Fresh Foods Boost Costco Margins

ELLIOT ZWIEBACH

Issaquah, Wash. — Costco Wholesale Corp. here said better operating procedures helped boost gross margins on fresh foods by approximately 0.5% during the fourth quarter ended Sept. 2, reversing a slight negative trend from earlier in the year.

Net income for the 16-week quarter rose 4.7% to $372.4 million, compared with the 17-week fourth quarter a year ago, while sales jumped 3% to $20.1 billion and comparable-warehouse sales increased 5%. For the 52-week year (compared with the prior year's 53 weeks), net income fell 1.9% to $1.08 billion, while sales rose 7% to $63.1 billion and comps were up 6%.

The company said the earnings decline was a result of several non-recurring non-cash charges related to revisions to the reserve for estimated sales returns after the company altered its returns policy; a charge associated with reducing adverse income tax consequences to employees; and a benefit primarily to merchandise costs for an excise tax refund on prior merchandise sales of phone cards.

However, earnings per share for the year were up because of the accretive nature of the company's stock buyback program.

Richard Galanti, executive vice president and chief financial officer, said average sales per location rose 2.4% to $130 million companywide ($132 million in the U.S.), compared with $127 million a year ago, with average transactions up about 3% and average frequency up about 2%.

Overall gross margins rose 38 basis points during the quarter to 10.74%, compared with 10.36% a year earlier.

TAKEN BY SURPRISE

Deborah Weinswig, an analyst with Citigroup Global Markets, New York, said she had anticipated a drop of one basis point rather than the increase. “Results were primarily driven by significantly better gross margin expansion, [and] Costco remains focused on implementing gross margin initiatives over the next couple of years,” she said.

Costco raised its gross margin outlook for fiscal 2008 by 20 basis points.

Galanti said the improvement in fresh foods margin did not result from any changes in pricing levels.

“If you look back at the last couple of quarters, there were some issues involving higher spoilage where a little too much [inventory] was brought in,” he explained. “When sales are just even by a couple of percentage points, you can get some extra spoilage, but we've been working on that, and we've improved some of the components — not the pricing but the components — of the margin, like spoilage.

“I think we picked up a few basis points on fresh foods margins simply because, after a couple of quarters of being down year-over-year, we were up [in the quarter]. And I think that is sustainable because of some anomalies in the second and third quarters that had nothing to do with pricing but simply [with figuring out how] we could do a better job just on operations.”

WASTE NOT, WANT NOT

In response to a question about the impact of inflation on fresh foods margins, Galanti said at least half of the 0.5% improvement resulted from “our own improvement in throwing away less.”

Asked whether Costco was able to pass through inflation more efficiently during the fourth quarter — as conventional supermarkets indicated they have done — Galanti replied, “I'm sure we can do as well as they do, recognizing we don't play exactly the same game.”

Galanti said Costco plans to boost capital spending in fiscal 2008 by approximately 25% — to between $1.7 billion and $1.8 billion, compared with $1.4 billion spent in 2007 — to open between 30 and 35 new locations, compared with 31 new units opened in 2007 (25 in the U.S., three in Canada and one each in the United Kingdom, Japan and Mexico).