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Thursday, May 27, 1999

An Investment Opinion
by Dale Wettlaufer

Costco Q3 Call

Longtime readers of the Boring portfolio, which I operate at the Fool, will know about this company, but general Evening News readers might not. The company is Costco Companies (Nasdaq: COST), a very unusual retailer of soft goods, consumer durables, fresh and packaged foods and produce, and services. Since this is a news slot, I've decided to enter a topical entry on Costco. Below, you will find my notes on their third quarter conference call. If you want to listen to the entire call, click this link. Here's the company's third quarter press release.

Since my space is limited here, I'm not going to try to explain Costco. I direct you to the first two pieces I did on the company, while I was still learning myself about what it does: Shopping Costco, Part 1 and Shopping Costco, Part 2. In short, this is one of the best retailers I've ever run across and one of the best businesses I've ever run across. Serving the customer is a religion to Costco and delivering the best value to customers is their gospel. At the current price, it's not cheap. But that's because it's a great company. For investors whose long-term goal is to match or beat the S&P 500, I think Costco's stock is in range.

Being a value investor who looks for a margin of safety and has a relatively high hurdle rate of 15%, it's not quite there for me yet. But if you assume your hurdle rate is the S&P 500, this horse can make that jump. I recently wrote about the company in our yearly "Stocks for Mom" special. My base operating and valuation assumptions are in there. If you don't know this company or if you don't care for its current valuation, you should make a point of learning about it. Go to one of its stores and visit, look at its cash flow and revenue growth dynamics, and talk to people about how they're in love with this company as customers. It'll open your eyes. Without further delay, here are the notes on the call.

Membership fees up 18% on a pro-forma basis. Concludes anniversary of $5 increase to basic membership last April 1.

Member renewals last year:
Business -- 91%.
Gold Star -- 81%
weighted average -- 84%

This year:
Business -- 91%
Gold Star -- 83%
weighted average -- 85%
strongest in company history

Primary business members -- 3.8 million
Business add-on members -- 4.2 million
Gold Star primary -- 9.3 million
Total household members -- 17.3 million
Spouse cards -- 29.6 million membership cards outstanding

Membership fees are strong and renewal rates are up.

Executive Membership
Total members 1.050 million
Second quarter-end, 1.15 million.
Decline represents the fact that initial marketing thrust throughout late '97 and early '98 was to do a free one-year upgrade. A year later, two-thirds or more of those people opt to downgrade back to regular membership.

On a paid basis, there were a little over 60,000 Executive Members at Q2-end. Q3-end, just under 100,000. Signing up about 3,000 per week. Upgrade was offered to just under 9 million existing members. About 10-15% opted for the upgrade, but two-thirds of those downgraded at renewal time to the $35-40 range. Once downgraded, it's very difficult to get them back.

3-4% renewal rate on Executive. Effective April 1, Costco rolled out Executive Membership to all states, to an additional 5 million members, but on a paid-only basis. Test in Arizona offering a 2% annual rebate on nearly all purchases. Rebate capped at $500. Hope to increase paid Exec Member penetration and increase member loyalty. Hope that it will increase average purchases and help drive new business members. Results will be clearer in 6-9 months.

Goal of up to 150,000 paid Exec Members by fiscal year-end. Current estimate closer to 140,000, taking the number of just under 100,000 now and 14 more weeks at 3,000 per week, although the 3,000 could increase a little bit as they put a little more effort into in-warehouse promotions.

Exec Member in-warehouse promotions to be most successful. Exec Membership, while a little slower than planned, does work. Services do work.

Gross margin in Q3 was up 5 basis points to 10.09%

Components of gross margin change, in basis points

                       Q1    Q2    Q3
Core                   -6    +4   -11
Ancillary businesses   +8   +11   +13
Int'l                  +9    +9    +8
LIFO                    0    -1    -1
Adjustments             0     0    -3
Total                 +11   +23    +5
One basis point = 1/100 of a percentage point

Core -- Q2 saw a one-time fairly sizable margin benefit related to tobacco. Without that, +4 in Q2 would have been -6. Both Q1 and Q2 were -6, with Q3 -11. Effect of passing on more competitive pricing to customers as the result of increasing membership prices $5 last year. That's just about anniversaried out by the end of the third quarter.

There was some weakness in softlines margins. Year-over-year, softlines margins were down 35 bp -- a reflection of both higher than normal markdowns in housewares (which ran a negative comp of 2%) and very low margins on a couple big blockbuster movies like A Bug's Life, which the company chose to sell at 1-2% markups because of the key pricepoint. Nothing beyond that really out of the ordinary.

The company feels pretty comfortable with preliminary goals of 10 bp gross margin improvement for FY 2000.

In adjustments, about 2 of that is gain sharing. A small amount of gain sharing with certain departments' employees goes into the direct labor line of COGS rather than through the SG&A line.

Ancillary businesses. Two pharmacies were added during the quarter, to 218 on a total base of 288 warehouses. Foodservice is in all locations. One-hour photo labs are in 280 locations. Five optical locations were added, to 260 locations. 12 print and copy shops were added. One hearing aid center was added, to 66 locations. Five gas stations were added, to 47 locations. This past week, the 50th gas station was opened and the company still plans to be at 70 by fiscal year-end.

About 55-60% of units have expanded fresh foods. That's continuing and will take well over another year. Overall, ancillary businesses have generated strong comps and strong sales. In fiscal 98, ancillary businesses represented $1.325 billion in sales. The original budget for this year was to be at $1.66 billion, or up 25%. The current estimate is now $1.75 billion, or up 32%. Half that increase is related to gas prices, but the rest is the result of strong comps. These are all good, profitable businesses. They drive up frequency of visits, they drive renewal rates, and they set the company apart from the competition.

SG&A came in at 8.89% of net merchandise sales versus 8.91% last year.

(Improvement) or increase in SG&A component as a percentage of net merchandise sales, in basis points
                       Q1     Q2    Q3
Core warehouse        (14)   (20)  (24)
Central                (1)     1    (3)
Ancillary businesses    2      2     7
International           8      9    10
Other                   1      6     8
Total                  (4)    (2)   (2)
One basis point = 1/100 of a percentage point

In other words, SG&A expenses as a percentage of net merchandise sales improved, or decreased, by two basis points this quarter.

International was higher as a result of the Japan opening and the ongoing work in Taiwan to open a second and third unit there.

The core business and central expense leverage continues to show great improvement. 9% comps helped that. Ancillary business SG&A increased due to higher sales penetration of these higher expense businesses. On the gross margin basis, the company saw a gross margin contribution from the ancillary businesses.

In terms of "other," which saw a six basis point increase as a percentage of net merchandise sales in Q2 and eight basis points in Q3, that relates to the company's gain-sharing program. This is a program rolled out this year to the company's 65,000 employees, 90% of whom are hourly. If the company exceeds by 3% the goals it has set for the year, a gain-sharing expense is recognized. The second trigger is exceeding by 3% budget goals on a warehouse-by-warehouse basis. That wins that particular warehouse's employees additional gain-sharing income. In the second quarter, $5 million in gain sharing expenses were accrued. In the third quarter, an additional $6 million was accrued. $1 million went into COGS and $5 million went into SG&A. Year-to-date, gain sharing expenses are $10 million in SG&A and $1 million in COGS. The company believes this is a good program, as it gets everyone at the company excited about the business.

For the balance of fiscal 1999, the company's guidance to Wall Street will be a slight net improvement in SG&A year-over-year. That's the goal.

Pre-opening expenses held no surprises for the quarter. Q3 pre-opening expense was down year-over-year. In the third quarter of 1998, Costco had $8.9 million in pre-opening expenses. $6 million related to six openings, which included the five openings in Detroit. By comparison, in Q3 of this year, that charge was $6.1 million. $2 million this quarter was related to three openings. $3.4 million in Q3 pre-opening expense was related to international stores, with a focus on Japan and Taiwan. $1.5 million in warehouse closing costs were taken, same as Q3 1998. Year-to-date, twice as much has been reserved for closing costs, $6.5 million year-to-date, versus $3.5 million last year. That's related to the fact that five to six relocations will take place this year, including three in Q4.

Operating income was up 22% year-over-year, to $176.3 million. Below operating income, interest expense was about the same year-over-year, at $10 1/2 million, while interest income and other showed an improvement, rising $3.1 million to $10.7 million. That's about six basis points to the bottom line. Whereas operating income was up 22%, pre-tax income came in up 24%, to $176.5 million.

Summary balance sheet and capital expenditures:

($ in millions)

Cash & short-term investments...$661
Other current assets...$317
Total current assets...$3,082

Net fixed assets...$3,771
Other assets...$265

Accounts payable...$1,807
Deferred membership fee income...$230
Other current liabilities...$625
Total current liabilities...$2,662

Long-term debt...$912
Deferred and other...$61

Total Liabilities...$3,636
Minority interest...$115
Shareholders' equity...$3,367
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY...$7,117 ($1 million rounding error)

Accounts payable as a percentage of inventories increased about 2 1/2 percentage points year-over-year. Accounts payable as a percentage of inventories was 86% versus 83.5% a year ago. That 2.5 percentage point improvement on $2.1 billion in inventories is about $50 million in cash flow. Average inventory levels per warehouse, while up year-over-year, increased less than in the past. At the end of Q1, average inventory per warehouse was up $720,000. At the end of Q2, average inventory was up $670,000 and at the end of Q3, this was higher by $442,000.

The original cap ex budget through Q3-end was $581 million (cap ex also includes foreign investment). Compared to the original budget, actual is about $535 million. Virtually all of that is delays in international. The company has run into some snags in the U.K., although they hope to open at least two or three in fiscal 2000. They're still on track for $700+ million in cap ex for the year and to be free cash flow-positive by $150 million or so. was commenced in November of last year. When it was started, it had about 400 SKUs (stock keeping units). It now has 900 and expects to have by calendar year-end about 2,000 items, with only about 5-10% of those items overlapping what is offered in the warehouse. They've added some new items of late. The white goods program with Whirlpool, which has done well, is also online. Even with the flower program and ink & toner program, the average transaction is above $300. The merchandise focus is on high-end unique items, and as a result, some vendor relationships are opening up. Also, corporate gift-giving is big.

Phase two -- summer to fall of 1999 -- will see a continuation enhancements of the business-to-business selection. They will add some online executive member services. They will also offer some additional categories and several site enhancements, like drop-down capabilities to show different SKUs, special orders for jewelry items, etc. A lot more personalization will be built in. Total expenditures for creating the site and getting phase one going were less than $1 million. Phase two, is another $2 million. The first two years of will take about $5 million in spending, including about $3 million in capital costs. The first year's sales will probably be a little shy of $20 million. The budget for next year will be at least $60 million and perhaps up to $100 million, with a marketing budget of $30,000 per month.

New Markets

Current estimates for sales in Atlanta stores are about $65 million each with recent comps running at 27% and are profitable. The fourth unit in the market is coming in late August in South Atlanta.

They've opened two stores in the Philadelphia market so far with another coming this fall. King of Prussia opened in October 1997 and Wilmington, Delaware opened last October. Last week, King of Prussia did $1 million in sales and is comping at 35%. Christiana has been open only six months and did about $800,000 last week.

Detroit has been a great market for the company. They just anniversaried on May 1 the five openings. They are currently annualizing over $60 million each. They're just getting into generating fee income, since they offered one-year free memberships when they opened there. Comps in the first few weeks of the anniversary are about zero because they're up against the opening weeks. That's not unusual.

Two stores opened in Chicago in November. They had been doing about $850,000 a week in January and February and are doing a little under $900,000 a week now. Signs-ups are about 75,000 per unit.

Japan opened on May 9. Sales for the first two weeks were $3.1 million. Signs-ups are off the charts.

In Q4, Costco plans to open 11 new units, including four relocations, so a net of seven. For the year, that would be net openings of 17, 3-4 shy of the plan for the year, which are moved into the fall of this year. They'll have 295 locations at the end of the year.

Coming openings:

June 24 -- Culver City, CA
July 10 -- Montgomeryville, PA
July 31 -- Taipei, Taiwan
August 18 -- Yonkers, NY
August 19 -- Bridgewater, NJ
August 26 -- Morrow, GA
August 27 -- Brentwood, TN

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