Costco Wholesale - Earnings Call - Q1 2012

Transcript

Speaker 2

Good morning. My name is Dawn, and I will be your conference operator today. At this time, I would like to welcome everyone to the first quarter fiscal year 2012 operating results conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you, Mr. Richard Galanti, Chief Financial Officer. You may begin your conference, sir.

Speaker 3

Thank you, Dawn. Good morning to everyone. This morning's press release reviews our first quarter fiscal 2012 operating results for the 12 weeks ended on November 20th. Let me start by stating that the discussions we're having will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and that these statements involve risks and uncertainties that may cause actual events, results, and/or performance to differ materially from those indicated by such statements. The risks and uncertainties include, but are not limited to, those outlined in today's call, as well as other risks identified from time to time in the company's public statements and reports filed with the SEC. To begin with, our 12-week first quarter operating results for the quarter, as you saw, our reported EPS came in at $0.73 compared to last year's EPS reported at $0.71.

As was noted in this morning's release, there were two large one-time items totaling $0.07 a share that hit this year's Q1 results. The first of these items was a settlement of an income tax audit at Costco Mexico. During the first quarter, Costco Mexico recorded an after-tax charge to their income tax line, which, when expressed in U.S. dollars, was $24 million. Since we consolidate Costco Mexico's operating results, the full Costco Mexico P&L is included in our income statement, including the $24 million hit to our income taxes line. The offset to this $24 million was a $12 million benefit to our income statement on the non-controlling interest line item near the bottom of the income statement. This represents, of course, our joint venture partners' 50% share of this hit.

In total, the impact to Costco's net income as a 50% owner in Costco Mexico was $12 million or $0.03 per share after tax. The $12 million number is a tax number, so it's after tax, of course. The second of the two one-time items was a $17 million or $0.04 per share charge to the SG&A line for our contributions to the Washington State I-1183 Liquor Initiative. Washington State voters approved the initiative by a 59% to 41% vote. The $17 million expense is not tax deductible under U.S. tax law, so again, it's a $0.04 a share hit to our EPS. In terms of sales for the first quarter, as was reported in the press release, our 12-week reported comp sales figures for Q1 showed a 10% increase, 10% in the U.S. and 11% internationally. Excluding gas price inflation and the impact of FX, the 10% reported U.S.

comp would be 6%, and the 11% reported international comp in local currency would be at 10%. For the company overall, excluding both of those, the 10% reported number would be at plus 7%. Other topics of interest I'll review are opening activities and plans. We opened four new locations during the first fiscal quarter of 2012, which ended November 20, one each in Pennsylvania, Texas, Wisconsin, and Georgia. For all of fiscal 2012, a current plan of 20 net new locations, 11 of which will be in the U.S., one each in Canada and the U.K., and seven in Asia, three in Korea, and four in Japan. This week, in fact, of the four in Japan, this week we will open two of these new Japan units, and with these openings, we'll end the calendar year and this week with 598 locations around the world.

I'll also briefly talk about Costco.com, our membership trends, and of course, the recent increase we took in our U.S. and Canada annual membership fees. A little discussion further on, of course, gross margins and SG&A in the quarter and our stock repurchase activities during the quarter. Very briefly, again, sales for the 12 weeks were up 12.5%, $21.2 billion this year in the first quarter versus $18 billion earlier. On a comp basis, again, the 10% for the quarter, excluding gas and FX, was up 7%, comprising a 6% U.S. without gas and a 10% international expressed in local currencies. The 10% reported comp was a combination of the average transaction increase of 6% for the quarter and an average frequency increase of 4%. The 6% includes FX and gas as well.

In terms of sales by geographic region, geographically, Northwest has been pretty consistent for the past few fiscal quarters in the high single-digit positive range. California has been in the 9% to 11% positive range, in fact, a shade higher towards the high end of that range in the most recent quarter. The rest of the U.S., Northeast in the mid-single digits, Southeast around 10%, and Midwest in the low double-digit comp increase. Internationally in local currencies, we were also doing fairly well, averaging in local currencies 12% in the fourth quarter, 11%, I'm sorry, 12% in the fourth quarter of 2011 this past summer, 10% in the first quarter, which we're reporting today, and 11% in the recent four-week November reporting month. We are seeing the positive tailwinds of gas and FX subsiding a little during the quarter.

For example, during the quarter, FX was a slight benefit to the comp. In November, it was a slight detriment, implying that we've seen that crossover to where the dollar weakness relative to all the other foreign countries shows a slight strength. Gas has come down a little bit from its higher level of inflation in the first quarter as compared to just November. In terms of merchandise categories in the first quarter, which is essentially September, October, and most of November, within food and sandwiches, comps were in the high single-digit positive with foods, candies, deli, and refrigerated being relative standouts. We continue to see year-over-year inflation in many of the food-related areas, while, again, not increasing inflation over the last few months, but as compared to a year ago.

Our hardline sales show slightly positive comps overall with slightly negative comps in electronics, offset by sales growth in tires, automotive, and hardware. Sales strength, rather, in tires, automotive, and hardware. Within the mid to high single-digit softline comps, small electrics, jewelry, and domestics were the positive standouts. Media, of course, you know, books, CDs, and videos continues to be one of the weaker departments. Within fresh foods, it was up 11%. All subcategories were pretty close to that number and showed strong results, again, partly from inflation year over year. Moving on to the other line items in the income statement, membership, $416 million a year ago, or 2.21% of sales, $447 million or 2.11% of sales this quarter, so up a little under 8% in dollars or $31 million and down 10 basis points.

We're again reflecting the things I just mentioned earlier in terms of comps, impacts of comps. I continue good showing in terms of dollar of increase, we think. Strong renewal rates continue, are 89% in the U.S. and Canada and 85% worldwide, and continue to see an increase in the penetration of the executive membership program. Our new member signups in Q1 company-wide were up 15% year over year. This is largely due to the strong international openings this past year in Asia and Australia. Even in the U.S., there was a small increase in year-over-year membership signups. In terms of numbers of members at Q1 end, at fiscal year end, we had 25 million Gold Star members. That's 25.5 million 12 weeks later at the end of Q1. Primary business, 6.4 and 6.4. Business add-ons, 3.8 and 3.8.

All told, 35.2 million households at year end, 35.7 million households at first quarter end, and including add-on card, the spouse cards, 64.0 million. It's now up to 64.9 million. At first quarter end, paid executive memberships totaled 12 million and were up about 270,000 from 12 weeks earlier, still getting about 23,000 a week increase during the past quarter. Again, our executive member base is about a third of our member base and a little over two-thirds of our sales. In terms of member renewal rates, as I mentioned, they actually have strengthened slightly. In the U.S. and Canada, we ended up at an 89.2% for the first quarter, up from an 89.1% at the end of the fiscal year, just tweaking up a little bit. Total worldwide has tweaked down a little bit from an 85.7% down to an 85.4%.

That's due in large part to many of these new openings, particularly in Asia and Australia. We're getting substantially higher than average signups, and in first years, you tend to have lower renewal rates to start with. That's a smaller piece of the pie, but nonetheless, an 85.4% for first quarter end. As you all know, we recently increased our annual membership fees in both the U.S. and Canada, essentially from $50 to $55 for primary memberships and from $100 to $110 for executive memberships. This again is in the U.S. and Canada. These increases became effective as of November 1st for new members signing up in the warehouses and will become effective January 1st for renewals. It was back in late November, early December when we mailed out the January renewals. In all, approximately 22 million members are impacted by this increase, approximately half of whom are executive members.

In terms of the timing of these increases hitting the income statement, remember that the membership fees are accounted for on a deferred basis. For example, approximately one-twelfth of the increased fee, that $5 or $10 increase from our January renewers, will be booked in the first month that they pay it, with an additional one-twelfth being booked in each of the succeeding 11 months. Increased fees from our February renewals will then be booked in essentially February through the following January and so on. No impact, of course, in Q1, very, very little impact in Q2, a small amount of impact in Q3, and more meaningful in Q4 and the first few quarters of fiscal 2013. The full impact of the increases is essentially a 23-month timeline given the deferred nature of accounting for this.

For example, the last group of members to be billed these new increased fee levels will be next December of 2012, and then, of course, that $5 or $10 increase will be booked to our income statement over that month and the succeeding 11 months. With regard to executive membership, as you know, we raised the cap on the 2% reward from $500 per year to $750 per year based on eligible purchases. Now going on to the gross margin line, the gross margins reported in the first quarter were down 35 basis points, 10.62% down from 10.97% a year ago. As usual, I'll ask you to make four columns and six line items, and the columns are a little different. We basically have the first two columns are Q4 2011 results, and the second two columns will be Q1 fiscal 2012 results.

The first two columns for Q4 will be reported as reported, and the second one without gas inflation. The dramatic amount of sales of gas and the fact that there's been big inflation, whether it's inflation or deflation, impacts the percentages of margins in SG&A, so we try to share that with you. Columns one and two will be reported, and column two will be without gas. For Q1 in 2012 as well, reported and without gas. The line items: first one is merchandising core. The reported in Q4 2011 was minus 24 basis points year over year. Q4 2011 without gas plus 2. Q1 2012 minus 32 reported. Q1 2012 without gas minus 10. Ancillary plus 6, plus 12, minus 2 and plus 2. 2% reward, 0 and minus 3, and then 1 and minus 3.

LIFO minus 12 and minus 12, and if there was no LIFO in Q1, 0 and 0. Other minus 5 and minus 5 and 0 and 0. Those all add up to, in both quarters, quarters four and quarter one, the reported margin year over year was down 35 basis points. In Q4 without gas, that minus 35 without gas is a minus 6, and in Q1, the minus 35 is a minus 11. Let me explain a little bit of this to you now. Our core merchandise gross margin for Q1, again, reported minus 32. The lower margin gas business represented about 8.5% of our sales in Q1 last year and about 10.5% of sales in Q1 this year. A little over 200 basis points increase in sales penetration on a margin business that is significantly lower as well.

Not only is it lower margin, but more importantly, the piece that we're taking out here is the year-over-year inflation in Gasoline, which distorts the denominator in these calculations. This alone resulted in a 24 basis point, minus 24 basis point impact to our overall company gross margin. While gross margins in our core merchandise business, that's food and sundries, hardlines, softlines, and fresh foods, still was lower year over year by 10 basis points, it's the lower aggregate sales penetration by inflation that caused it to be down so much in the reported. Food and sundries and fresh foods were slightly lower year over year, while non-foods, hardlines, and softlines, which is a smaller percentage of the total, was positive. I know many of you will ask, why is core gross margin net of Gasoline impact down year over year, 10 basis points, and what does that mean?

There are two factors I want to mention here. First, we did choose to be a little more aggressive in pricing going into the fall and Christmas holiday season. We all see what's going on in the economy. We've been aggressive on inventory levels, and we wanted to drive our top-line sales. We believe we have done that. This had an impact on the comparison of gross margins year over year in Q1, but it's no secret that this is what we do, and we feel that it was appropriate to do that over the last few months. The second factor that impacted the year-over-year comparison of Q1 gross margins can be seen in our interest income and other line, which showed a dramatic increase in Q1 year over year. I'll go into more detail in a minute about that.

Approximately $8 million of the year-over-year variance, in fact, $9 million of income this year in Q1 versus $1 million of income last year. This was due to FX gains related to the purchase of foreign currencies in our foreign operations, by the way, related to the purchase of foreign currencies at a rate more favorable than the rate used to record the foreign merchandise payables. For example, Canada buying merchandise that is payable in U.S. dollars, they will buy either contracts or convert some of them to U.S. dollars. GAAP accounting requires that these FX results be included as a component of interest income and other, even though from our perspective, it is related to buying and selling of merchandise. In fact, internally, we credit this to the buyer's margins and then take it out of the margin for GAAP reporting purposes.

The same thing happened to a slightly lesser extent in Q4. Prior to that, we haven't seen a kind of volatility in this. Usually, it's been a couple million positive, a few million negative, but we wanted to point that out because it's certainly part of the reason that we saw both this quarter and the last quarter the underlying core margin ex gas being a little bit further down. For Q1 overall, we were aggressive on pricing, and again, $9 million or 4 basis points was down below the line in income statement under those FX items I mentioned. Lastly, with respect to gross margins, we booked no LIFO in either Q1 2011 or Q1 2012. So far this year, through the end of Q1 2012, just for the first 12 weeks, our LIFO indexes for our U.S.

inventories is ever so slightly deflationary, not enough to warrant even booking that small amount as a positive. Now moving on to SG&A, our reported SG&A percentages Q1 over Q1 were lower or better by 18 basis points, coming in at a 10.13 this year compared to 10.31 last year. Again, we'll have the same four columns for SG&A: Q4 reported, Q4 without gas, and Q1 reported and Q1 without gas inflation. The line items, the first one is operations. Q4 reported, I'm going to just give you some perspective. Q4 reported was plus 44 basis points, so lower or better by 44. Without inflation, plus 20. In Q1, plus 28 reported and plus 9 without inflation. Central, minus 2 and minus 5, and for Q1, plus 4 and plus 2. Equity compensation, plus 2 and plus 2, and then for Q1, minus 6 and minus 7.

Quarterly adjustments, which is minus 10 and minus 10 for Q4, reported and without gas. In Q1, it's minus 8 and minus 8. That minus 8 is the $17 million I-1183 charge to SG&A. All told, reported plus 34 or lower by 34 basis points year over year in Q4 2011 as compared to the prior Q4. Without gas inflation, the 34 would really be plus 7. The reported was for this quarter, again, was 18 basis points better or lower versus, again, adjusting for gas inflation, minus 4. The core operations, plus 28 without the big gallon gas price per gallon gas inflation would have been only plus 9. By the way, the 9 basis points in core, payrolls were a little more, I believe, than all of that, or a big part of that, and we've certainly been working on driving more efficiency in the warehouse.

Our central expense was lower year over year in Q1 by a 4. Adjusting for inflation, better by 2. Our compensation expense, as I mentioned already, it's year over year, the delta there has to do with, one, there's a substantially, you know, the grants in the last year were substantially higher than the ones going out of the equation from five years ago. Finally, as I mentioned, the $17 million of expenses for I-1183 hurt SG&A by 8 basis points, reported SG&A. Overall, SG&A percentage improved a little in the fiscal quarter, and we will continue to focus on the things that I've talked about in the past about driving efficiencies in the warehouse. I think in these tough times, it's made it a little easier to do that, but not on the backs of our employees' wages or health benefits.

In terms of factors that will impact our outlook in the future, it's the things that we all know about. Sales trends, of course, are paramount. Healthcare and gasoline sales and inflation and deflation, which we'll take out for you. Certainly, as we expand overseas, particularly in Asia and Mexico and Australia, which have lower SG&A, that increasing sales penetration to the extent we continue our plans to open more units overseas should help that a little bit. Next on the income statement is pre-opening expense, $12 million last year in the quarter, $10 million this year, so $2 million lower and a basis point better. Last year, we had eight openings in the first quarter. This year, only four.

This year's $10 million number included a little over $3 million for the two Japan openings that are opening tomorrow and Saturday, in the first couple of weeks of the first three weeks of Q2. The pre-opening, much of that pre-opening is in Q1. In terms of provision for impaired assets and closing costs, we had a charge last year of $4 million. This year, we had a credit of $1 million due to a small gain on the disposition of a piece of property, so a $5 million year over year swing for the quarter. All told, reported operating expenses in Q1 came in at $525 million last year, up $18 million to $543 million this year.

This year's $543 million figure includes, of course, the $17 million I-1183 initiative charge and does not include because it's below the line that $9 million I mentioned and I discussed that's in the interest income and other line that in terms of how we manage our business internally relates to our buyers and their buying of merchandise. These amounts mainly reflect the, hold on, I've got a line here. Below the operating income line, reported interest expense was about the same in both quarters, both first quarters, Q1 2012 coming in at $27 million compared to $26 million a year earlier in the quarter. These amounts mainly reflect the interest expense on our $2 billion debt offering that we did in February of 2007.

As I have mentioned previously, we anticipate paying off $900 million of this $2 billion of debt in mid-March of 2012, so a few months from now. On an annual basis, beginning with the debt paydown, the anticipated annual pre-tax interest expense savings to Costco, given that we're paying about 5.4% debt and foregoing interest income of sub 50 basis points on our current cash investment, it's around $44 million pre-tax per year, but again, that'll start in mid-March. Now turning to interest income and other, as you noticed, there was a big increase in this number year over year. In Q1 last year, it was $6 million. In Q1 this year, it was $37 million. Again, try to give you a little bit of light on that. It has to do with the FX things I mentioned, as well as Costco Mexico, and we'll go through that.

Actual interest income for the quarter came in at $10.5 million versus $7 million a year earlier, so better by about $3.5 million. The other component of interest income and other amounted to $23 million this year in the aggregate versus a loss of $4 million last year, or better by $27 million year over year. $15 million of that positive of that $27 million variance relates primarily to a gain in U.S. dollars held at our Mexico joint venture. Again, because of the strengthening of the dollar rate to peso and the fact that historically we, Costco Mexico, have kept, you know, the goal is to keep about half of our excess cash down there in dollars, recognizing the volatility in the currency and recognizing that they buy many goods that are sourced in the U.S. With the strength of the U.S.

dollar, let me go back to your, okay. Yeah, so that $15 million variance, basically, Costco Mexico, again, we consolidate those numbers, had $12 million of income just related to the fact that they held U.S. dollars compared a year ago in the quarter when they had a $3 million loss for the same reason. With the strength of the U.S. dollar year over year compared to the peso, our Mexico operations benefited from an FX gain on our U.S. dollar denominated cash. Again, GAAP accounting is how you take care of it. Because we own 50% of the venture, half of that gain was deducted as part of the non-controlling interest line down below, such that a total benefit from us was approximately $7.5 million pre-tax.

Much of the remaining year over year benefit of the approximately $12 million of that $27 million I talked about related to our buyers managing the cost of foreign currency denominated, the foreign currency inventory purchases in our foreign operations previously disclosed. To a lesser extent, the required mark-to-market accounting for our foreign forward exchange. As I discussed earlier, buyers consider what they have done to manage foreign exchange rates and pricing merchandise and associated gross margins. I think you'll see in the last two fiscal quarters, and why I'm pointing it out now is that it's how we run our business. We've never seen big changes in it in terms of the level of volatility as we have in the last couple of periods. Overall, pre-tax income was up 10% versus last year's Q1 from $504 million last year to $553 million this year.

Excluding I-1183, pre-tax income would have been $570 million or up 13% year over year. Our tax rate, it came in again as a reported 40.8%, certainly higher than last year's 34.2%. Excluding the two items mentioned in the press release, our effective Q1 tax rate was 35.3%, still about a percentage point higher than last year when we had a one-time benefit of a discrete item that made it up about 1% higher than, it was 1% lower than it would have been. Now for a quick rundown of other topics. Depreciation and amortization, $205 million in the quarter. The balance sheet, I don't have to tell you, is strong. Accounts payable, on a reported basis, accounts payable as a percent of inventories. Last year was 105%. This year was 99%. More importantly, merchandise, and a lot of that has to do with construction payables.

More importantly, merchandise inventories as a percent of inventory. Merchandise accounts payable as a percent of inventory was 91% last year and 92% this year. Average inventory per warehouse was up 8% from $11.8 million last year at Q1 end to $12.8 million this year, up $966,000. Now recognizing we don't know exactly what the exact inflationary number there is, but using the various LIFO indices and what we see coming through the front end, if you assume 3% to 5% inflation or 3% to 4% inflation, even at 3% inflation, that would be about a little under half of that $966,000 increase. Much of the balance of these increases are spread across many departments. Of course, that's related to that inflation. Perhaps a little more inventory as well in the likes of jewelry and electronics.

I might add, though, in talking to our Head Merchant yesterday and asking about any issues related to year-end and seasonal markdowns, he felt that we were quite clean going into the end of season here. In terms of CapEx, our first quarter 2012 CapEx was $343 million. For the year, we expect it to be $1.5 billion or a shade under. This compares to CapEx last year of $1.3 billion. Some of the higher annual year-over-year estimated CapEx is due to both the higher penetration in number of units planned overseas, particularly in Asia, and a little bit more ramp-up hopefully going near the end of this fiscal year, going into fiscal 2013. Dividends, as you know, in the spring, we raised our dividend from effectively $0.82 a share to $0.96 a share on an annual basis.

On an annualized basis, this dividend, a $0.96 per share annual dividend, represents the cost to the company of about $420 million. At Costco.com in the first quarter, sales were up 9%. In terms of expansion, I mentioned we're going to open 20 units this year, 4 in Q1, 2 in Q2, which are the two Japan openings this quarter, 4, a net of 3 in Q3, 4 plus 1 relo. In the fourth quarter, we have 11 planned, and so far we're on track to do those. Inevitably, one or two of those may slip into the next fiscal year, but we'll see how that goes. In fiscal 2011, assuming we do 20 net new units, that'll be 3.5% square footage growth. In fiscal 2012, in fiscal 2011, it was 3.5%.

Assuming we open 20 this year on a base of 592, that would be also about 3.5% square footage growth. Again, as I mentioned, the 20 would include 11 in the U.S., 1 each in Canada and the UK, 3 in Korea, and 4 in Japan. Some of you asked for square footage. At Q1 end, our total square footage was 84,982,000 square feet. In terms of common stock repurchases, during the quarter, we purchased an additional 2.1 million shares for a total of $173 million. All told, since inception back in mid-2005, we purchased 110 million shares for just under $6.2 billion. Our supplemental information packet, which includes some additional stats, will be posted on the Costco Investor Relations site later this morning. Before I turn it back to Dawn for Q&A, hopefully, I've explained a few of the nuances of this quarter's income statement.

Of course, the two items I mentioned in this morning's press release, as well as the $9 million in the interest income and other line that relates to the buyers, purchasing, selling of merchandise, and in fact, it's essentially half on a pre-tax basis, half of that $12 million of income from holding U.S. dollars in Mexico. A little bit unusual in a few of these things, but nonetheless, hopefully, we've given you some transparency in particularly that big interest income and other line. With that, I'll turn it back to Dawn for questions and answers.

Speaker 6

At this time, I would like to remind everyone, in order to ask a question, please press star then the number one on your device. Your first question comes from the line of Deborah Weinswig with CitiGroup.

Speaker 0

Good morning, Richard. Can you talk a little bit about inflation, the core categories that you're seeing it in, and what's your outlook for the rest of the year?

Speaker 3

Certainly fresh foods. I hear anecdotal items all the time, including at last week's budget meeting from our fresh foods people, and they give examples of anywhere from 5% to 8% on many meat, pork, and poultry items. In produce, you see it all over the board because it's not only the economy, it's demand from overseas, as well as crops, what happened with the weather. Across non-food categories, we did see, actually, I think in November on the call, we mentioned that in electronics and TVs, first time in as many months as I can remember, we actually saw the average selling price per TV go up a little bit versus down. A lot of that has to do with the fact that the TVs, yet again, are getting better, crisper, and cheaper.

People are upgrading and perhaps spending more per TV, but getting a larger television with more clarity or whatever it is these days. Across many categories, of course, jewelry has continued to be inflationary. The thing I want to differentiate between is when we talk about inflation, it's year over year. In the last three months, we actually have seen less than 20 basis point delta in the LIFO index year over year. If I look, and these are just some samples, and these are inflationary items in just the last three months. These are anecdotal, but if I looked across things like blueberries are 60% up. I assume the blueberry crop wasn't very good this year. Grapes were up 20%. Prawns are up 12%. I'm just looking down the list here. Other types of blueberries are up only 12%.

On the deflationary line, peanut butter is quite a bit up. On the deflationary side, gas is actually slightly down in the month, although that, I'm sorry, in the month compared, not compared to a year ago, but compared to the beginning of this fiscal year. Various electronics items might be down on an exact item 10% to 25%, but the average selling price on some items have gone up, as I mentioned. Butter is down 10% to 15%. It's a mixed bag. When you ask them, when I ask the buyers, if I asked them two or three months ago, aside from there's been a little bit of lessening of continued inflation as compared to the previous month, when do you see prices coming down a little bit?

The pat answer from three to six months, or from two or three months ago, about looking forward six months, was in three to six months. If you ask them today or last week, it's in three to six months. I don't think we know completely with that regard, but the feeling is that prices have perhaps flattened out a little bit more of late, but still inflationary compared to a year ago.

Speaker 0

Okay, thanks. In terms of basis points, how much of your gross margin deterioration should we think of as price investments, and should we think of this as a one-quarter investment? Also, on the same topic, we saw Sam’s Club last quarter with a 28 basis point gross margin decline, which is the first time I think in at least 12 quarters, and they're talking about price investments as a new strategy. I am just wondering if there's a more aggressive pricing stance in the club industry overall.

Speaker 3

There are a hundred different reasons, honestly, including different countries, including the ancillary businesses, some of which work on significantly more margins because we look at it as a margin of the item on the selling floor, which includes direct labor and supplies in the optometry and the pharmacy and things of that sort. We, I can tell you, Sam’s is ever competitive, and I think they would say the same about us. We do not view this as really competitive related. It's more us related, frankly. In terms of will it sustain itself, we'll see. I'm not trying to be cute about it, but it's by no means all of the reason of whatever somebody thought it was going to be and what it was, but it's certainly a component of it.

Speaker 0

Okay, and then last question. As you open more clubs outside the U.S., how does that change your return on invested capital outlook?

Speaker 3

If it goes like we hope it goes, it'll be a positive. You know, tomorrow's going to be another day. We'll see. As we've shared with you, one of the reasons that we have increased the proportion of locations overseas is because we're doing well. We've had great returns so far in Asia, and three of our best openings ever were in Australia. We're excited about that. What moves the needle, of course, short term, is the existing results on the whatever 500 plus out of our 600 units that are in the U.S. and Canada.

Speaker 0

Okay, great.

Speaker 3

The simple answer is yes.

Speaker 0

Okay, great. Best of luck the rest of this holiday season, Richard.

Speaker 3

Thanks.

Speaker 6

Your next question comes from the line of Robbie Holmes with Bank of America.

Speaker 4

Oh, thanks. Good morning, Richard.

Speaker 3

Hi.

Speaker 4

The question, just two questions. I guess the first is, can you talk about the categories where you were most aggressive on pricing in this quarter? Maybe a little more detail there. Maybe also on the inventory investment that you're talking about that was made, same thing, maybe the same categories. Maybe speak to us about where the inventory investment was as well. Thanks.

Speaker 3

Yeah, in terms of where we're sharp, we're always going to be sharpest on items that are those high visibility consumer items. Whether it's milk or ground beef and steaks or Advil or Tide, those key competitive items where $0.50 or $1 makes a big difference in somebody's eyes because it's a wow. As well, given the season, it was across many items in non-foods. If we could take, and I'm not going to give you a specific example, but if we can take an item that, and I'm making this up, but retail is for $179 or $189, and we're normally $139, and we can go to, whether it's one, we go to $119, that's huge because the savings versus traditional retail is that much greater.

Many times it works and sometimes it doesn't in terms of driving sales, but overall, each buyer and each department looked at different things that they felt would be high-impact items. I don't want to overemphasize this whole aspect because it's different. We were talking about this yesterday. It's different than late 2008 when we said, hey, the economy is in crisis and this is all new to us and the market was down 30% or 40% and people are, as house values are going down, and we wanted to do something to drive sales specifically on a handful, in a big way, on a handful of very high volume items. This is more across the board in a general feeling, but there are plenty of ways for us to get margin and it's a balancing act.

We felt we did what was right for our customer and for our business in terms of continuing to drive sales. When we look across categories, if I look at the $966,000 per warehouse, just dividing the increase in inventory divided by number of warehouses at quarter end, you have to figure roughly half of it's inflationary, but there's no sub-department that is more, and let's say there's about 25 sub-departments, 27 sub-departments, there's no sub-department that's more that even has three digits in it. It really is across the board. Certainly, the biggest ones on the list would be, as you'd expect, as I mentioned, jewelry and electrics.

Speaker 4

Just to clarify, is this really a holiday strategy, or should we sort of expect you to be maybe a little more aggressive in price over the next year or so as you're sort of rolling through the membership fee increase?

Speaker 3

I think, yes, yes, yes, then no, no, no. I mean, I wanted to try to explain why some of the margin's down a little bit. We don't view it. It's something that we look at every day and every week. Certainly, as you know, Jim Sinegal and now Craig Jelinek has said, and says constantly, we are first and foremost a top-line company to drive sales, and we think we are investing in the future. I don't know if it's another quarter or half a quarter or two years. We'll let you know each quarter, and I'm not trying to be coy, but as you know, we don't give specific direction.

Speaker 4

Got it. Thanks.

Speaker 6

Your next question comes from the line of Zhihan Ma with Bernstein.

Speaker 0

Thank you. Richard, can you talk?

Speaker 3

What is that? Operator, can you hear me?

Speaker 6

Yes, sir. I think our line disconnected. We'll take the next question.

Speaker 3

Okay, try to get her back on. Thank you.

Speaker 6

Yes, sir.

Speaker 0

Hello, Adrienne?

Speaker 5

Yes, I'm here. Can you hear me?

Speaker 0

Your line is open. Yes, we can.

Speaker 3

Hi.

Speaker 5

Richard, hi. Sorry, I don't know what happened. My question was about, you know, talking a little bit about the categories as we're heading into the holiday season. Maybe give us a sense of what's working, what's not. Talk about sort of the consumer electronics, how that's faring. Specifically on soft lines, it seems as if the category had been stronger the last few quarters, up low doubles, the last few quarters up high singles, and now mid-singles. Maybe give us some color in terms of what trends you're seeing in soft lines. Thanks.

Speaker 3

Okay, let me just pull my notes out here a little bit. In terms of what's working and what's not working, I got to tell you, over the last six and eight months, it seems like it's been the same things. Certainly, food is strong. Fresh food is strong. Certainly, jewelry is strong in part because of inflation, significant inflation in some of those items. Across many of the non-foods, mid-ticket items, we've seen relative strength, not as, not on the high, you know, and we've mentioned a couple of those each month, whether it's housewares or small electrics or things like that. Within electronics, if I look at the last couple of months and quarters, again, it was slightly, I believe in November, yeah, in November, electronics was slightly up year over year as a %. For the quarter, I think it was slightly down.

The trend during the last three months was up a little bit. Of course, a lot of that has to do with TVs, which we mentioned, I think in the call was up in the high to mid-single digits in dollars in the past month. It continually amazes me that, and I think in the four weeks of September, we sold just a shade under 300,000 televisions, which is a mind-boggling number. It really is across the board. Now within the other one you mentioned, soft lines, let me just look real quick. Jewelry and apparel, but in terms of any trending down, I don't think, I know men's and women's apparel tend to fluctuate up and down, but based on what we're getting in. I don't have the other detail than that right in front of me here. Let me see here. In November, I'm just looking here.

Again, the ones we mentioned were hardware, I'm sorry, and chat life. Small appliances were strong. Women's apparel was double digits. Men's apparel was mid-single. No real, nothing that stands out there, Adrienne.

Speaker 5

Okay, thanks, Richard. My other question, as it relates to the pricing environment, it sounds as if this is more proactive than reactive in terms of your decision to be a bit more aggressive. Can you give us a sense of what's out there on the competitive landscape? Clearly now BJ's private, what you're seeing out of them, Walmart has obviously been very vocal of kind of winning back the holidays and going after the weekend and the entire season pretty aggressively. If you could just kind of give us a sense, characterize what you're seeing out there, how intense, how aggressive, and maybe in response to your aggressiveness as well. Thanks.

Speaker 3

I would agree with your comment of proactive as compared to reactive. You know, who is our toughest competitor? Clearly, Jim and Craig, but outside of Jim and Craig, it's, you know, Sam’s is our most direct competitor, more so than BJ’s in terms of intensity. Although BJ’s has gotten stronger than they had been. I think I've mentioned as long as a year ago, there seemed to be a period of time for a couple of years where we less and less even price shopped them a lot. We are now over the last year. You know, BJ’s gotten a little tougher, but you know, we feel very strongly that, again, we're being proactive in this and not, there's not this, oh no, there's something new happening out there. Sam’s has always been tough, and we're pretty tough ourselves.

I don't, I'm not trying to sound arrogant about it, but again, we aren't seeing a lot. You know, outside of that, certainly we recognize that in some categories like media, you know, the internet is changing that landscape. You see that in our warehouses. Over the last year, we've reduced a little bit of the square footage of things like, you know, CDs and DVDs, and to a little lesser extent, books, because there are still plenty of people that want to buy physical books. We've done other things. In the one-hour photo, there's a lot of very cool things that we do with prints on canvas and photo books and things like that that is actually driving that business with a plus sign in front of it. In terms of competition, for those of you who've known us for a lot of years, it's the same things.

When our numbers are good, we scrutinize them more. You've seen that our strength in some of our overseas items and overseas locations like Asia, like Mexico, and like Canada, which is, of course, segmented out and shows a higher margin. We want to make sure that we're competitive, not just because there's a competitor across the street, but because we want to be strong up there. We were cognizant of the economy and our strength, and we want to make sure that that's going to continue.

Speaker 5

Okay, Richard. On the buyback, could you give us any sense of the appetite there? Obviously, we know you could do more if you opted to, but give us any sense of pace and appetite going forward.

Speaker 3

If you look at last year, I think we did about $600 million, $600-something, $640 million. I don't have it in front of me. I think in the fourth quarter, it was annualized closer to $1 billion, $950 million, let's say. If you take the 12 weeks that we spent, what we spent, $173 million, that is roughly about $750 million. That is a little bit down than the annualized figure in Q4. As we've told everybody, we are an ongoing buyer as long as we feel that the outlook continues, and we do, not just for us, but for the crazy world that we live in. We have been essentially a daily buyer.

We tend to do that in a matrix format that if the stock's going up, we're buying a little less that day, and if it's going down, we're buying a little more, recognizing we can't predict exactly. Certainly, there was a lot of strength during the quarter. There were days when we were buying on an annualized basis. If you just do simple math, if you're buying 25,000 shares a day, that's about $500 million a year. If you buy 50,000 a day, that's about $1 billion a year. When people have talked about what do I put in my model for the next five years and say, A, we don't know, but certainly, that $1 billion number a year is a starting point. Is it a little less than that? Could be. Could it be a little more? Sure.

Speaker 5

Great. Best of luck.

Speaker 6

Your next question comes from the line of Chuck Grom with North Coast Research.

Speaker 1

Good morning, everyone. The money is spent to get Washington State I-1183 Liquor Initiative passed. Can you give us some analysis of what you expect to get back from that or boost in liquor sales in Washington, I guess starting from zero when it takes effect middle of next year?

Speaker 3

First of all, you know, the $17 million, I think the total was about $19 million, just about a little under $2 million was booked in Q4, small enough that we didn't even talk about it. Of that money, it's probably twice or more than we wanted to spend to start with what we thought we were going to spend. As we go forth, once you're into it, you do it. Generally speaking, in states where we sell spirits, it's about 2% of sales. I don't have the exact amount of sales, but it'll be a decent return on even that larger investment. We keep in mind, we did it more because of the principle that our mission is to sell merchandise to our members at the lowest price.

You can see, even with higher taxes afforded on the spirits in the state of Washington, we believe that our members are going to be able to buy spirits at a lower price, and that's what we do for a living.

Speaker 1

Okay, thank you. Looking at Gasoline, the Gasoline category, Richard, can you give us a sense of how, same story, gallons moved and how the profitability per gallon was?

Speaker 3

As you know, historically, in terms of the latter part of that question, profitability generally is better when prices are going down and worse when they're going up. Although in the last year, both of those extremes have come into the center a little bit more. Even when it's going up a little, we're making a little more than we used to, and when it's going down a little, we're making a lot more, but a little less than we used to. In terms of comp gallons, if I look at comp gallons over the last year, it was generally in the 10% plus range. I think in the most recent month or recent quarter, it was 6%, so still a positive.

Speaker 1

All right, good. Looking at how the consumer is behaving in this Christmas season, especially the transition from the first fiscal quarter into the holiday season, how do you judge their discretionary spending mood compared to where you'd like it to be or even last year?

Speaker 3

I think we, again, began this fall Christmas holiday season aggressive in terms of, you know, merchandising, but still scared about the world and the economy and the purchasing power. Again, I think we've generally done better than the consumer confidence indices would suggest. We're still not thrilled that we'd like it to be better. Overall, again, I think I can't tell you what it is beyond November, but, you know, through November, we were pretty pleased with the numbers.

Speaker 1

All right, thanks a lot, Richard.

Speaker 6

Your next question comes from the line of Sean Naughton with Piper Jaffray.

Speaker 4

Yeah, thanks for taking my questions. This is actually Mark Sinova in for Sean. Just a couple of quick questions. First, I wonder if you can just comment on anything you're seeing with the consumer right now, you know, both negative and positive as far as, you know, trading down, trading up, increases that you're seeing in private label sales or anything like that. Secondly, also as it relates to Asia overall, wondering what you feel the opportunity is there if it's up since last time you commented on it. I think in Japan, you said that you believe you could probably have around 49, 50 stores there at full penetration. I wonder if you're seeing anything currently in that market that might cause you to opt that. Thank you.

Speaker 3

Sure. I apologize. What was the first question again? I was writing down the second question.

Speaker 4

Oh, yeah, absolutely. Anything positive or negative you're seeing in the consumer right now, as far as trading up, trading down in brands or products?

Speaker 3

Yeah, in terms of trading up and down, we probably don't see as much of that as other types of retail, whether it's lower-end discounters or general discounters and others, partly because we don't allow us to do it. I mean, we try not to trade down merchandise in terms of what we're presenting. We're still trying to upsize, up quality merchandise. Certainly, nothing like we saw after late 2008. In the first half of 2009, I remember we saw trading down in patio furniture and trading down in some of the meat items and things like that. We're not seeing any of that right now. In terms of increasing penetration of private label, again, that's more evolutionary than revolutionary right now. I would say in the first six months of 2009, it was more revolutionary.

I think anecdotally, I mentioned back then, and again, that was right after the financial crisis of late 2008. In the first six months of 2009, we saw up to 300 basis point increase in sales penetration of private label on the food and sundry side of our business, which is 60% of our business. That's unprecedented. Normally, in a given year, you might see 50 to 100 basis point improvement as we add items and so forth. I'd say it's more in the evolutionary path right now. We're keep coming out with new stuff, and we will expect to see that grow. When Jim has been asked in the recent past about that, if it's currently, the private label is currently in the low 20s, kind of a goal over the next however many years, not two or three, but not 10 or 12.

We'd like to see it in the low 30s, but that's going to take time.

Speaker 4

Great. As far as your opportunity in Asia.

Speaker 3

Oh, yeah, Asia, you know, look, we're doing more than we did a year ago, and that was more than we did two years ago. I think the 49 number you looked at in Japan goes back to when we had like five units in Japan instead of the 12 we'll have by the end of this week, or the 11 that we'll have by the end of this week. I think the 49 was based on, I think I remember saying back then, who knows what the heck it's going to be if we continue to be successful, certainly, and how do we do 49 instead of 50, I'll never know.

At the end of the day, if you look at both the population and the retail economy of Japan compared to Canada, where we have 85 units or so, it could be a lot more than 49, but right now, opening four this year is a lot more than one or two. We've got more in the pipeline, so we'll just keep going north. I can't predict what it'll ultimately be. I know in Taiwan and Korea, if you go back five years ago on those kind of templated slides, where will we be, what's the potential of the market? I think in each of those countries, we had five to seven units, and we said one day we might have 15. More recently, in the last year, I've seen that slide that says, you know, a potential of 25 each. Again, it's the numbers increasing.

It's still going to be slow. It's not like we're going to see us open 20 units in year three hence from now.

Speaker 4

All right, thank you and best of luck.

Speaker 6

Your next question comes from the line of Peter Benedict with Baird.

Speaker 4

Hey, Richard. Quick question. Have you seen any change in the pace of new member signups, either Gold Star or Executive, since you guys raised, I guess, the fee on November 1 for new members?

Speaker 3

No. It's really been a non-issue so far, recognizing the big question is what are renewers going to do, not what a new person coming in the warehouse is going to do, starting November 1.

Speaker 4

Right.

Speaker 3

Even when it was originally announced in the press release, in talking to our Head of Marketing and Membership yesterday, he basically indicated that it's in the low, very, very low hundreds of even comments in blogs and Twitter and Facebook things, and 90% of them are positive. Anecdotally, like, are you kidding? I say that every week when I get gas. Or, are you kidding? I say that every week when I get flowers. I think our members are our best defenders of the fact that it's not been an issue. We'll give you more color on that in a quarter and two quarters from now when we've got three and six months of renewers under our belt.

Speaker 4

Okay, great. Did you give us the average price per gallon of gas in the first quarter? That's the number we'd like if you have it. Thanks.

Speaker 3

It's up 26%. In Q1, it was 352. In Q1 a year ago, it was 279.

Speaker 4

All right, great. Thanks so much.

Speaker 6

Your next question comes from the line of Greg Melich with Evercore ISI.

Speaker 4

Hi, thanks, Richard. I want to follow up a little bit on the gross margin. If I caught it right, you said that non-food was actually up slightly a little bit. I was curious, was that category or mix or what areas was that occurring?

Speaker 3

It was more in hard lines and soft lines. I don't think, I don't know off the top of my head. I haven't looked at the sub-detail, Greg.

Speaker 4

Okay, maybe the other way is that all that pressure you did see there, the six basis points, since it was all on the food side, I imagine the cadence through the quarter was that it would be more towards the end. Is that true? Given that it's a holiday kind of focus and your quarter ended the 20th, remind us of how your holiday sales tend to play out. I imagine the weekend before Thanksgiving is a pretty big one for you, but if you could remind us on that, that would be helpful.

Speaker 3

A lot of it was not just seasonal. I mean, it was seasonal fall as well. I mean, if you recall, even in Q4 year over year, kind of the core was up only two basis points net of gas inflation, which was less than it was in Q3. In Q3 and Q2 going back year over year, it was much more positive. I think it's trended a little bit. I wouldn't suggest that the last month was much more of an impact than the first month, other than sales penetration of the last month, but not in terms of percentages. Maybe a little, but not much.

Speaker 4

And what.

Speaker 3

I don't have all the color on that in front of me.

Speaker 4

Okay, just going back to the first part of the question on the non-food side of it, was there any impact from the runoff of some of the Apple product that you were recycling? I guess I know you got rid of them around this time last year.

Speaker 3

No, we finally anniversary the sales hit to that, so that's a small help going forward. I wouldn't see, you know, probably a big chunk of our Apple sales were iTunes cards, which had a decent margin. Probably on the iPods, it was a little lower than average margin, but not meaningful. Not a meaningful delta to impact our numbers.

Speaker 4

That shift wouldn't have changed it. Okay, great. Thanks.

Speaker 3

I don't think so. Yep.

Speaker 6

Your next question comes from the line of Christopher Horvers with JPMorgan.

Speaker 4

Good morning. It's actually Aaron for Chris. Can you maybe dive into the core SG&A margin rate, and do you see or do you expect the leverage point to improve throughout the rest of the year? How is healthcare costs impacting that as well?

Speaker 3

You know, healthcare is still, the dollars are still rising in the high singles, which is a little better than the low doubles in terms of dollars. Workers' comp has turned the other way a little bit, so it's hurting us a little more, although workers' comp in aggregate dollars is not nearly as big as all of healthcare.

Speaker 4

Of course.

Speaker 3

Again, core SG&A, the payroll was good, and I would hope and expect that to continue. One of the things that we emphasized in the last couple of quarters is overtime. As wonderful as we think we are sometimes in terms of efficiency of operations, by just focusing on it in the warehouses, we've cut thousands of hours of overtime. Time and a half is a lot more expensive than time. That's a piece of it. Nothing does more for you than a tough economy to make you focus on it. I don't know if it's going to get, if the inflection points or the threshold points based on sales comps have come down a little. I think it's come down compared to a few years ago, and I think we've got further to go.

As I mentioned to many of you, probably 30 plus of Craig's 40 plus years in retail have been in operations. Clearly, he is focused on that, and of course, he has a great merchant in Doug and the people under Doug on the merchandising side to worry about more merchandising things. I think Craig is very focused on the operation side of our business and driving costs. That being said, it ain't easy. If you look over the last eight quarters of what we've said, it generally has been towards payroll has trickled in a little better and probably a little bit better than better in the last couple of quarters.

Speaker 4

Great. Maybe just looking at gas prices, have receded a little here. Have you seen any negative impact at all on traffic trends?

Speaker 3

Our traffic remains at 4%. It's almost scary to us because, you know, we keep saying when it's going to subside a little bit, and it's just month after month, we're doing pretty well. As I mentioned, the gallonage comp in Q1 was 6. I don't have Q4 in front of me. I don't have the exact number. I bet you it was 8 to 11. I don't remember exactly. Let's call it 10. It's come down a little, but the overall frequency, and when we talk about that frequency number, that's front-end frequency, not gas. To the extent we got more people coming in to get gas, you know, a fraction of those people are coming into the warehouse.

Speaker 4

Great. Thanks and best of luck.

Speaker 3

Thank you.

Speaker 6

Your next question comes from the line of Colin McGranahan with Bernstein.

Speaker 4

Hey, Richard. First question, just on the other income. It was a big variance, and I think I understand the $8 million piece that is, you know, the hedge on merchandise purchasing, but help me understand the $15 million piece on cash a little bit. I mean, how much cash are you holding in Mexico? If the peso weakened versus the dollar over the course of the quarter, and certainly versus a year ago, why is that such a big benefit?

Speaker 3

That is exactly what happened. What happens is any company in any country, if they hold foreign currency, they have to mark to market at the end of the fiscal period. In Mexico, our strategy from time beginning, or for many years, has been, you know, not exactly, but to hold about half of their excess cash in dollars. That has basically been agreed to by the shareholders of Costco Mexico. Us, one half of that, and Comercial Mexicano, one half of that. Recognizing that the peso historically has been weaker and recognizing further that we end up buying a lot of U.S. goods. That is not to do with managing payables each month, but that has to do with on an ongoing basis. We buy goods that are payable in U.S. dollars.

When Costco Mexico, I think at year-end, in dollars, not how many dollars they held, but if you converted their entire cash into dollars, it was around $300 million. Let's say, and these are not exact numbers, but let's say half of that was being held in U.S. dollars, that would be $150 million. During Q1, the peso weakened quite a bit. I do not have the exact number, but it was 10% on $150 million. There is $15 million. Now, by the way, that has hit us and hurt us. Last year, in the same fiscal quarter, in Q1 of 2011, we had a $3 million hit. We did not talk about it because it is $3 million, and it is noise because there are lots of things in our P&L that go positive and negative.

The other thing that makes this line item stand out more than ever before, it was fiscal 2011 when we started to consolidate Mexico into our numbers rather than just having half of Mexico's income on this line. It is still a little convoluted, but again, this bigger volatility, it could easily.

Speaker 2

have been the other way if the pay stubs strengthened. I hope that I don't have to, in the future, every quarter, talk about another line item here, but because it was such a big amount. If I look at the last four fiscal quarters, just this particular item, it was about $9 million in Q1-12 to the positive. I'm sorry, about $11 million in Q1 to the positive. In Q4, it was not that big of a positive. In Q3, it was a $4 million loss, and in Q2, it was a $2 million loss. Historically, we really haven't talked about it, but this is the biggest it's ever been, and it really stood out.

Speaker 3

Okay, so it's the fact that you're holding U.S. dollars in Mexico. That is what you're marking to market, not pesos to dollars.

Speaker 2

Right, right, and then because Costco Mexico's P&L is recorded to have a gain based on its dollar holdings.

Speaker 3

Yep.

Speaker 2

Half of that gain is ours. Kind of silly, but.

Speaker 3

You're just marking to market over the course of the quarter, so if the peso stays where it is, it doesn't matter where it was a year ago.

Speaker 2

Exactly.

Speaker 3

We can't really predict this going forward other than watch the peso over the course of the quarter.

Speaker 2

Right.

Speaker 3

Okay.

Speaker 2

If you look at it, none of us know exactly where it's going to go, but if you look at what's happened, generally, there's been a couple of big jumps in the peso weakening versus the dollar on a long-term basis. By doing this, it's been a little bit of a benefit, but certainly not something you can count on.

Speaker 3

Okay, I may have missed it. Did you talk about E-commerce.com growth?

Speaker 2

Yeah, it was up 9% in the quarter. I think that's down from the low double digits in last year and in the fourth quarter. The only other big news there is we are looking, we're in the process of re-platforming Costco.com. That'll happen towards, you know, this, probably sometime in the second calendar quarter of next year. As I've shared with people, as they've asked, right now, our dot-com site, the search engines can't search on it, so if you just punch in Kirkland Signature into Google, you're going to be ways down before you see Costco.com. There are some simple things that we're doing there, and of course, we're looking to expand dot-com overseas, but that'll be not next Thursday, that'll be over the next two to three years.

Speaker 3

Okay, anything particular about the deceleration?

Speaker 2

No, you know, keep in mind we've taken a relatively slow approach to dot-com. I mean, we don't do a lot of marketing for it. We sell a lot of big-ticket items. We have less than 3,700 or 800 items on there, and I think, again, one of the big things is, since search engines can't search, you punch in "television" or something else, you know, Costco.com doesn't come up. You punch in "Kirkland Signature" and the first thing, I'm not going to tell you who, you all go do it now, but the first thing doesn't, Costco.com doesn't come up. That's because we have an old system that we, starting about eight months ago, began the process of investing to re-platform it.

Speaker 3

Okay, and then finally, I know we've kicked this around a bunch already, but on the little bit more aggressive pricing, it sounded like there was a little bit of a philosophy change, and obviously, this is the first quarter of core merchandise margins down that we've seen in a couple of years. What exactly did you see or feel that you said, now's the time to kind of get a little bit more aggressive on the margin?

Speaker 2

I don't think there was a great aha moment around here. It was more we've had good numbers, particularly doing well in overseas countries, and, as I've said many times over the years, Jim has been toughest when we're doing well, and that's a good thing. It keeps us reminded that we got to where we are because we're tough on pricing, and let's make sure we continue to do that. I'm trying to walk the line between not, we don't view it as big of an issue other than it's certainly part of the issue, and I felt obligated to let you know that certainly part of the margin issue is it, but it's not this giant mindset change in terms of what we want to do.

Speaker 3

Okay, that's fair. I'll slip one last one in here. Are there any additional political contributions we should know about going forward?

Speaker 2

No, absolutely not.

Speaker 3

Okay, fair enough.

Speaker 6

Your next question comes from the line of Mark Miller with William Blair.

Speaker 0

Hi, good morning. Follow-up on e-commerce, you know, your growth here is tracking out similar to your overall business, ex gas, whereas the consumer's obviously shifting faster to e-commerce. Do you think that re-platforming change will change the trend for you, or, Richard, what other changes might the team be thinking about? Specifically as it relates to shipping, we're seeing more retailers moving towards incentives in that area. Might that be something you'd also consider?

Speaker 2

are several things we're looking at, but again, I don't want to overemphasize that because keep in mind it's 2% of our, 2 or 3% of our, 2.5% of our business, and our goal is to get you in the store with the giant chickens and the gasoline and everything else, and great giant chickens, I might add. We are great merchants out there doing that. We recognize that this is a very profitable business. As a % of sales, it's more profitable than our whole company overall. We also want to stick to some of our disciplines. We recognize we continue to change a little bit, and we'll continue to do that. We don't want to go crazy and say, oh my God.

I do believe that some of the promotional stuff and free shipping stuff, which is catching everybody's attention, that hasn't helped us for sure, but I don't see us going to a free shipping now. Certainly, that has not really been talked about, other than how do we communicate to our members what our, we feel very open and honest about communicating what our all-in price is. If we keep having great value, and time and again, we have great value relative to all the other guys out there, we'll continue to drive that business. If it starts heading the other way, we'll figure out what we need to do to change that. We don't really see that other than, certainly, there's been a lot more cyber promotions out there right now that we're not prepared to do.

Speaker 0

Okay, and then just on the gross margin, there's a lot of puts and takes, but as we move through this fiscal year, you're going to come across some normalization, presumably, in this gas price impact on the margins. Would you think that later in the year, the company might be in a position to see rising gross margins again based on what you see today, or is the more aggressive pricing possibly offsetting that opportunity?

Speaker 2

Yeah, I'd love to give you my thoughts, but I can't really guide you there. In terms of just looking at inflation versus deflation in gas, you know, that's the $64,000 question. In Q1 a year ago, as I mentioned, the average selling price was $2.79. In Q2, the average selling price a year ago was $3.01. In Q3, it was $3.63. It was also $3.63 by coincidence in Q4. It actually went down a few cents in September, $3.58, $3.48 in October, and $3.44 in November. It actually is ever so slightly deflationary, but as compared to Q2, you know, if the price in November at $3.44 and the price in Q2 last year at $3.01, so that's $0.40, that's a 13% or 14% increase, not a 26% increase. It will be less of an impact, and all things being equal, it will finally pencil off, but who knows?

If it doesn't change the back half of this year, it will be very little impact.

Speaker 0

Okay, and then my last question is on the membership fee growth ex currency. How do you look at the trend here versus where you were through the back part of last year? We don't get exactly the membership fee revenues ex that currency. How do you look at that trend?

Speaker 2

When we look at it compared to our budget, we feel great. I mean, everything's, we're signing up new members, even in the U.S., net new members, which is a positive given, you know, as a % of, you know, openings as a % of total U.S. openings. We're seeing our renewal rates, you know, strengthen a little bit in the U.S., and they're only going down overseas simply because you've got a lot of new units that have lower first-year renewal rates. Assuming those trends continue, I think we feel very good about it.

Speaker 0

Great, thanks. Best of luck in the holidays here.

Speaker 6

Your next question comes from the line of Dan Bender with Jefferies.

Speaker 0

Hi, good morning. In the past, you, and still now, you've been sensitive to, you know, keeping the comps at a certain level. Your comparisons are going to start getting more difficult. You know, obviously, you had pretty good year this past calendar year. I'm just curious, as you lapse some of that, if you have any plans of doing incremental investment in either inventory or price to keep that level up?

Speaker 2

I'll let you know when we get there. Certainly, traditionally, those are the kinds of things we do, but we're not going to go crazy. Certainly, opening more units overseas helps your comps a little bit because they're starting off at a higher rate. It helps your sales growth a little bit, not your comps necessarily. As Jim Sinegal mentioned to us in the budget meeting last month, I think it was last month, he said, "Guys, it's no secret that this is what we do for a living." I don't want, I'm trying again to explain Q1, but not get people concerned that there's this big sea change out there, because there's not.

Speaker 0

Right. What about in terms of the online business? As you noted before, there's a lot of cyber promotions out there, but if you look outside of, you know, just around the Thanksgiving Day weekend, you've got a lot of retailers, both big box and pure online, that are enhancing their web offerings. Is there anything that you're doing other than the search changes that you talked about to, you know, stand out in the crowd a little bit more, whether it's adding more items to the site or offering more discounts or whatever?

Speaker 2

No, we want to, we know how, we have to recognize that the internet is different than brick and mortar. We also can't be too alarmist about what's going on out there. We're going to, we are doing a few more MVM, you know, multi-vendor mailers. There's some more couponing for just Costco.com. Other than that, I don't think we're doing a whole lot more.

Speaker 0

Okay, great, thanks.

Speaker 6

Your next question comes from the line of Simeon Gutman with Consumer Edge Research.

Speaker 2

Why don't we take two more questions?

Speaker 3

Can you hear me?

Speaker 4

Hello?

Speaker 3

Hello, this is Saye. Can you hear me? Sorry.

Speaker 4

Yes.

Speaker 3

Okay, can you just talk a little bit about private label in the quarter and what you experience and also how that flows through, if at all, to the gross margins?

Speaker 2

Private label is up slightly. Generally speaking, looking at the past few years, private label penetration has been up anywhere from 50 to 100 basis points year over year. Probably in a given quarter, you're not going to see that much of a dramatic change other than we're adding new items. The same thing with margins. I mean, the difference between a brand and a private label margin could be as much as 600 or 800 basis points and as little as 100 or 200 basis points. It's on an item-by-item basis. A lot of times, I use the example years ago when we went into a private label diaper. Because diapers are an item that is retail footballed all the time, it was an item that our realized gross margin across the country on $300 million of branded diapers was probably in the mid-single digits.

If we've shifted at a lower price point because private label is a lower price point, we've shifted to a price point in the low double digits. There you've got 500 plus basis points. I'm sure there are plenty of items where it's a lot less than that. Net-net, it's a positive.

Speaker 3

It's a positive overall.

Speaker 2

I would guess, yeah, did it move the needle in Q1? I don't know.

Speaker 3

Okay, all right, great. Thanks a lot.

Speaker 2

will take two more questions, and I think that'll be it.

Speaker 6

Your next question comes from the line of Joe Feldman with Chelsea Advisor Group. Joe, your line is open.

Speaker 2

Joe left. Next.

Speaker 6

Your next question comes from the line of Chuck Grom with Deutsche Bank.

Speaker 5

Hey, good morning.

Speaker 0

This is your Jeff.

Speaker 5

I was just hoping I could ask a question about if you expect any major operational changes with Mr. Sinegal's departure near term?

Speaker 2

Not really. Keep in mind, as in the press release, he's going to be around for the next year in a consulting capacity. Many of you know Jim, that's a big shadow there. He's going to spend a lot of time, no doubt, traveling and with Craig. We don't really see any sea changes out there, particularly. When Craig has been interviewed, even in the local newspaper, you know, his view is it's more of the same, focusing on value. If anything, I think since Craig 20 or so months ago became President, you know, he's elevated his game in terms of understanding what has gotten us to where we are in terms of that discipline of value. You know, you're going to see, you know, the DNA around here is pretty intact.

Speaker 5

Great, thanks. Just one follow-up. Just wondering if I could get a little bit more color. I know a lot of people have asked, but just about less leverage in the one-Q kind of versus Q despite the better core comp. Just if I could get a little more detail, I'd appreciate it. Thanks.

Speaker 2

I'm sorry, say that again.

Speaker 5

Trying to get a handle on a little bit less SG&A leverage in the first quarter versus the fourth quarter despite the better core comp.

Speaker 2

I can't, it's hard to pinpoint. There's hundreds of things going on, penetrations in different countries, year-end accruals that either way. We try to look at the big ones and let you know what they are. I can't necessarily put my finger on that exact, other than the trend has been good. If it was a little less in Q1 than Q4, so be it.

Speaker 5

Thank you.

Speaker 2

Okay.

Speaker 6

Your final question comes from the line of Robert Carroll with UBS.

Speaker 0

Hi, Richard. Just one quick last one on the pricing. Is there any link to be made with the timing of some of the mild pricing investments along with the membership fee increase? I mean, should we think about that as a way of almost investing in price in order to ensure continued high renewal rates for when the members see the increase?

Speaker 2

Look, money is fungible, whether it's pricing or membership and everything else. We're going to keep doing what we're doing. Clearly, it's not an exact direct link because fee increases in terms of when we earn them aren't starting really until January when we're getting the cash and, you know, into Q3 when we're getting something to book. I view those as independent.

Speaker 0

Okay, as you start to see the membership fee income ramp up as something that's recognized over the next couple of years, we shouldn't necessarily think about a curve on pricing investments following that?

Speaker 2

What I've read into some of the analysts out there, some of them assume, you know, the majority of it's going that way. Some of them assume the minority of it's going that way. We really can't predict that other than saying that, you know, as our numbers are good and we feel numbers for the company, not membership, but just as our earnings continue to progress and we feel strong about member loyalty and we look at the economy, we're going to continue to work to drive sales. This is just another, you know, arrow in the quiver. Thank you. I forgot that word.

Speaker 0

Great, thank you.

Speaker 2

Okay, thank you, everyone, and have a good day and holiday. Go shopping at Costco.

Speaker 6

This concludes today's first quarter fiscal year 2011 operating results conference call. You may now disconnect.