Boring Portfolio

Boring Portfolio
Costco Call, Part 2
CFO Discussion

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Oct. 8, 1999) -- This is a continuation from Part 1 of Costco Wholesale's (Nasdaq: COST) Q4 financial results conference call. This is a summary of comments made by Richard Galanti, CFO.

Ancillary Businesses

During the fourth quarter, the company opened nine additional pharmacies to total 227, three additional food service courts to total 292, four one-hour photo labs to total 285, four more optometry shops to total 264, added one print shop to total 13, maintained hearing aid centers at 66, and opened up 20 gas stations to total 67. About 60% of units, or about 173-174, have expanded fresh foods with plans for the remaining 120 or so to transition over a couple of years.

Since the end of the year, the company has opened an additional four gas stations to total 71. Costco estimates it will open another 10 by the end of 1999. The plan is to add 40 this year and another 40 in fiscal 2001.

Overall, these businesses generated $1.797 billion in sales this year, up 36% from last year's $1.325 billion. Without gas, these businesses were up 24%. The original budget in this area was $1.660 billion. About half of that variance is due to gas price increases, but even so, $50 million to $70 million of this outperformance came on top of what they thought was an aggressive budget for the year. These are all good, profitable businesses and the company thinks they help drive renewal rates upward and continually set the company apart from its competitors. "I can assure you that we'll keep coming up with new concepts and new ideas to keep us on top. While we have nothing to announce today, we're working on some other things," said Galanti.

Sales, General, and Administrative (SG&A) Expenses

SG&A was flat year-over-year at 8.63% of net sales.

SG&A category as a percentage of sales, improvement/decline expressed in basis points:

                  Q3     Q4     FY99 
Core warehouse   +24     +20    +20
Central           +3      +2     +1
Ancillaries       -7      -7     -5
International    -10      -7     -8
Other             -8      -8     -6
Total             +2       0     +2
The 8-basis-point decline in "other" was employee gain-sharing. The company paid out $19 million in gain-sharing, $17 million in SG&A, and $2 million in COGS.

Margin improvements in core and central goes a long way in offsetting ancillary SG&A and, in their infant stages, international. The other good news for fiscal 2000 is that gain-sharing will be in year-over-year rather than being included for the first time, as the program was instituted in fiscal 1999. For FY 2000, the original budgets assume a slight improvement in SG&A as a percentage of sales -- a low single-digit basis point improvement.

Costco has an increased relative and actual number of store openings in new markets and competitive markets planned for this year, as well as a small increase in international openings -- a third Taiwan unit, an eighth and maybe ninth UK unit, and possibly a second Japan unit.

In terms of pre-opening expenses, Q4 '98 was a little under $7 million with about half of that being international pre-openings related to some of the new countries Costco has entered. Q4 '99 was $10 million, with about $2 million being international pre-opening expenses.

Closing Costs

During Q4, several things happened that haven't come up in the past, at least to this magnitude. Five relocations were opened in Q4. One was unusual in that the best alternative was to buy adjacent land, open a new facility, and then demolish the old building, which was on the books for $5 million. So in addition to the normal closing costs, which could be several hundred thousand dollars to move merchandise and steel racking, there was an unusually large charge on just one closing.

Also, last quarter, the company dramatically upped the number of planned relocations. Looking out over the next 15 months through the end of calendar 2000, the company has committed to do another 10 units. Of those 10, three more are demolition alternatives, where "the best alternative for us -- and it's a very positive ROI going forward on a book and a cash-on-cash ROI basis -- is to buy additional land, actually demolish the old building, and build the new building. Just those three, plus the one we did in Q4, account for $20 million of the charge," said Galanti.

There were some unusual things on asset impairments for the quarter. The company agreed to sell one site from which the store was located for $3 million below book after a prior deal to sell the property didn't materialize at a higher price. That was just a coincidence that it happened during this particular quarter. The company doesn't think there is anything unusual in these numbers. There's just a lot of stuff going on as the company grows.

Mexico is unconsolidated and goes below the line.

Balance Sheet, Cash Flows

Cash and investments, $697 million.
Inventories: $2,210 million
Other current assets: $409 million
Total current assets: $3,316 million
Net fixed assets: $3,907 million
Other assets: $282 million
Total assets: $7,505 million

Accounts payable: $1,913 million
Other current liabilities: $953 million
Total current liabilities: $2,866 million
Total debt: $919 million
Deferred and other: $67 million
Total liabilities: $3,852 million
Minority interests: $121 million
Stockholders' equity: $3,532 million

Accounts payable was up 2.5 percentage points from 84% last year. One of the reasons the cash position is up $260 million is not only increased earnings but improved working capital dynamics.

The original cap ex budget for this year was $737 million, which included new warehouses, relocations, remodels, international, and depot construction for refrigeration and frozen for some parts of the country. The actual was $788 million. Despite the company's increase in cap ex beyond plan, free cash flow was very strong. The company had $65 million from the exercise of stock options and disposed of a few extra properties, which was in the $20 million to $30 million range.

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