Costco Wholesale Earnings Call Nuggets: Gross Margins and Price Investments

Costco Wholesale Corporation (NASDAQ:COST) reported its second quarter earnings and discussed the following topics in its earnings conference call. Here’s what executives had to say.

Gross Margins

Deborah Weinswig – Citi: As we look out for the rest of fiscal ’12 and you start to cycle much easier gross margin compares, how should we think about gross margins for the rest of the year especially as one of your competitor is talking about very aggressive price investments?

Richard A. Galanti – EVP and CFO: Well, I think, needless to say I can’t give you any guidance since we don’t guide, but clearly, I think our message has been that we continue to invest in price and I think we do it more than talk about it frankly, and so we will continue to do that, but that’s what we do. I think the other message that we have tried to convey over the last couple of quarters and we will continue to do so is, while there is certainly a lot of tough competitors out there, this is us, not them in terms of what we do for a living, and we are not, in our view while we – every day, every competitor responds to one another, but overall we are responding to ourselves here more than anything.

Deborah Weinswig – Citi: Okay. Then can you talk about anything you’re doing in terms of improving productivity on the floor?

Richard A. Galanti – EVP and CFO: Well, I mean, it is a never-ending battle. I mean, we’re constantly are working to speed the frontend line, whether it is redoing the software for a credit and debit, pruning out all the things that all of us do out there. You know, this last year I know one focus – these are all anecdotal, has been in operations, and again, I think this is where Craig has put a lot of effort into given his operations background. Operators have put a focus on overtime hours. You are always going to have overtime hours, whether it’s because of weather, people didn’t come in because they were sick or a holiday where you misjudged something, whatever it is our physical inventories, but that being said with a focus on and I think that that’s the key word focus. We saw just in couple of quarters a few million dollars just by having fewer actual hours and so saying those hours even if they were still worked, those hours worked as regular hours rather than overtime hours. That extra half was a reduction. So those are the types of things we’re doing. I think we still get a lot of benefit from – again what I talked about over the last couple year’s sustainability. Again it’s not all us it’s everybody, it’s the vendors, we are all working through this end, but it’s taking grams of resin out of water bottles and packaging into square containers instead of round and making liquid everything detergents and the like more concentrated. All those things are having, I think real benefits to all of us. I think we do a good job of managing healthcare and workers compared, and relative to – in our view relative what our third party providers tell us they are seeing elsewhere, but it’s a lot of blocking and tackling and trying to not do things that we’re doing, that we don’t need to be doing. So in the last three or four years our active SKU count has come down from 4,100, 4,100 plus down the 3,800, 3,750. That again was our doing a conscious effort to say, the top 200 items out of roughly 4,000 are 35% to 40% of sales, you can imagine what the bottom 200 are and every time we can take a palate or some something out that doesn’t make sense. You are always going to have some slow things, because it makes sense for the small business owner and the restaurant owner whoever it might be, but if every time you could take a product out in mass quantity – mass out something, some existing item bigger, you’re going to have more productivity, so all those things that we do I think – for those of you who have followed us for many years, I feel that we have continued do little things that have helped us and we already helped by what’s happened in the economy and trying to be more efficient, but there is one big thing.

Deborah Weinswig – Citi: Lastly, I’d say this earnings season, we’ve heard a lot about volume declines. Can you talk about maybe what’s happening with the national brands and then maybe also with Kirkland Signature?

Richard A. Galanti – EVP and CFO: The first part of the question I heard the question, but what was the first part you said.

Deborah Weinswig – Citi: We’ve heard a lot about volume declines throughout the quarter on (HBN CPG) side, so could you maybe talk about what’s happening national brands versus private label?

Richard A. Galanti – EVP and CFO: Sub department wise we haven’t seen any of that kind of issue in general. You see the constant pressures on what we call media and one-hour photo, but in terms of we’ve seen continued increase in the penetration of private label even within existing private label items recognizing the bigger part of that increase in my view tends to be where we continue to add items. In the last year, year and a half we’ve continued ad some canned good item – canned vegetables, canned fruits and the like. We’ve got that great peanut – peanut butter pretzel that I love, so there’s lot of things out there that we’re doing, but we’ve not seen any giant change as it relates to the kind of impact we saw in the first half calendar ’09 right after the financial crisis. I think in a given year, we probably see 0.75% increase in penetration, maybe half, maybe 1, but I remember in that six months we saw 2 to 3 percentage points just in six months, and again, that was again people focusing on figuring out how to save money. I think one of the things that we continue to see impactful is, is when we introduce the private label item, it not only drives penetration to that item which generally is a little bit – is a better margin, but also gets the brand to choose and the emphasis is to be more competitive because they are losing market share, so it’s a win-win for us and our numbers.

Price Investments

Charles Grom – Deutsche Bank: Just on the price investments that you’re doing, I’m just curious, are the number of SKUs increasing each month that you’re lowering prices on or is it the same basket of products each month? I guess the second follow-up would be, how you’re guys measuring the success of those price investments, are you seeing a big increase in unit velocity when you do the price investments?

Richard A. Galanti – EVP and CFO: We are not the most formal when it comes to trying to analyze, did it work or not. I remember years – when we had rapid inflation in middle of ’08 and we lowered the price of our chicken – at the end of ’08 when we saw comps going towards zero and I gave you examples I think over a four week period we had about $32 million of actual markdowns on a little bit number of highly visible items, and one of them was the rotisserie chicken that had gone from $4.99 to $5.99 and we brought it back to $4.99. Well, as we put a dollar divided by six by the $5.99 that was darn close in my view to the margin, the entire margin, so no matter how many more chickens you sold, it didn’t help margin, it hurt it. So, we’re merchants at heart and we drive – we attempt to drive the top line. I’ll give you another anecdotal example, last August or so in Canada, where historically the soda and hot dogs was at C$1.99. Well, many years ago, the Canadian dollar was about $0.65 on the U.S. dollar. Well, in one fell swoop, Jim said take it down to C$1.50. Now, that’s just because that’s the right thing to do. Clearly, that impacted the bottom line negatively, but I got to tell you, in a country where they have had a good economy and there is a lot of talk about inflation up there, we got national attention of being the only game in town that is lowering the price anything. So, we saw increases in traffic and certainly increases at food court as well. So, that’s what we do, and we feel good about the quarter in that we are getting our improvement from expense leverage and buying back a little stock and the like, and certainly the membership fee as that improves and the deferred accounting that helps you, but we feel good about you know what we do with pricing and we will continue to do it, but we have always shown that we – when we need a little margin over time, we figure out ways to do it and do it the right way.

Charles Grom – Deutsche Bank: All right and then could you just provide me – in late 2008, when you did do the price investments, did it last for more than a few quarters or was it longer than that?

Richard A. Galanti – EVP and CFO: Well, that was a – that was more of what I’d called back then the perfect storm. You know, again, we are heading towards zero and we wanted to go into Christmas in early January with some – driving it, and whether that was the reason as comps did turnaround a little bit then. You know, this is more that – we feel that we are strong. We have got a lot of good things going on. We are always reminded by Jim and now by Craig, let’s not get too ahead of ourselves in terms of our success, and let’s keep driving that top line. So, again, I can’t give you guidance, it’s going to be for another six weeks or another 25 weeks, but we don’t worry about it honestly and not because we’re cavalier, because we know that we have the ability to continue to drive sales and if we need a little margin over time we feel we can get it.

Charles Grom – Deutsche Bank: Got you. Okay. Then just I was a little surprised only 145 million of buyback in the quarter given the cash balance. I mean, I know you got the $900 million tranche coming due in a couple of weeks. But what are the Boards thoughts on accelerating the buyback here, clearly trying to open up more than 20 to 25 stores a year has been challenging because of delays and your cash position is only going to continue to grow. What are you guys going to, I mean what’s the priority here?

Richard A. Galanti – EVP and CFO: The Board, every quarter talks about it. You say what we do, they are certainly knowledgeable of and comfortable with. Part of it has to with the strength in our stock price and we kind of look at it on a periodically update it with kind of matrix pricing buying more as the stock goes down and less as it goes up a little bit and then adjust that upward over time as the stock has gone up. There are number of weeks in which you – quarter were, again on a given daily basis rebottle less, but we feel comfortable we’ll continue to look at it. I don’t want to judge what we, I and the Board will consider and do. We recognize that we have a high-quality challenge with cash. I, you have heard it before, but I still mean it. I am confident that we will continue to increase our expansion and some of that expansion is going to be more expensive given the international rate of expansion. Overtime all things being equal I would guess we would increase it, but again we’re not going to feel pressured to do it this Thursday or next week, but you’ll continue to see us buy stock back and the Board is supportive of that.

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