May 31, 2007
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Executives
Richard A. Galanti - Chief Financial Officer, Executive Vice President
Analysts
Deborah Weinswig - Citigroup Chuck Grom - J.P. Morgan Adrianne Shapira - Goldman Sachs Gregory Melich - Morgan Stanley Christine Augustine - Bear Stearns Bob Drbul - Lehman Brothers Dan Binder - Buckingham Research Todd Slater - Lazard Capital Markets Peter Benedict - Wachovia Securities Dan Geiman - McAdams, Wright & Ragen Mitchell Kaiser - Piper Jaffray Stacy Pak - Prudential
Operator
Good morning. My name is Laurie and I will be your conference operator.
At this time, I would like to welcome everyone to the Costco third quarter earnings conference call. (Operator Instructions) I will now turn the call over to Richard Galanti, Chief Financial Officer.
Please go ahead, sir.
Richard A. Galanti
Thank you, Laurie and good morning. As with every conference call, I will 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 our 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 third quarter ’07 operating results for the 12 weeks ended May 13th, for the quarter as you know we came in with a reported $0.49 a share, compared to last year’s third quarter $0.49 a share.
As outlined in this morning’s press release, excluding the additional sales return reserve adjustment and the associated reduction in gross margin on the sales adjustment taken in Q3, earnings per share would have been $0.56, representing a 14% increase above last year’s $0.49 figure. This compares to our March 8th guidance of $0.52 to $0.56 and current first call of $0.56.
Please recall also that our March 8th guidance included an estimated $0.02 per share hit in Q3 related to the change we made at the beginning of this fiscal year to our method of allocating during the fiscal year certain payroll related expenses, such as FICA taxes. As you will recall, this change, while a zero effect to the entire fiscal year, helped Q1 by $0.01, actually hurt Q2 by a very small amount, and also hit Q3 not by $0.02 but a little under $0.01, and not the $0.02 per share hit that we had originally budgeted or estimated.
Again, it’s a zero sum gain for the year. It will be no affect on the company but in terms of comparing it to last year.
In terms of sales for the quarter, our 12-week comparable sales figure showed an increase of 7%. We will report, of course, our four-week month of May next Thursday, June 7th.
Other topics of interest or review, our opening activities, we opened a total of six new locations during the third quarter of the year, which ended 2.5 weeks ago. Five new in the U.S.
and one in Canada, such that fiscal year-to-date, we’ve opened 23 total units, including one in Mexico, so 22 net new units in terms of what we consolidate into our numbers during the first 36 weeks of the year. We have eight additional openings planned in Q4, all net new units, before our September 2nd fiscal year-end, so for the year it looks like we’ll be at 30 net new locations in ’07, or 31 including the Mexico site.
In the last several weeks, a couple of the units had actually slipped out of August into the first quarter of ’08, so we have a fairly expansive upcoming fiscal year ’08, which I’ll talk about later. I will also review today the normal things, ancillary business results, online results, membership trends.
I’ll certainly speak about the returns policy that was put into place in the U.S. between mid-February and early April, update you on recent stock purchases, go through your balance sheet, and provide you a little updated direction and guidance for the upcoming quarter.
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Operator
(Operator Instructions) Your first question comes from the line of Mark [Melakowski]. Mr.
Melakowski, your line is open. Your next question comes from the line of Deborah Weinswig.
Deborah Weinswig - Citigroup
Good morning. Some of the office product superstores have said that they are seeing a slowdown in the small business customers.
Can you elaborate on any issues you might be seeing in your business, or if you think that it might be just specific to those retailers?
Richard A. Galanti
Well, so far I’m hopeful it’s just specific to other retailers. We haven’t seen any dramatic change in our mix between wholesale and business customer, and again our comps in the last quarter have actually been a little better than they had been in the first-half of the year, so at this point the answer is no, we haven’t seen any impact.
Deborah Weinswig - Citigroup
And then can you also discuss and maybe provide some color on the Martha Stewart exclusive, and the gross margin policy around exclusives? As well, should we expect to see more exclusives in addition to private label continuing to grow?
Richard A. Galanti
First of all, I think it got a little more press than one would expect relative to -- from our side to start with, simply because they indicated an announcement of inking a deal. The deal was I think one or two days old when that was announced, but it was in line with their quarterly numbers.
We’re excited about it. We’ve done other what I’ll call co-branded opportunities with Newman’s Own and Quaker and Starbucks and others.
We are thrilled to be able to do this and together we will develop some products on the food side. There’s really not a lot to say other than that.
At this point, we are in the process of doing that. In terms of margin policy, our margin policy for all products is 14 on branded and 15 -- no more than 14 on branded and 15 on private label.
This would be in the private label category as a co-branded item but it doesn’t mean that everything will be 15. Some of that of course is based on competition, some of it is based on certain pricing points.
My guess is having a co-branded item does lend it to have at least a fair margin, which some other retailers would argue that 15 is unfairly low. We look at that as on the high-end of fair.
Again, there is nothing specific to that item that will be any different, other than the fact that sometimes we can get a little closer to our own fairness, if you will, by having a co-branded item.
Deborah Weinswig - Citigroup
Okay, and then when you are giving us the percentage of items that are private label, would you include your exclusives in there as well?
Richard A. Galanti
I would include our co-branded, yes.
Deborah Weinswig - Citigroup
And then last question, obviously you discussed in the last quarter call and alluded to it here as well on the fresh food side, can you just talk about what you think is happening with that business? Is there any change in terms of competition, et cetera?
Richard A. Galanti
It is still a good business. I think for several years, we were enjoying mid-teen comps in that business as just -- every quarter, it was like clockwork.
It is still generally every quarter stronger than the company’s comp. I think this quarter it was in the high singles.
So it is still an important part of our business and expanding. As important, not only is it a profitable business unto itself at a good margin, it is also a business that we think distinguishes us from others in terms of the quality, and we continue to roll out new items in that area.
So I would expect to see its comp, if you will, at least that’s our plan, for it to grow at a rate faster than the rest of the company in part because we continue to find new things to expand into in that wide category. Now, in terms of competition, probably the toughest component of it, which is half of fresh foods, is meat because we are competing not only with our other two warehouse clubs, but every supermarket and specialty supermarket out there and as you well know, every week their ad’s in the paper.
Not that all meat is the same quality. It’s all healthy and good but there is of course, good, select and choice, and when you see our presentation I think it tends to be at the upper end.
But nonetheless, even at the upper end our direct competitors, most importantly Sam’s as well as the large supermarket chains, tend to be very competitive whether it is ground beef or steaks.
Deborah Weinswig - Citigroup
Great. Thanks so much.
Operator
Your next question comes from the line of Charles Grom.
Chuck Grom - J.P. Morgan
Thanks. Good morning.
Can you speak to the cadence of TV returns during the quarter, and if you saw a spike during the February 26th to April 1st period? And then, also what you guys learned when you went back and studied the historical data a little bit more on kind of the pattern of returns or the aging of returns.
Richard A. Galanti
First of all, in terms of -- we actually expected a little spike, simply because sometimes you -- even though we didn’t make any formal announcement over the change in policy, it was out there pretty quick. Looking at some local newspapers around the country, one headline that I remember that I like the most was “You better bring everything back now because things are changing” when in fact that’s not the case.
Everything purchased prior is grandfathered in. According to Jim, he said he saw a little spike in the first couple of weeks.
Less than expected and we’ve actually, just in terms of looking at actual returns in a given week versus sales that week as kind of an ongoing percentage, we have seen a very slight dip in that number in the last month. But that inarguably should not relate to the return policy change because very little, if you think about it, if today is May 31st, the earliest change we made in mid-February, so mid-February to mid-April, mid-May, we’re only 75 days.
The most impacted item purchased is 75 or 80 days old. It can’t be -- it’s still -- anything out there that’s bring-backable is still bring-backable, if you will.
Returnable I guess is a better word. So in that regard, I can’t explain why this month is a little different, other than maybe people think hey, they’ve got this new return policy, I can’t bring it back.
So really that’s going to be more impactful over the next 12 to 18 months, I think. In terms of what we saw differently, keep in mind again historically, it was a fairly -- a more simplistic approach that didn’t delve down to the item.
When we were doing our analysis initially earlier this year, making decisions on what we were going to do in terms of changing the return policy, we had IT drill it down to the item. Now, think about it -- even though they are computers and they are fast, it literally was a time cruncher and a massive eater of computer time, because literally we took every returned item and I tried to identify when it was returned -- I’m sorry, when it was originally bought.
When we first started that, because o the time crunch, we literally had to look at the item and then look at all the previous sales from that member, identified member, virtually all cases -- most cases you had the identification of that member -- and then lag that. We originally started with data that was mid-05 to mid-06 data, because we could look back further there.
Given the time crunch, we looked back over the course of the year and then extrapolated the last 10% or 12% of the return dollars, because most of it is in that first year. With that indicated, needless to say, at Q2 end was a big change in what we had historically booked.
That’s what we booked and we booked to those numbers. Unfortunately, in accounting you have to book to data.
Needless to say, these are estimate but we booked what we felt was the correct estimate. Now, what changed during the next 10 to 12 weeks?
During the next 10 to 12 weeks, we completed that study -- not only completing it in terms of going back beyond a year but completing it in terms of looking at all data from the middle of ’06 to the end of Q306. Well, two things happened; the tail on that last 15% or so which we extrapolated over the course of a year and beyond looking backwards, had a longer tail on it than we anticipated, than we estimated.
Secondly, lag data, even for the current 12 months looking backwards, so what was returned today looking back over the last 12 months, people in the last five quarters compared to the previous five quarters, so Q205 to ’06 versus Q306 to Q307, are taking longer to return things. Why, I can’t tell you but those things together added up to a big chunk.
Now, why didn’t we know that? When you have a big chunk in front of you and you are looking at it and it is based on literally millions of items returned that are only a year-and-a-half old, and it was so bigger than the previous estimate, you figure that’s got to be correct.
But more importantly, that original data, the first churn of that major study which we completed literally after Q2 end a few days before Q2 reporting, under accounting rules we had no choice, correctly so, to book according to what our best estimate was. We did so.
During the next 10 to 12 weeks, we completed that. That’s what it is.
Now, one of the questions I was asked is does this have any impact into the return policy change? It has a very miniscule impact on that simply because of the that that as of Q3 end, there are some purchases that have been made over the last 60 days that in the future won’t be returned because they will finally anniversary beyond their 90-day from when they were purchased.
But that is a very small amount and really any impact from that you’ll start to see on an increasing basis going forward.
Chuck Grom - J.P. Morgan
Okay, but just to clarify, you don’t expect anymore reserves to hit the P&L in the fourth quarter? You guys are done with the study?
Richard A. Galanti
Yes, we are done with the study. We feel it is robust, it is granular and I don’t want to have to go back to anyone.
In all seriousness, it was a study that we took on close to a year ago. We began it.
Our first real date -- earlier this year, rather, earlier this fiscal year -- and our real first data came out just a few days before reporting Q2 and we booked to it because that was our best data.
Chuck Grom - J.P. Morgan
Just switching gears, second question, could you provide some details on your decision to mail the multi-vendor coupon book over the past couple of months, and what the approach is going to be with the summer passport book? I know last year you kept it in-store.
Are you going to mail it this year?
Richard A. Galanti
We’re going to mail it. Last year we handed it out at the warehouse and the savings, of course, I think it was like $5 million to $7 million of mailing costs.
The cost is does it get into everybody’s hands, how many end up on the floor of the parking lot, and at the end of the day, the sales data in terms of the multiplier effect of how many more you sell of those items was about the same -- I mean, ever so slightly less but about the same, a rounding error. But we felt that -- the operators felt that they probably spent more time -- what you do is -- the thought was in the warehouse, they’d be sitting there and customers would take them.
Well, every time you walked in the warehouse, you had two employees standing there handing them out. We probably spent not $5 million to $7 million, but a chunk of that just on standing around handing them out and the other chunk on picking them up in the parking lot.
Chuck Grom - J.P. Morgan
And then just on the multi-vendor coupon book as well?
Richard A. Galanti
Yes. I don’t know if all those are mailed.
I think we do that both ways still, Chuck. Some of those multi-vendor mailers are done regionally, some are done nationally.
Chuck Grom - J.P. Morgan
All right, thanks. Good luck.
Operator
Your next question comes from the line of Adrianne Shapira.
Adrianne Shapira - Goldman Sachs
Thanks. Richard, we didn’t hear you call out anything, any impact related to margins due to gasoline.
Should we take away that there was none, and if not, how have you been better managing that situation?
Richard A. Galanti
The entire management is luck in the sense that we are subject to the competitive vagaries of the nearby gas stations. We have dipped our toe in the water ever so slightly in some hedges, like less than a few hundred thousand dollars worth of risk and impact for one month a couple of months ago, and in a low-margin business, actually even the thought of hedging has gotten a little wild because of the giant gyrations in gas, so we are not doing any of that.
Getting to your first question, there really was not a major impact quarter over quarter, so we’ve got our fingers crossed. Looking back now versus a few years ago, the negative weeks are a little less negative and the positive weeks are a little more positive but there’s still variations.
I think this quarter, everybody is worried about continuing rising gas prices, which in theory hurts us a little bit. We haven’t seen it yet in terms of the hurt but I’m not suggesting it’s a big, great profit yet either, so --
Adrianne Shapira - Goldman Sachs
Talking about geographical disparities, you talked about the Southeast being a little bit better but still at the lower end. Do you think that has anything related to the housing market and what’s going on in the Southeast?
Richard A. Galanti
Probably a little but it also probably has something to do with we’ve cannibalized there as well. We’ve opened some more units in Florida and Atlanta, and even in a couple of the lesser cities like the Carolinas, where we have lower volume units but opening a second unit.
Adrianne Shapira - Goldman Sachs
Okay, and then just lastly on the guidance, I just want to revisit that. If we look back on the last Q2 conference call, you had mentioned at that point, Q4, $0.84 was certainly within the range and the year had been $2.50 to $2.60.
It sounds as if sales are still holding up well. I’m just wondering why the change to the $0.81 to $0.83 for the quarter?
Richard A. Galanti
In fairness, I looked at our numbers and I look at where First call is and I’m going into an environment where I still want to be a little conservative. Recognizing that again, we are still going to feel the impact of electronics in Q4.
I can’t assume that we are going to have a 7% comp. I’m hopeful we can but I can’t assume that.
Again, I think there’s not a lot of change other than every month we do an upcoming rolling three months. Hold on one second.
I’m just kind of leaving it where it is. If you wanted to add or subtract a penny to both sides, you are welcome to but I think that the $0.83 First call number is probably a decent number.
I gave it a range from there down a little bit. I can certainly make the range $0.80 to $0.84 instead of $0.81 to $0.83 but again, it’s -- we’re two weeks in to a 16-week quarter.
We don’t know year-end -- there are year-end accruals which we try to be conservative on, like benefits and what have you. We could easily miss any of the two or three different accruals by a penny a share, while still managing things well, so we’ll have to wait and see until we get there.
Adrianne Shapira - Goldman Sachs
Thanks.
Richard A. Galanti
I’m just trying to be a little conservative.
Operator
Your next question comes from the line of Gregory Melich.
Gregory Melich - Morgan Stanley
Thanks. Two questions; one, could you just make sure I’m thinking about this right on the merchandise margins?
You said that of the 11 basis points decline that effectively electronics, which is close to 9% of sales, drove all that decline. Did I hear that right?
Richard A. Galanti
Yes. If I took that department out -- roughly 80% of our sales are the sum of food, sundries, hard lines, soft lines and fresh foods.
About 9% of the 100, so 9% within the 80%, is what I call majors. If I took majors out of the 80%, the rest of the 80% would have been up a little.
Gregory Melich - Morgan Stanley
Okay so really ex majors, which is electronics and other appliances --
Richard A. Galanti
I would have been up a couple of basis points.
Gregory Melich - Morgan Stanley
So you could say by an inference then, majors and other appliances had margins down close to 100 basis points.
Richard A. Galanti
Over.
Gregory Melich - Morgan Stanley
Over, okay. And then the second is --
Richard A. Galanti
All of that is what I call D&D -- the impact of returns and salvage and disposition of those items.
Gregory Melich - Morgan Stanley
But that’s because of the charge, that’s just --
Richard A. Galanti
No, the charge is kind of an inception to date balance as of Q3 end. Just looking in the quarter of what happened in the quarter, our year-over-year margin of electronics or majors is down over 100 and -- I don’t have that detail in front of me.
I think what -- gross margin for a given item is the sum of about eight line items. It’s the initial markup, its freight, its rebates, its incentive allowances, payment terms, 2% net 30, its D&D, which we call damage and destroyed when you salvage something.
So we add all that up, year over year our gross margin for department 24, which is about 9% or 10% of sales, majors, was down year over year -- hold on. It was down year over year by over 1.5%.
Gregory Melich - Morgan Stanley
And the bulk of that was through the returns and salvage?
Richard A. Galanti
What I call D&D was a like amount, down over 150 basis points. The actual initial markup of a good, you know, we buy it for X and we sell it for Y, that was slightly up -- very slightly but -- so it’s not a competitive issue.
It’s our return issue. Of course, that has been driving numbers for three years now on an increasing basis as we are seeing 50% and 60% increases in this category.
Gregory Melich - Morgan Stanley
My second question is in terms of CapEx; if it’s a little bit lower this year but you are going to be doing more openings next year, do you want to give us a number or should we just assume it is more than $1.5 billion, or is there something else we should put into that?
Richard A. Galanti
If you wanted to throw out a number, I would probably use $1.6 billion, $1.65 billion.
Gregory Melich - Morgan Stanley
Thanks.
Operator
Your next question comes from the line of Christine Augustine.
Christine Augustine - Bear Stearns
Thank you. Could you discuss what sort of sales trends you are seeing in your seasonal items that have been set in the clubs this spring?
Richard A. Galanti
Well, they’ve been good. If I look at the three standout categories within electronics, two of them were lawn and gardens and sporting goods, so seasonally patio furniture and plants and all those things.
Christine Augustine - Bear Stearns
Are there areas within either food and sundries or maybe in the fresh piece of the merchandise categories where you are seeing inflation? If so, what sort of categories are those?
Richard A. Galanti
Meat and -- hold on a second. I’ll look at our last month inflation categories -- gasoline course was up, that’s not food.
Blueberries were up 20%, shredded mozzarella up over 20%, chicken up 12% to 15%, coffee up 12% to 13%, both Uban and Folgers, and I’m sure other ones, too. This is just the top of the list in terms of --
Christine Augustine - Bear Stearns
Any dairy?
Richard A. Galanti
Any dairy -- butter, up high single digits; cheese, I mentioned the mozzarella, up 25%. Again, I’m sure there are other cheeses.
What I’m looking at is a list of the top 25 based on LIFO dollars, so it could be -- I’m sure there are other cheeses but they don’t reflect on this summary sheet.
Christine Augustine - Bear Stearns
Do you think at some point you’ll be more willing to discuss specifics with regard to gross margin initiatives?
Richard A. Galanti
After we get it. I say that -- the reality is, and I’m not trying to be cute.
I’m trying to, as many of you know, Jim’s the boss. Jim has talked with the buyers about what needs to be done to improve margins while remaining competitive and there are some initiatives underway.
Now, I’m not trying to be cute or coy, but we are really not prepared to talk about them.
Christine Augustine - Bear Stearns
Okay. Thank you.
Operator
Your next question comes from the line of Bob Drbul.
Bob Drbul - Lehman Brothers
Just one question for me; can you elaborate a little bit more in terms of what you think is happening in Canada with the pick-up that you saw?
Richard A. Galanti
I’ll ask and find out and let you know. I didn’t have a good explanation I know last time, and I’m sorry.
When it was down a little in the quarter on a local currency, but it really sprang back to life this quarter and ended up with a nice number. So I don’t have any specifics on that.
Bob Drbul - Lehman Brothers
And how about California? Can you maybe just give us some insight in terms of any trends you are seeing in California with the improvements there?
Richard A. Galanti
Again, California is one of those markets where we keep cannibalizing. We have the highest volume units and the most mature units, and if anything, if I look back over the last few years, California comps have always lagged a little, if you will.
If we were X, they were X minus a little, and that X minus a little, that gap got a little wider, generally speaking, over the last few years. In this quarter, it sprang back a little and I can’t explain it from an economist standpoint other than it is happening.
Bob Drbul - Lehman Brothers
Can you just elaborate on how you think we should think about D&A for this year and next year as well? It just seems to be a little lighter than I would have thought.
Richard A. Galanti
Depreciation?
Bob Drbul - Lehman Brothers
Yes, and amortization.
Richard A. Galanti
I think -- I don’t know exactly what we expect for the year now, but if it’s $40 million versus $50 million increase -- it’s really a function of when we open locations. If anything, per given location it should go up a little.
We haven’t changed our depreciable lives of items. The cost of a building and the cost of equipment has continued to go up a little every year, particularly in the last couple of years.
Again, for cash flow purposes, we simply use a rounded $50 million number because it is usually in the 40 to 50 range.
Bob Drbul - Lehman Brothers
Okay. Thank you.
Operator
Your next question comes from the line of Dan Binder.
Dan Binder - Buckingham Research
A couple of questions regarding the reserve. I was curious -- was there any part of the reserve that was taken as a one-time that would have normally been taken in the quarter in the operations numbers?
Richard A. Galanti
My guess is there is some. The question is over how many years do you go back.
Clearly with the impact that we see on -- if you look back to, as an example, I think I looked at some numbers back in -- if you look at the current nine months, the dollars returned every day represent a little over 50% of the dollars are electronics, so it’s only 9% or 10% of sales dollars and 50%-plus of return dollars. If you look over ’04 I believe I looked at, it was like 7% of sales and a third of the return dollars.
And my guess is the return dollars related to electronics have had ever higher disposition costs related to salvage, because you are talking about big ticket items that depreciate. I can’t -- it’s hard to go back and estimate what piece of it.
If you assume that the sales returns reserves at quarter ends, total company, inception to date, is around $600 million in sales and a little over $100 in margin and disposition costs, I can’t estimate how much of that relates to this year, last year, and the year before. My guess is certainly half of it or more relates to the last three years, so is it a penny or two a year?
It could be but there’s no way to know that. Recognizing if it were, it was something that was also in the prior year, some amount.
My guess is the delta year over year on a correct basis would have been a nominal increase but again, I’m not trying to skirt the issue. What we know it is now, we haven’t done the study as of each quarter end.
Dan Binder - Buckingham Research
I realize you don’t want to discuss a lot of the details behind the gross margin initiatives that you mentioned, but in terms of magnitude, is this a 20 basis points opportunity, 50, 100? I realize that would be very aggressive but --
Richard A. Galanti
It’s not -- it’s less than 100 but again we have to realize it first. My guess is it comes over a couple of years.
But there are things that buyers have changed and other components of our business have changed starting in the next few weeks that we are implementing. When I say starting in the next few weeks, that doesn’t mean you get the full impact for 10 weeks this quarter because it is a starting process.
Hopefully you are starting to get a full impact of something, or a better portion of an impact starting in next year.
Dan Binder - Buckingham Research
As a starting point, would 20 basis points over a couple of years seem reasonable?
Richard A. Galanti
I would go out on that limb.
Dan Binder - Buckingham Research
What’s that?
Richard A. Galanti
I’d go out on that limb.
Dan Binder - Buckingham Research
Okay, and then with regard to the extended warranties that you’ve put on electronics and the concierge service, how much would you say that’s costing you? Obviously you are going to gain something on the return side but you are spending a little bit more to get -- I’m assuming you are spending a little bit more to get the extended warranties and obviously the concierge service.
What would you estimate that’s costing you?
Richard A. Galanti
We’re not disclosing it but we are booking something now for that -- well, the cost of concierge service we’re booking now. The cost of the second year warranty, we’ll booking based on estimates from some outside people in this business.
But that’s included in the cost of sales for that department going forward.
Dan Binder - Buckingham Research
Okay, and then a final question relating to coupons. There seems to be a little bit more use of coupons as you get a greater share of vendor support in the last several months.
I’m curious; as you think about this quarter versus this quarter last year, would you anticipate a significant benefit? I say significant meaning a point or more benefit from the way you are couponing versus last year?
Richard A. Galanti
I don’t think it’s a point or more. Is it more than a quarter of a point?
It could be in a given quarter but I would say it’s been an evolutionary change, not a revolutionary change over the last number of years. But looking at it in a give week, you could see a difference just based on something start or end a week early, but in a given quarter not 100 basis points.
No way.
Dan Binder - Buckingham Research
Great, thanks.
Operator
Your next question comes from the line of Todd Slater.
Todd Slater - Lazard Capital Markets
Thanks very much. I have an additional type of question on the reserve.
I didn’t understand entirely how the $100 million will get taken. Is it on electronics bought before the second quarter or third quarter going back all the way?
And then on forward purchases, how do you account for the extended warranties and the salvage costs? What do the gross margins look like in electronics going forward compared to let’s say the club average?
How is that changing?
Richard A. Galanti
Keep in mind, the total gross margin now in the electronics department is in the low single digits because of what has happened, the low to mid single digits, trending downward from a normal number, something in the 8 to 10 range perhaps three or four or five years ago to wherever it is today. In terms of how we account for the concierge service, that’s expensed monthly, whatever the costs are.
There’s some nominal -- so that number’s expensed. The warranty, every time we sell an item, a TV or a computer, we are booking a small amount on every computer based on expected warranty.
Keep in mind, even in electronics, stuff usually breaks quickly or a long time later, so the second year -- and this again, it is not -- it is warranty work, not return work. People can’t just bring it back to us.
They have to go through the warranty process and we’ll compensate the vendor or the vendor’s third part for that process. So we are reserving for that.
Now, how does the reserve get impacted? In theory, if you think about it, as of Q3 end, we looked at all prior quarter sales going back a couple of years and that very small amount less beyond the two years, but most of it is done over the first two years, and we looked at actual lag data going back over the last couple of years of actual returns and saw when those are coming back to estimate that as of Q3 end, if we were to close our doors today, what would come back using that same lag experience?
As we go forth each quarter, we will have new lag data for the upcoming three months. If you think about it, let’s take a year from now in the third quarter of ’08.
In that quarter, recognizing that a majority of your returns are done in one year, a greater majority are done in two years, a vast majority, that as we get further and further down the road, four years from now will you still have a TV returned that was purchased six years ago? Sure, there’s going to be one or two of those but what you will see is that lag data should change.
I’ll give you the extreme example that I’ve used. A year or so ago when the iPod with the movie screen came out.
That first week, we sold many thousands of units. That same week, we had returned about half as many of those thousands of units.
Maybe 100 of them were broken and the rest of them were just upgrading the one that you bought a year ago that was $10 more and didn’t have a movie screen. That is almost entirely eliminated because anything bought more than 90 days ago can’t be returned.
So that’s I think an extreme example but a good example of where you are going to see the lag data beyond 90 days for something goes to zero rather than has a tail out for a couple of years.
Todd Slater - Lazard Capital Markets
Okay, so looking at the low single digit, mid single digit margin range in the business now, that would be after the costs of let’s say the monthly concierge expense and the extended warranty?
Richard A. Galanti
In the last three months, we’ve had kind of the double whammy. You have the concierge service starting up.
It’s not a big number but it’s nonetheless a number that is an expense. You’ve got the returns from historical stuff, so you’ve got it hitting you right now.
Todd Slater - Lazard Capital Markets
Right but the returns of the historical stuff are now going to be covered by the reserve.
Richard A. Galanti
Only those things purchased after the policy went into effect.
Todd Slater - Lazard Capital Markets
Got it. So it’s not going to be -- none of the reserves on anything going forward.
Richard A. Galanti
Correct.
Todd Slater - Lazard Capital Markets
Okay, great. Thanks a lot.
I got it.
Richard A. Galanti
Hold on. Let me just clarify the reserves.
There’s what I’ll call a balance sheet reserve balance, which is this number that we have now, the $600 million of sales returns reserves and the roughly $100 million of margin related reserves and disposition related to that $600 million. That number is related to expected future returns on purchases that occurred between the last day of Q3 and prior.
As we go forward, that number should change and improve to the extent that that number has been abused by electronics. Unrelated to that, we are expensing every month the costs associated with the technical support call-in number.
We are also reserving on every new TV and computer where we’ve extended the warranty from whatever the normal one was, call it a year, to now two years, that what is the anticipated cost of fulfilling that warranty obligation through the manufacturer or the manufacturer’s third-party that does that work for them. We’ve talked to each of those manufacturers and again, this is when it’s broken.
When it’s under warranty, it is a normal manufacturer’s warranty. If your kid throws a baseball through it, it’s not covered.
Historically, if your kid threw a baseball through it, my guess is we would take it back, if somebody actually had the gall to do that.
Todd Slater - Lazard Capital Markets
Thank you.
Operator
Your next question comes from the line of Peter Benedict.
Peter Benedict - Wachovia Securities
Could you comment a little bit more about the outlook for your membership income growth? It did accelerate, as you said, in the third quarter to about 15%.
Should we expect another modest acceleration in the fourth quarter? And then does it start tapering off in ’08?
What can you tell us about that?
Richard A. Galanti
I think you will still see an increase year over year. It should start to taper off where -- keep in mind while the increase was effective in May, the real bulk of the increase was effective July 1st.
We started in store with new members charging the higher $5 May 1st. The July 1st is when the first renewal notices went out and needless to say, 87% of our members signing up roughly are renewing members.
So it’s really a July to July. I think we are still on a little bit of an up-tick through month 12 and then still showing an increase year over year but perhaps not as much from months 13 to 23.
Peter Benedict - Wachovia Securities
And then just a couple of modeling questions; can you give us what the option expense number was in the third quarter? And then, I might have missed this, the number of shares that you actually bought back in the third quarter?
Richard A. Galanti
I don’t think we give that number out, the detailed option expense number.
Peter Benedict - Wachovia Securities
Okay, well then the shares that you bought back?
Richard A. Galanti
Actually, it may be in the cash flow, so let me take a look. I don’t have it in front of me.
We haven’t finalized the cash flow yet.
Peter Benedict - Wachovia Securities
Okay, and then the number of shares you bought back in the third quarter?
Richard A. Galanti
The number of shares I can tell you. Hold on a second.
In the third quarter, we bought back 11.315 million shares.
Operator
Your next question comes from the line of Dan Geiman.
Dan Geiman - McAdams, Wright & Ragen
Good morning. Could you talk about the competitive environment?
Would you say that it eased during the quarter, or was it as strong as it has been, what you’ve seen over the past few quarters?
Richard A. Galanti
I think it has been as tough as it’s been. There is always a region where it gets a little easier, and as soon as somebody mentions it, it seems to go the other way, and I mean that.
If anything, probably in the last year, fresh foods like meat have been a little more competitive than I mentioned. Again, our ability to get a little more margin has to do also not just with initiatives but the private label impact, the co-branded impact, where we could set ourselves apart on certain quality items, whether it is high-end almonds and olive oil or some unique items in non-foods.
Dan Geiman - McAdams, Wright & Ragen
Okay, great.
Operator
Your next question comes from the line of Mitchell Kaiser.
Mitchell Kaiser - Piper Jaffray
Good morning. I was wondering, I know you are not going to give a lot of detail on the gross margin, but could you just talk about would one of the ways to expand margin maybe look at changing your philosophy on 14% branded and 15% private label?
And then, if you could help us, refresh us on how that policy was set?
Richard A. Galanti
I was just struck down by lightning. I think that would be something that I would still call sacrosanct.
The policy, if you go back to the beginning of time when Jim and Jeff wrote an original business plan and started out with here’s the footprint and here are the different areas and how that’s evolved, my guess is 15 was put into place as a cap on all items at least 15 years ago, maybe close to 20 years ago. It’s been a long time.
Probably about four years ago, maybe five is when the suggestion was made internally that on private label, recognizing we develop these items and whatever other reasoning we could come up with, the suggestion was made that perhaps on private label, recognizing that it’s a greater -- in every instance, it’s a much greater savings to the customer than the competing national brand, dollar savings, that we could cap it at 15 instead of 14, and Jim agreed. And so that didn’t mean that you got automatically 100 basis point extra on everything, because not all that was at 14 and not all of it went to 15.
You are still subject to competition and probably more importantly, you are subject to price points. I am making this up, but let’s say an item was out there at $14.99 and it happened to be at 14%.
Now that you went to 15, you are not going to go to 15, 14. You are going to stay at $14.99.
When you raise the cap on what is now 16% or 17% of sales, 17% of sales, when you raise the cap from 14 to 15, my guess is over the course of the next year or two you saw the margins for that basket of private label go up half that amount.
Mitchell Kaiser - Piper Jaffray
Okay, that’s helpful. So it’s not conceivable as you continue to push along with vendors and become a bigger portion of their mix, that maybe that could go up above 15?
Richard A. Galanti
Well, that won’t go up. To the extent we buy better, again if you go back 20 years ago, the unwritten theory was is that if you bought $1 better you give $0.90 or $1 back to the customer.
Now it is give most of it back to the customer. I’m not trying to be cute to say it’s 51% but I think the buyers have a little more flexibility, and recognizing even with our 14 and 15 cap, our margin is just under 11.
So there is still room in there. I think what we are recognizing is that none of us, whether it’s other clubs or other category diamond retailers, win this game playing the penny game on commodity items.
While we all play it and we all make lower margins on lots of commodity items, where you make it is on items where you can distinguish yourself, where items where in our view that we can sell more of because we are a higher end, we have a higher end customer; on specialty items and the food area, where we have been pretty creative of late and continue to be so; on private label, where you can get a little extra margin. So those are the types of things that are going to separate us.
Mitchell Kaiser - Piper Jaffray
Okay, fair enough and then just one last one, if you don’t mind; you mentioned the 7% the first couple of weeks of May. Would that be inclusive of FX and gas and cannibalization on those sorts of things?
Richard A. Galanti
I think I said a little under 7.
Mitchell Kaiser - Piper Jaffray
Okay, inclusive of those things?
Richard A. Galanti
Inclusive.
Mitchell Kaiser - Piper Jaffray
Thank you.
Operator
Your next question comes from the line of Stacy Pak.
Stacy Pak - Prudential
Just not to go too far out on a limb here but I just wanted to see; can you comment, with the magnitude -- how do you feel about 50 basis points over a couple of years? Just following up on that gross margin conversation you just had, is there anything on the efficiency side as well, or is it really all about getting a better margin on these areas where you can differentiate yourself?
Richard A. Galanti
I’ll take the last question first. We are always working on the efficiency things.
I don’t think there’s a lot built into there based on we are going to do something better tomorrow. We are always trying to do that.
Arguably, it’s not like there’s a lot of silver bullets out there that -- we’re not running a shabby show, so you always get some little improvements there but they tend to be little. I really hesitate to go any further out on a limb than the earlier comment because we have to wait and see where we come out.
I’m hopeful that as we get into the middle of ’08 and we start to hopefully see some improving trends, we could talk more about things.
Stacy Pak - Prudential
Thanks.
Operator
You have a follow-up question from the line of Charles Grom.
Chuck Grom - J.P. Morgan
Just to clarify your recent comment there, do you have a sense for how many of the 4,000 SKUs in your stores are actually at a 14% to 15% margin? Are there say 60% at 11% to 12% and that could be a way you could get there?
Richard A. Galanti
I have no idea off the top of my head. I bet a smaller percentage than that as the top of that.
Recognizing though you’ve got some items -- you’ve got tobacco, which is still, even though it’s been declining, it is still 5% or 6% of sales at a sub five. You’ve got I’m sure items like Coke and Pepsi that range from the 4 to 7 or 8 range, depending on who is footballing the item that week and what region.
You’ve got copy paper and things that are single digits, so it is not like there’s a bunch of -- there are probably some items that are closing in on the 14 but there’s ways to improve things.
Chuck Grom - J.P. Morgan
Thanks.
Richard A. Galanti
There are plenty of items out there.
Operator
At this time, there are no further questions. Mr.
Galanti, do you have any closing remarks?
Richard A. Galanti
No. Thank you and, as Bob and I said earlier today, we look forward to a quarter when it is about a half-a-page press release and nothing unusual.
Thank you very much, guys.
Operator
Thank you. That does conclude today’s Costco third quarter earnings conference call.
You may now disconnect.
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