Costco Wholesale (COST) F1Q 2014 Results Earnings Call December 11, 2013 11:00 AM ET
Richard Galanti - CFO
John Heinbockel - Guggenheim Securities
Paul Trussell - Deutsche Bank
Meredith Adler - Barclays Capital
Michael Montani - ISI Group
Matthew Fassler - Goldman Sachs
Jason DeRise - UBS
Chuck Cerankosky - Northcoast Research
Scott Mushkin - Wolfe Research
Charles Grom - Sterne Agee
Michael Exstein - Credit Suisse
Peter Benedict - Robert W. Baird
Budd Bugatch - Raymond James
Good morning. At this time, I would like to welcome everyone to the Q1 earnings conference call. [Operator Instructions] Thank you. I would now like to turn the conference over to Richard Galanti. Please go ahead sir.
Thank you, operator, and good morning to everyone. This morning’s press release reviews our first quarter earnings results for the 12 weeks ended November 24.
As with every conference call, I’ll start by stating that the discussions we are 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, for the quarter our reported earnings came in at $0.96 a share, compared to last year’s earnings per share of $0.95. Several items of note that impacted the year over year comparison. I’ll go through six items.
Membership fee increase, as I’ve been mentioning for the last many quarters, the fee increase that we did in the U.S. and Canada in late 2011 and early 2012, that benefited this first quarter earnings by about $8 million pretax, or $0.01 a share. That will be the tail end of the benefit of that increase showing in our numbers.
Interest expense was higher year over year in the first quarter by $14 million pretax or $0.02 a share. This of course related to last December’s $3.5 billion debt offering in conjunction with the $7 per share special dividend.
FX, in the first quarter the foreign currencies we operate in weakened versus the U.S. dollar, primarily in Canada and Japan. This resulted in our foreign earnings in the first quarter, when converted into U.S. dollars, being lower by about $14 million pretax or $0.02 a share than those earnings would have been, had FX exchange rates been flat year over year.
Gasoline profits, gas is a very good business for us. It drives frequency, we feel, and year over year it’s always profitable, although it tends to be volatile. And the first quarter that impacted earnings by a little over $0.02 a share.
Stock expense, that’s a line item that we have in our SG&A, it was higher year over year in the first quarter by a little over $0.02 a share as well. We have over 4,000 people, generally managers and buyers and above, who receive restricted stock units as a significant part of their annual compensation.
Such grants are made annually each October, or in our first fiscal quarter. These RSU grants then typically vest over a five-year period, with accelerated vesting when a recipient reaches 25, 30, and 35 years of employment with the company.
Now, factors driving this increase included a 24% increase year over year in our stock price on the dates in which the RSUs are granted each year, additional levels of accelerated vesting given many employees’ long tenure with the company, and a large number of employees in the plan.
I should note that this past October, our RSU grants were reduced by an average of around 15%. That is, the number of RSUs granted to each recipient. The increased expense occurred, of course, notwithstanding that reduction.
IT modernization, talk again about that. We’re in our probably second full year of a major modernization effort. And as discussed in the past several quarters, these efforts will continue to negatively impact our SG&A expense percentages throughout fiscal 2014 and probably a little beyond that, especially as the new systems are placed into service and depreciation begins. In the first quarter, on an incremental year over year basis, these costs impacted SG&A by about $12 million or about 3 basis points.
Turning to our sales for the first quarter, our 12-week reported comparable sales figures for the first quarter showed a 3% increase, 3% in the U.S. and 1% internationally. As indicated in our release, excluding a gas price deflation and the impact of FX, the 3% reported U.S. comp would have been 4% for the quarter. The 1% international would have been up 6%, and the over 3% for the company would have been plus 5% on a basis excluding gas deflation and FX.
Other topics of interest, opening activities and plans, we opened 13 locations during the first quarter of fiscal 2014, 9 throughout the U.S., 1 in Alberta, Canada, 1 in Monterey, Mexico, our third in that city, and 2 new units in Australia, bringing Australia now to 5 total units in operation.
During the fiscal quarter, one location was closed, in Acapulco, Mexico. This was due to the extensive damage that resulted from the severe flooding down there from Tropical Storm Manuel. That may or may not reopen this fiscal year, but most likely certainly in calendar ’14.
Since the end of the first quarter, we have opened in Q2 two new locations, one in Illinois and one in Canada, in Ontario. That gives us 15 new openings thus far in fiscal 2014. For the entire fiscal year, we have a current plan of 30 new locations, 16 of which are planned for the U.S., 4 in Australia, including the two we recently opened, 3 in Canada, 2 each in Korea, Japan, and Spain - and of course those would be our first two units in Spain - and one additional location in Mexico.
I’ll also discuss later in the call ecommerce activities, membership trends, and of course a discussion on the components of margin and SG&A.
Again, quarterly results, total sales were up 5% to $24.5 billion. On a comp basis, a reported 3, which again, excluding gas deflation and FX, was a 5 on a normalized basis. In terms of the 3% reported comp, that was a combination of an average transaction decrease of 2%, actually up almost 1% excluding deflation and FX, and an average frequency increase of just under 4.5% for the quarter.
In terms of sales comparisons geographically, for the first quarter, the better performing regions in the U.S. were in the Southeast, Midwest, and Texas. Internationally, in local currencies, the better performing countries were Canada, Mexico, and Australia.
In terms of merchandise categories for the quarter, for the first quarter, within food and sundries, candy, deli, and refrigerated were the relative standouts. Hardlines was probably the most challenging category. Majors came in negative for the quarter, challenging of course in televisions and in cameras. And better-performing departments within the hardlines were office and automotive, but slightly negative overall for the department.
Within the low double digit softlines positive comps, small electrics, apparel, and jewelry were the relative standouts. And within fresh foods, comps in the mid singles. Better performing departments included produce, meat, and deli.
Moving down the line items of the income statement, in the first quarter, membership fee income came in at $549 million or 2.24% of sales. That’s 7.3% or a $38 million increase versus the first quarter of last year, and as a percentage of sales, up 4 basis points. As I mentioned earlier, that did include the extra $8 million, the first time that incremental benefit from the fee increase we did almost two years ago.
In terms of membership, we continue to benefit from strong renewal rates. A little over 90% in Canada and the U.S., and just under 87% worldwide, continued increased penetration of the executive members, and of course the benefit I just mentioned, from the fee increase.
Our new membership signups in the first quarter companywide were up 17%. That’s of course due to the fact that we opened 13 units this year in the first quarter versus 9 a year ago, and this year’s first quarter included three international openings, which tend to have higher signups at opening.
In terms of number of members at Q1 end, Gold Star members came in at the end of the first quarter at 29.6 million, up from 28.9 million 12 weeks earlier, at the end of the fiscal year; Primary Business at 6.7 million, up from 6.6 million 12 weeks ago; Business Add On at 3.5 million each.
So, total total member households, which, at the end of the fiscal year had been at 39 million even, came in at the end of the first quarter at 39.8 million. So, all told, we have 72.5 million card holders out there at the end of the first quarter, from 71.2 million at fiscal year-end.
In terms of paid Executive members, they stood at 13.9 million of those totals, an increase of about 330,000 during the quarter, or a little over 27,000 new Executive members per week increase. They represent about 35% of our member base now, and over two-thirds of our sales.
In terms of renewal rates, as I mentioned, they’ve continued to be strong. Our total membership eked up a little bit from 90.0 at the end of fiscal year to 90.2 worldwide, and worldwide from an 86.3 to an 86.5.
Going down the gross margin line, our reported gross margins were up 13 basis points, up to 10.81%. As usual, I’ll ask you to jot down four columns and six line items. Basically, the first two columns would be reported for the entire fiscal year of ’13, and then the second column would be also for the entire year fiscal ’13, but without gas. And then for the first quarter, columns three and four would be reported and then without gas deflation.
Going down the lines, the core merchandise year over year, ancillary businesses, 2% Reward, LIFO, other, and total. So again, going across, core merchandising for the fiscal year, fiscal ’13 versus fiscal ’12 was lower by 4 basis points in both of those columns. Ancillary businesses was better in the fiscal ’13, plus 6, in both of those columns. 2% Reward, minus 2 in both columns. LIFO, plus 5 basis points in both columns. Other, plus 2 in both columns. That was a nonrecurring legal settlement, which benefited our margins last year. And the total fiscal ’13 over fiscal ’12 was up 7 basis points, both on a reported basis and without gas.
For the first quarter, merchandise core reported was up 12, but without gas deflation up 3. Ancillary, up 5, but without gas, plus 2. 2% Reward, minus 3 and minus 2. LIFO, minus 1 and minus 1. Other, zero and zero. So again, total reported for the first quarter year over year and the first quarter was 13 basis points up, but taking out gas, deflation was up 2 basis points.
Now, the core margin, in terms of core merchandising the component gross margin being up again 12, but 3 excluding gas. Both food and sundries and hardline subcategories were up in basis points year over year, while softlines was down slightly year over year and fresh foods had lower year over year gross margins as well.
Ancillary business gross margins were up, as I mentioned, 2 basis points without gas. Ecommerce, business centers, and pharmacy also showed higher margins year over year, offsetting slightly lower gas margins.
Our 2% Reward, again increasing sales penetration in that, and therefore increasing Executive member rewards, caused a 2 basis point year over year reduction in margin, due to the reward program. And LIFO, last year in the quarter we had a $2 million LIFO credit. This year, there was a very small LIFO charge of about $1 million, so about a 1 basis point swing year over year.
Moving on to SG&A, our SG&A percentage in the first quarter was higher or worse by 17 basis points, coming in at 10.22% this year in the first quarter, compared to 10.05% last year in the first quarter. Again, we’ll do the same four columns, reported for all of fiscal ’13 and then without gas, and then columns three and four reported for the first quarter year over year and then without gas for the first quarter year over year.
In terms of operations, in the fiscal year both columns are the same, columns one and two, zero and zero for operations; central, zero and zero; RSUs, or stock compensation, minus 3 and minus 3; quarterly adjustment, plus 2 and plus 2, for a total in fiscal ’13 SG&A was higher by 1 basis point or minus 1 year over year.
Columns three and four, operations on a reported basis was 9 basis points of that 17, minus 9. Without gas, zero. Central, minus 3 and minus 2. Stock or RSU compensation, minus 5 and minus 5. No quarterly adjustments. And then again total minus 17 or 17 basis points higher year over year in the first quarter. And again, without gas, minus 7.
Now, core operations, again, was flat, excluding the impact of gas deflation. Within operations, our payroll SG&A percentage was actually 2 basis points better year over year, while benefits, workers comp, and related expenses were about 4 basis points worse year over year. So those are the two big factors within SG&A [unintelligible].
Central expense was higher year over year, 2 basis points without gas, again primarily related to the increased IT spending as we continue our modernization efforts. This, as I said, will continue to be a drag on SG&A, especially as the new systems are placed into service and depreciation begins.
And finally, SG&A expense related to stock compensation, as I mentioned earlier, I won’t go through the detail again, was 5 basis points year over year.
In terms of preopening, $6 million higher, coming in at $24 million in the first quarter. Last year, in the first quarter, we had nine openings. As I mentioned, we had 13 opening this year, so no real surprises there.
All told, reported operating income in the first quarter totaled $639 million last year and was up to $668 million this year, an increase of $29 million. And I won’t go through the items I mentioned earlier.
Below the operating income line, reported interest expense was higher versus last year, coming in at $27 million, up $14 million from last year’s $13 million in the quarter. That’s essentially the $3.5 billion debt offering we did and the interest expense associated with that. We did that, I believe, in mid-December, so there will be a little bit of a year over year negative impact in Q2, and then there will be no delta year over year.
Interest income and other was lower by $2 million in the quarter, coming in last year at $20 million, and this year at $18 million. Actual interest income component was slightly up, while the other component was slightly down, nothing of size to mention.
Overall, pretax income was up from $646 million last year in the first quarter to $659 this year. Below pretax, our effective tax rate this quarter came in at 34.6%, or about 0.2% better or lower than last year’s rate of 34.8%. I think most of it relates to the various discrete items that impact each year, and so a little bit of an improvement there.
Overall, net income was up $416 million last year to $425 million this year in the first quarter.
Quick rundown of other topics. Our balance sheet, of course, is included in today’s press release. In terms of depreciation and amortization for the first quarter, it was $231 million. One of the metrics we always talk about is our accounts payable as a percent of inventory. On a reported basis, last year it was 108%. This year, in the first quarter, it was 99%.
Now, both of those numbers include quite a bit of non-merchandise payables, particularly as we ramp up expansion, so construction payables, if you will. If you just look at merchandise accounts payable to inventories, last year’s 108 was a 94, and this year’s 99 was an 89. I’ll talk about that in a moment, why that came down a little.
Average inventory per warehouse last year in the first quarter was $13.2 million. This year, in the first quarter, it was up $1.2 million to $14.5 million, or up about 9%. Both of those AP ratios and the higher inventories is, for the most part, because of how Thanksgiving fell one week later in the calendar this year. So the first week of Q2 versus last year it was the last week of Q1. Much of that excess has since been burned off, and talking to the senior merchants, their view is no issues with inventory levels going into the last few weeks, before calendar year end.
In terms of capex, for the quarter it was $572 million. Capex is estimated to be about $2.4 billion this year, compared to $2.1 billion last year, the higher year over year spend, of course, due to the increased level of planned openings.
In terms of dividends, our quarterly dividend remained at $0.31 a share or $1.24 on an annualized basis. Based on shares outstanding, that’s about a $540 million annual expenditure.
Costco Online, we’re now in four countries, U.S., Canada, U.K., and most recently Mexico. Mexico ecommerce commenced operations in late October. For the first quarter, sales and profits were up over last year. Q1 ecommerce sales were up 24%. And excluding, again, the relative recent smaller startups in the U.K. and Mexico, U.S. and Canada, the quarter was up 22%.
And ecommerce still is a relatively small part of our company, running about 2.5% of our total sales. We’ve got a variety of initiatives in that area. We’re always asked those questions, so I’ll point out a couple of things. Of course, a year and a half ago, we replatformed the site, and shortly thereafter, added mobile apps.
We’ve combined, in the last year, some ecommerce merchandising efforts, within line efforts. We think that’s given us a better merchandise capability there. We’ve added a few categories, most particularly apparel, some apparel items. And we’ve done, I think, a better job of improving the timing of shipments by expanding the various shipping points, getting merchandise more quickly to our members.
In terms of expansion, last year we opened 26 units and started fiscal ’13 a quarter ago at 608 units and ended at 634. So it was up a lot of 4% square footage growth. This year, assuming we get to the 30 net units, on a base of 634 that would round up to about 5% square footage growth. Now, again, if we get to 30, and we expect to, 16 in the U.S., 4 in Australia, 3 in Canada, 2 each in Korea, Japan, and Spain, and one in Mexico.
Square footage at Q1 end totaled 92,654,000 square feet.
With that, I’ll turn it back to the operator for Q&A, and I’ll put myself on speaker phone here.
Earnings Call Part 2: