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COST > SEC Filings for COST > Form 10-Q on 20-Mar-2013All Recent SEC Filings

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Form 10-Q for COSTCO WHOLESALE CORP /NEW


20-Mar-2013

Quarterly Report


Item 2-Management's Discussion and Analysis of Financial Condition and Results
of Operations (dollars in millions, except per share, membership fee data, and warehouse number data)

FORWARD-LOOKING STATEMENTS

Certain statements contained in this Report constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. They include statements that address activities, events, conditions or developments that we expect or anticipate may occur in the future and may relate to such matters as sales growth, increases in comparable store sales, cannibalization of existing locations by new openings, price or fee changes, earnings performance, earnings per share, stock-based compensation expense, warehouse openings and closures, the effect of adopting certain accounting standards, future financial reporting, financing, margins, return on invested capital, strategic direction, expense controls, membership renewal rates, shopping frequency, litigation impact and the demand for our products and services. Forward-looking statements may also be identified by the words "believe," "project," "expect," "anticipate," "estimate," "intend," "strategy," "future," "opportunity," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," and similar expressions. Such forward-looking statements involve risks and uncertainties that may cause actual events, results, or performance to differ materially from those indicated by such statements. These risks and uncertainties include, but are not limited to, domestic and international economic conditions, including exchange rates, the effects of competition and regulation, uncertainties in the financial markets, consumer and small business spending patterns and debt levels, conditions affecting the acquisition, development, ownership or use of real estate, actions of vendors, rising costs associated with employees (including health care costs), energy and certain commodities, geopolitical conditions, and other risks identified from time to time in the Company's public statements and reports filed with the SEC. Forward-looking statements speak only as of the date they are made, and we do not undertake to update these forward-looking statements, except as required by law.

This management discussion should be read in conjunction with the management discussion included in our fiscal 2012 annual report on Form 10-K, previously filed with the SEC.

OVERVIEW

We operate membership warehouses based on the concept that offering our members low prices on a limited selection of nationally branded and select private-label products in a wide range of merchandise categories will produce high sales volumes and rapid inventory turnover. This turnover, when combined with the operating efficiencies achieved by volume purchasing, efficient distribution and reduced handling of merchandise in no-frills, self-service warehouse facilities, enables us to operate profitably at significantly lower gross margins than traditional wholesalers, mass merchandisers, supermarkets, and supercenters.

We believe that the most important driver of increasing our profitability is sales growth, particularly comparable sales growth (we report comparable sales as sales in warehouses open for at least one year, including relocations, remodels, and expansions). Comparable sales growth is achieved through increasing the frequency with which our members shop and the amounts that they spend on each visit. Sales comparisons can also be particularly influenced by two factors that are beyond our control, including fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations) and changes in the cost of gasoline and associated competitive conditions (primarily impacting domestic operations). The higher our comparable sales exclusive of currency fluctuations, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial


Table of Contents

Item 2-Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued) (dollars in millions, except per share, membership fee data, and warehouse number data)

factor in sales growth is the health of the economies in which we do business, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, including a wide range of global, national and regional wholesalers and retailers, including supermarkets, supercenter stores, and department and specialty stores, gasoline stations, and internet-based retailers. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items. Our philosophy is not to focus in the short term on maximizing prices that our members can be charged, but to maintain what we believe is a perception among our members of our "pricing authority" - consistently providing the most competitive values. This may cause us, for example, to absorb increases in merchandise costs at certain times rather than immediately passing them along to our members, negatively impacting gross margin.

We also achieve sales growth by opening new warehouses and, to a much lesser extent, relocating existing warehouses to larger and better-located facilities. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. However, the negative aspects of such growth, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are lessened. Our rate of square footage growth is higher in foreign markets, due to the smaller base in those markets, and we expect that to continue.

Our financial performance also depends heavily on our ability to control costs. While we believe that we have achieved successes in this area historically, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize the wages and benefits that they earn. Rather, we believe that achieving our longer-term objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce. This may cause us, for example, to absorb costs that other employers might seek to pass through to their workforces. Because our business is operated on very low margins, modest changes in various items in the income statement, particularly gross margin and selling, general and administrative expenses, can have substantial impacts on net income.

Our operating model is generally the same across our U.S., Canada, and Other International operating segments (see Part I, Item 1, Note 10 of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefit costs as a percentage of country sales, and/or less direct membership warehouse competition. Additionally, we operate our lower-margin gasoline business only in the United States and Canada.

In discussions of our consolidated operating results, we refer to the impact of changes in foreign currencies relative to the U.S. dollar, which are references to the differences between the foreign-exchange rates we use to convert the financial results of our international operations from local currencies into U.S. dollars for financial reporting purposes. This impact of foreign-exchange rate changes is typically calculated as the difference between the current period's currency exchange rates and the comparable prior-year period's currency exchange rates.

Historically (prior to the July 2012 acquisition of the 50% noncontrolling interest), our operations in Mexico were through a 50% owned joint venture (Mexico). For the twelve and twenty-four weeks ended Februay 12, 2012, the financial position and results of Mexico's operations are fully consolidated


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Item 2-Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued) (dollars in millions, except per share, membership fee data, and warehouse number data)

and the joint venture partner's share is included in "net income attributable to noncontrolling interests". In July 2012, we acquired the remaining 50% interest in Mexico from our joint venture partner, and therefore, have included 100% of Mexico's operations within "net income attributable to Costco" for the twelve and twenty-four weeks ended February 17, 2013.

Our fiscal year ends on the Sunday closest to August 31. References to the second quarters of 2013 and 2012 relate to the twelve-week fiscal quarters ended February 17, 2013, and February 12, 2012, respectively. References to the first half of 2013 and 2012 relate to the twenty-four weeks ended February 17, 2013, and February 12, 2012, respectively. Certain percentages presented are calculated using actual results prior to rounding. Unless otherwise noted, references to net income relate to net income attributable to Costco.

Key items for the second quarter of 2013 as compared to the second quarter of 2012 include:

Net sales increased 8% to $24,343, driven by a 5% increase in comparable sales and sales at the 24 net new warehouses opened since the end of the second quarter of fiscal 2012. Net sales were favorably impacted by the strengthening of certain foreign currencies against the U.S dollar;

Membership fees increased 15% to $528, primarily due to the impact of raising our annual membership fees, and new membership sign-ups and higher membership renewal rates at warehouses open for more than one year;

Gross margin (net sales less merchandise costs) as a percentage of net sales increased six basis points;

Selling, general and administrative (SG&A) expenses as a percentage of net sales increased two basis points;

Net income increased 39% to $547, or $1.24 per diluted share, compared to $394, or $0.90 per diluted share. The current quarter results were positively impacted by a $62 tax benefit, or $0.14 per diluted share, in connection with the special cash dividend paid by the Company in December 2012 to the Company 401(k) Plan participants;

On November 28, 2012, our Board of Directors declared a special cash dividend of $7.00 per share. On December 18, 2012, approximately $3,049 was paid in connection with this dividend. Additionally, on December 7, 2012, we issued $3,500 in aggregate principal amount of Senior Notes; and

On January 24, 2013, our Board of Directors declared a quarterly cash dividend in the amount of $0.275 per share, which was paid subsequent to the end of the second quarter.


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Item 2-Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued) (dollars in millions, except per share, membership fee data, and warehouse number data)

RESULTS OF OPERATIONS

Net Sales



                                         12 Weeks Ended                                  24 Weeks Ended
                              February 17,            February 12,            February 17,            February 12,
                                  2013                    2012                    2013                    2012
Net sales                    $       24,343          $       22,508          $       47,547          $       43,689
Increases in net
sales:
U.S.                                      7 %                     9 %                     8 %                    10 %
International                            11 %                    13 %                    12 %                    14 %

Total Company                             8 %                    10 %                     9 %                    11 %

Increases in
comparable warehouse
sales:
U.S.                                      5 %                     8 %                     6 %                     9 %
International                             6 %                     8 %                     7 %                     9 %

Total Company                             5 %                     8 %                     6 %                     9 %

Increases in
comparable warehouse
sales excluding the
impact of gasoline
price inflation and
foreign currencies:
U.S.                                      5 %                     7 %                     6 %                     7 %
International                             4 %                    10 %                     5 %                    10 %

Total Company                             5 %                     7 %                     5 %                     7 %

Net Sales

Net sales increased $1,835 or 8%, and $3,858 or 9% in the second quarter and first half of 2013, respectively. These increases were attributable to an increase in comparable warehouse sales and sales at the 24 net new warehouses opened since the end of the second quarter of fiscal 2012.

Changes in foreign currencies relative to the U.S. dollar positively impacted net sales during the second quarter and first half of 2013 by approximately $131, or 58 basis points, and $248, or 57 basis points, respectively. The positive impact in the second quarter and first half of 2013 was primarily due to the exchange rate of the Canadian dollar. Gasoline price inflation positively impacted net sales by approximately $146, or 33 basis points, during the first half of 2013, due to a 3% increase in the average sales price per gallon.

Comparable Sales

Comparable sales increased 5% and 6% in the second quarter and first half of 2013, respectively, and were positively impacted by increases in both shopping frequency and the average amount spent by our members. Changes in foreign currencies relative to the U.S. dollar during the second quarter and first half of 2013 as well as gasoline price inflation in the first half of 2013 positively impacted comparable sales results. The increase in comparable sales includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations) primarily in our Other International segment due to increased warehouse openings in Asia.


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Item 2-Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued) (dollars in millions, except per share, membership fee data, and warehouse number data)

Membership Fees



                                          12 Weeks Ended                                  24 Weeks Ended
                               February 17,            February 12,            February 17,            February 12,
                                   2013                    2012                    2013                    2012
Membership fees               $          528          $          459          $        1,039          $          906
Membership fees as a
percent of net sales                    2.17 %                  2.04 %                  2.18 %                  2.07 %
Total cardholders
(000's)                               69,100                  65,700                  69,100                  65,700

Membership fee revenue increased 15% in both the second quarter and first half of 2013. These increases were due to the impact of raising our annual membership fees, new membership sign-ups and higher membership renewal rates at warehouses open for more than one year, and new warehouses opened since the end of the second quarter of fiscal 2012. For the second quarter of 2013, our member renewal rates have increased slightly relative to the second quarter of 2012, currently at approximately 89.8% in the U.S. and Canada, and approximately 86.5% on a worldwide basis.

As previously reported, we increased our annual membership fee in the U.S. and Canada effective November 1, 2011, for new members, and January 1, 2012, for renewal members. We account for membership fee revenue, net of estimated refunds, on a deferred basis, whereby revenue is recognized ratably over the one-year membership period. These fee increases had a positive impact on membership fee revenues of approximately $35 and $65 in the second quarter and first half of 2013, respectively, and will continue to have a significant impact through the fourth quarter of fiscal 2013.

Gross Margin



                                         12 Weeks Ended                                  24 Weeks Ended
                              February 17,            February 12,            February 17,            February 12,
                                  2013                    2012                    2013                    2012
Net sales                    $       24,343          $       22,508          $       47,547          $       43,689
Less merchandise costs               21,766                  20,139                  42,492                  39,070

Gross margin                 $        2,577          $        2,369          $        5,055          $        4,619
Gross margin as a
percent of net sales                  10.59 %                 10.53 %                 10.63 %                 10.57 %

Gross margin as a percentage of net sales increased six basis points compared to the second quarter of 2012. Gross margin in our core merchandise categories (food and sundries, hardlines, softlines, and fresh foods) when expressed as a percentage of net sales was unchanged over the prior year. Gross margin for core merchandise categories, when expressed as a percent of core merchandise (rather than net) sales, increased eight basis points. This was primarily due to increases in hardlines and softlines partially offset by a decrease in fresh foods. The gross margin comparison was positively impacted by five basis points due to a $9 LIFO benefit in the second quarter 2013 compared to a charge of $3 in the prior year. Increased penetration of the Executive Membership 2% reward program negatively impacted gross margin by one basis point, due to increased spending by Executive Members. Warehouse ancillary and other business gross margin increased by two basis points. Changes in foreign currencies relative to the U.S. dollar positively impacted gross margin by $13 in the second quarter of 2013.

Gross margin on a geographic segment basis, when expressed as a percentage of the segments own sales (gross margin percentage), increased in our U.S. operations as compared to the second quarter of 2012 due to the LIFO benefit discussed above and improvements in hardlines and softlines. The gross margin percentage in our Canadian operations decreased due to our continued investment in merchandise pricing, primarily in fresh foods. The gross margin percentage in our Other International operations was unchanged.


Table of Contents

Item 2-Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued) (dollars in millions, except per share, membership fee data, and warehouse number data)

Gross margin as a percentage of net sales increased six basis points compared to the first half of 2012. Our core merchandise categories gross margin when expressed as a percentage of net sales decreased four basis points, due to decreases in food and sundries and fresh foods margins. Gross margin for core merchandise categories when expressed as a percent of core merchandise (rather than net) sales, increased three basis points for the first half of 2013. This was primarily due to an increase in hardlines partially offset by a decrease in fresh foods. The gross margin comparison was positively impacted by three basis points due to an $11 LIFO benefit in the first half of 2013 compared to a charge of $3 in the prior year. Increased penetration of the Executive Membership 2% reward program negatively impacted gross margin by one basis point due to increased spending by Executive Members. Warehouse ancillary and other businesses gross margin increased eight basis points in the first half of 2013. Changes in foreign currencies relative to the U.S. dollar positively impacted gross margin by approximately $26 in the first half of 2013.

The gross margin percentage in our U.S. operations increased as compared to the first half of 2012 due to the LIFO benefit discussed above. The gross margin percentage in our Canadian operations increased in our warehouse ancillary and other businesses. The gross margin percentage in our Other International operations increased, primarily in our food and sundries category.

Selling, General and Administrative Expenses



                                         12 Weeks Ended                                24 Weeks Ended
                              February 17,           February 12,           February 17,           February 12,
                                  2013                   2012                   2013                   2012
SG&A expenses                 $       2,361          $       2,178          $       4,693          $       4,322
SG&A expense as a
percent of net sales                   9.70 %                 9.68 %                 9.87 %                 9.89 %

SG&A expenses as a percentage of net sales increased two basis points compared to the second quarter of 2012. Our warehouse operating costs as a percentage of net sales remained unchanged from the prior year. Leveraging of payroll costs as a result of increased net sales was offset by increases in employee benefits, predominately healthcare and workers' compensation expenses. Additionally, higher stock compensation expense increased our SG&A percentage by two basis points. Changes in foreign currencies relative to the U.S. dollar increased our SG&A expenses by approximately $9 in the second quarter of 2013.

SG&A expenses as a percentage of net sales decreased two basis points compared to the first half of 2012. This improvement was partially due to contributions made to an initiative reforming alcohol beverage laws in Washington State in the first quarter of 2012, with no comparable charge in 2013, which resulted in a positive impact of four basis points. In addition, our warehouse operating costs improved four basis points largely due to leveraging of our payroll costs as a result of increased net sales which was partially offset by increased workers' compensation expense. The overall warehouse operating cost improvements were offset by higher stock compensation expense and higher central operating costs, predominately related to the continuing modernization of our information systems and related activities, which increased our SG&A percentage by three basis points each. Changes in foreign currencies relative to the U.S. dollar increased our SG&A expenses by approximately $19 in the first half of 2013.


Table of Contents

Item 2-Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued) (dollars in millions, except per share, membership fee data, and warehouse number data)

Preopening Expenses



                                           12 Weeks Ended                                  24 Weeks Ended
                               February 17,             February 12,           February 17,             February 12,
                                   2013                     2012                   2013                     2012
Preopening expenses            $           6            $           6          $          24           $            16
Warehouse openings,
including relocations                      5                        2                     14                         6

Preopening expenses include costs for startup operations related to new warehouses and the expansion of ancillary operations at existing warehouses. Preopening expenses vary due to the number of warehouse openings, the timing of the opening relative to our quarter end, whether the warehouse is owned or leased, and whether the opening is in an existing, new, or international market.

Interest Expense



                                           12 Weeks Ended                                   24 Weeks Ended
                               February 17,             February 12,            February 17,             February 12,
                                   2013                     2012                    2013                     2012

Interest expense $ 25 $ 27 $ 38 $ 54

Interest expense in the second quarter and first half of 2013 primarily relates to our $1,100 of 5.5% Senior Notes issued in fiscal 2007, and our $3,500 of Senior Notes issued in December 2012. In the second quarter and first half of 2012 interest expense also included interest related to our $900 of 5.3% Senior Notes issued in fiscal 2007, which were paid off in March 2012.

Interest Income and Other, Net



                                           12 Weeks Ended                                   24 Weeks Ended
                               February 17,             February 12,            February 17,             February 12,
                                   2013                     2012                    2013                     2012
Interest income                $          10           $            11          $          20           $            22
Foreign-currency
transactions gains
(losses), net                             13                        (3 )                   21                        20
Other, net                                 3                         2                      5                         5

Interest income and
other, net                     $          26           $            10          $          46           $            47

The increase in foreign-currency transactions gains and losses, net in the second quarter was attributable to favorable mark-to-market adjustments related to forward foreign exchange contracts entered into by our foreign subsidiaries as the U.S. dollar strengthened during the second quarter 2013 compared to a weaker U.S. dollar during the same period in the prior year. See Derivatives and Foreign Currency sections in Part I, Item 1, Note 1 of this Report.

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