn't applicable to everything, there are plenty of similar opportunities we are exploring, and we feel optimistic about our ability to drive business growth.

Perfect. My follow-up question is about the competitive environment. It seems that one of your largest competitors is approaching things differently now. They invested heavily in pricing last year but seem to be less focused on that now. Could this be influencing the core-on-core gross margins? Is the competitive landscape becoming somewhat easier?

It's really evident across the board with traditional retailers as well. One thing I've pointed out in the last few quarters is that the fresh side has become increasingly competitive compared to historical levels. That's just how it is. However, we're not only up against one direct competitor; we’re facing traditional merchandise retailers and supermarkets as well. Overall, we haven't observed any significant change.

So you see the competitive climate is stable, not worsening not getting better?

I think that's fair.

Good afternoon. This is actually Erica Eiler on for Rupesh. Thanks for taking our question. So, I was actually hoping to dive a little bit deeper into your online grocery efforts. Can you maybe talk a little bit more about how the Instacart and dry grocery ramps are going so far and what you're seeing with these offerings? And then any metrics you can provide such as type of basket you're seeing into how you're viewing the incrementality of the purchase, et cetera, would be helpful.

Yes. Currently, our two-day delivery service with UPS extends across the entire Continental United States. Most packages arrive in one day, but we guarantee delivery within two days. We're also witnessing a limited number of sign-ups from members who use this service primarily for online orders due to their distance from physical stores. Over the past few years, Instacart has significantly expanded its geographic reach. Notably, the value proposition for customers purchasing from Instacart or our same-day grocery site, which utilizes the Instacart platform for fresh items, has improved considerably. This enhancement reflects their growth and operational structure. We believe we can provide significant value as an anchor for our customers. Consequently, we have reduced pricing four times over the past two years on goods sold, which are marked up less than what you might find in a physical store. Business is thriving, with high double-digit growth, albeit starting from a smaller base.

Hey guys, this is Steve on for Simeon. Thanks for taking our questions. So, apparel has obviously been a huge call out for you guys, but it looks like the soft line comps have been trending a little bit lower over the last couple of months kind of towards the mid-single-digit range. Can you just give us some color on what you're seeing within the category, any notable call out there?

Hold on. Within soft lines and jewelry, performance has been somewhat weak. Household furniture has also shown some softness.

All right. If I can sneak a little more in. On the MSI growth, did you guys call out what exactly was the fee high contribution for the quarter?

$10 million. Thank you very much. Have a great afternoon everyone.