Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations
(amounts in millions, except per share, share, and warehouse count 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, changes in comparable 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, capital spending, 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, and the demand for our products and services. Forward-looking statements may also be identified by the words “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “likely,” “plan,” “potential,” “predict,” “project,” “seek,” “should,” “target,” “will,” “would,” or similar expressions and the negatives of those terms. 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, breaches of security or privacy of member or business information, conditions affecting the acquisition, development, ownership or use of real estate, capital spending, actions of vendors, rising costs associated with employees (generally including health care costs), energy and certain commodities, geopolitical conditions (including tariffs), and other risks identified from time to time in our 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 statements, except as required by law.
This management discussion should be read in conjunction with the management discussion included in our fiscal 2019 Annual Report on Form 10-K, previously filed with the SEC.
OVERVIEW
We operate membership warehouses and e-commerce websites based on the concept that offering our members low prices on a limited selection of nationally branded and private-label products in a wide range of merchandise categories will produce high sales volumes and rapid inventory 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, these volumes and turnover enable us to operate profitably at significantly lower gross margins (net sales less merchandise costs) than most other retailers.
We believe that the most important driver of our profitability is sales growth, particularly comparable sales growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, and sales related to e-commerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: 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 our U.S. and Canadian operations). The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative (SG&A) 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 factor in sales growth is the health of the economies in which we do business, including the effects of inflation or deflation, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global,
national and regional wholesalers and retailers, including those with e-commerce operations. 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 merchandise mix, including increasing the penetration of our private-label items and through online offerings.
Our philosophy is to provide our members with quality goods and services at competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” on quality goods– consistently providing the most competitive values. Our investments in merchandise pricing may include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting gross margin as a percentage of net sales (gross margin percentage). We believe our gasoline business draws members, but it generally has a lower gross margin percentage relative to our non-gasoline business. It also has lower SG&A expenses as a percent of net sales compared to our non-gasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our near-term net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our SG&A expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. Additionally, actions in various countries, particularly China and the United States, have created uncertainty with respect to how tariffs will affect the costs of some of our merchandise. The degree of our exposure is dependent on (among other things) the type of goods, rates imposed, and timing of the tariffs. The impact to our net sales and gross margin will be influenced in part by our merchandising and pricing strategies in response to cost increases. While these potential impacts are uncertain, they could have an adverse impact on our results.
We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are continuing to decline in significance as they relate to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our e-commerce business growth, domestically and internationally, has also increased our sales but it generally has a lower gross margin percentage relative to our warehouse business.
The membership format is an integral part of our business and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase the penetration of our Executive members, and sustain high renewal rates materially influences our profitability. Our paid membership growth rate may be adversely impacted when warehouse openings occur in existing markets as compared to new markets.
Our financial performance depends heavily on controlling costs. While we believe that we have achieved successes in this area, some significant costs are partially outside our control, particularly health care and utility expenses. With respect to the compensation of our employees, our philosophy is not to seek to minimize their wages and benefits. 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 operates on very low margins, modest changes in various items in the consolidated statements of income, particularly merchandise costs 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 Note 11 to the condensed consolidated financial statements included in Part I, Item 1, of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefits costs as a percentage of country sales, and/or less or no direct membership warehouse competition.
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 calculated based on the difference between the current period's currency exchange rates and that of the comparable prior period. The impact of changes in gasoline prices on net sales is calculated based on the difference between the current period's average price per gallon sold and that of the comparable prior period.
Our fiscal year ends on the Sunday closest to August 31. References to the first quarters of 2020 and 2019 relate to the 12-week fiscal quarters ended November 24, 2019, and November 25, 2018, 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.
Highlights for the first quarter of 2020 as compared to the first quarter of 2019 include:
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Net sales increased 6% to $36,236, driven by an increase in comparable sales of 4% and sales at 17 net new warehouses opened since the end of the first quarter of 2019;
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Membership fee revenue increased 6% to $804, primarily due to sign-ups at existing and new warehouses;
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Gross margin percentage increased 30 basis points, primarily due to our warehouse ancillary and other businesses and an adjustment in the first quarter of 2019 to our estimate of breakage on rewards earned under our co-branded credit card program;
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SG&A expenses as a percentage of net sales increased 17 basis points, primarily due to operating costs related to warehouse, ancillary and other businesses and stock compensation;
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The provision for income taxes in the first quarter of 2020 was positively impacted by a benefit related to stock compensation of $77, or $0.17 per diluted share compared to $59, or $0.13 in the first quarter of 2019. The first quarter of 2019 was also positively impacted by a benefit of $27, or $0.06 per diluted share, related to the Tax Cuts and Jobs Act (2017 Tax Act);
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Net income increased 10% to $844, or $1.90 per diluted share, compared to $767, or $1.73 per diluted share in 2019; and
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On October 18, 2019, our Board of Directors declared a quarterly cash dividend of $0.65 per share, which was paid on November 15, 2019.
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RESULTS OF OPERATIONS
Net Sales
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12 Weeks Ended
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November 24,
2019
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|
November 25,
2018
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Net Sales
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$
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36,236
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$
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34,311
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Changes in net sales
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U.S
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6
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%
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|
12
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%
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Canada
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3
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%
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4
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%
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Other International
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7
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%
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8
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%
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Total Company
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6
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%
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|
10
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%
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Changes in comparable sales:
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U.S
|
5
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%
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11
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%
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Canada
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3
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%
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|
2
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%
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Other International
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3
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%
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|
4
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%
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Total Company
|
4
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%
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|
9
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%
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Changes in comparable sales excluding the impact of changes in foreign currency and gasoline prices (1):
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U.S
|
5
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%
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|
8
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%
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Canada
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5
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%
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|
5
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%
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Other International
|
4
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%
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|
6
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%
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Total Company
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5
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%
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|
7
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%
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_______________
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(1)
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Excludes the impact of the revenue recognition standard for the period ended November 25, 2018.
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Net Sales
Net sales increased $1,925 or 6%, during the first quarter of 2020 compared to the first quarter of 2019. This increase was attributable to an increase in comparable sales of 4% in the first quarter of 2020, and sales at the 17 net new warehouses opened since the end of the first quarter of 2019.
During the first quarter of 2020, changes in gasoline prices negatively impacted net sales by $122, or 35 basis points, due to a 3% decrease in the average sales price per gallon. Foreign currencies relative to the U.S. dollar also negatively impacted net sales by approximately $103, or 30 basis points, compared to the first quarter of 2019, attributable to our Canadian and Other International operations.
Comparable Sales
Comparable sales increased 4% in the first quarter of 2020 and were positively impacted by increases in shopping frequency and average ticket. Comparable sales for the first quarter of 2020 were negatively impacted by cannibalization (established warehouses losing sales to our newly opened locations) and the shift in timing of the Thanksgiving holiday to the second quarter of 2020.
Membership Fees
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12 Weeks Ended
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November 24,
2019
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November 25,
2018
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Membership fees
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$
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804
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$
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758
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Membership fees as a percentage of net sales
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2.22
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%
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2.21
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%
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Total paid members as of quarter end (000s)
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54,700
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52,200
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Total cardholders as of quarter end (000s)
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99,900
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95,400
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The increase of 6% in membership fees was primarily due to signups at existing and new warehouses. Changes in foreign currencies relative to the U.S. dollar had a slight negative impact on membership fees. At the end of the first quarter of 2020, our member renewal rates were 91% in the U.S. and Canada and 88% worldwide.
Gross Margin
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12 Weeks Ended
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November 24,
2019
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November 25,
2018
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Net sales
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$
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36,236
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$
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34,311
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Less merchandise costs
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32,233
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30,623
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Gross margin
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$
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4,003
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$
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3,688
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Gross margin percentage
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11.05
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%
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10.75
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%
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The gross margin of our core merchandise categories (food and sundries, hardlines, softlines, and fresh foods), when expressed as a percentage of core merchandise sales (rather than total net sales), increased four basis points, primarily due to increases in hardlines, softlines, and food and sundries partially offset by a decrease in fresh foods, which was driven primarily by initial operating losses from our new poultry processing plant. This measure eliminates the impact of changes in sales penetration and gross margins from our warehouse ancillary and other businesses.
Total gross margin percentage increased 30 basis points compared to the first quarter of 2019. Excluding the impact of gasoline price deflation on net sales, gross margin as a percentage of adjusted net sales was 11.01%, an increase of 26 basis points. This was primarily due to a 19 basis-point increase in our warehouse ancillary and other businesses and 13 basis points related to an adjustment in the first quarter of 2019 to our estimate of breakage on rewards earned under our co-branded credit card program. These increases were partially offset by a six basis-point decrease in our core merchandise categories.
Gross margin on a segment basis, when expressed as a percentage of the segment's own sales and excluding the impact of changes in gasoline prices on net sales (segment gross margin percentage), increased in our U.S. operations, primarily due to our warehouse ancillary and other businesses and the adjustment mentioned above, partially offset by decreases in our core merchandise categories. The segment gross margin percentage in our Canadian operations increased, primarily due to our warehouse ancillary and other businesses. The segment gross margin percentage in our Other International operations increased, primarily due to our core merchandise categories and our warehouse ancillary and other businesses, partially offset by increased spending by members under the Executive Membership 2% reward program.
Selling, General and Administrative Expenses
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12 Weeks Ended
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November 24,
2019
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November 25,
2018
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SG&A expenses
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$
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3,732
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$
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3,475
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SG&A expenses as a percentage of net sales
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10.30
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%
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10.13
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%
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SG&A expenses as a percentage of net sales increased 17 basis points compared to the first quarter of 2019. Excluding the impact of gasoline price deflation on net sales, SG&A expenses as a percentage of adjusted net sales was 10.26%, an increase of 13 basis points compared to the prior year. Operating costs related to warehouse ancillary and other businesses, which include e-commerce and travel, increased five basis points, primarily due to the wage increases and bonding leave benefits for U.S. and Canadian hourly employees effective in March 2019. Stock compensation was higher by four basis points, primarily due to accelerated vesting for long service. Central operating costs related to maintaining, upgrading and expanding our technology capabilities were higher by four basis points.
Preopening Expense
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12 Weeks Ended
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November 24,
2019
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November 25,
2018
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Preopening expenses
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$
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14
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$
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22
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Warehouse openings, including relocations
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United States
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3
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6
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Canada
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1
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2
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Other International
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0
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0
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Total warehouse openings, including relocations
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4
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8
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Preopening expenses include startup costs related to new warehouses and relocations, developments in new international markets, new manufacturing and distribution facilities, and expansions at existing warehouses. Preopening expenses vary due to the number of warehouse openings, the timing of the openings relative to our quarter-end, whether the warehouse is owned or leased, and whether the opening is in an existing, new or international market. For the remainder of fiscal 2020, we expect to open 17 warehouses, including two relocations.
Interest Expense
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12 Weeks Ended
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November 24,
2019
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November 25,
2018
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Interest expense
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$
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38
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$
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36
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Interest expense is primarily related to Senior Notes.
Interest Income and Other, Net
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12 Weeks Ended
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November 24,
2019
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November 25,
2018
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Interest income
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$
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32
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$
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21
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Foreign-currency transaction gains, net
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(4
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)
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(5
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)
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Other, net
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7
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|
6
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|
Interest income and other, net
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$
|
35
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|
$
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22
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Interest income increased for the first quarter of 2020, due to higher average cash and investment balances and higher interest rates. Foreign-currency transaction gains, net, include the revaluation or settlement of monetary assets and liabilities by our Canadian and Other International operations and mark-to-market adjustments for forward foreign-exchange contracts. See Derivatives and Foreign Currency sections in Item 8, Note 1 of our Annual Report on Form 10-K, for the fiscal year ended September 1, 2019.
Provision for Income Taxes
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12 Weeks Ended
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November 24,
2019
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November 25,
2018
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Provision for income taxes
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$
|
202
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|
$
|
158
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Effective tax rate
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19.1
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%
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|
16.9
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%
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The effective tax rate for the first quarter of 2020 was favorably impacted by $77 due to excess tax benefits from stock compensation. The effective tax rate for the first quarter of 2019 was favorably impacted by discrete tax benefits of $59 related to excess tax benefits from stock-based compensation and $27 related to the 2017 Tax Act.
LIQUIDITY AND CAPITAL RESOURCES
The following table summarizes our significant sources and uses of cash and cash equivalents:
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12 Weeks Ended
|
|
November 24,
2019
|
|
November 25,
2018
|
Net cash provided by operating activities
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$
|
2,102
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|
|
$
|
2,177
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|
Net cash used in investing activities
|
(630
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)
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|
(737
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)
|
Net cash used in financing activities
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(836
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)
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|
(700
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)
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Our primary sources of liquidity are cash flows generated from warehouse operations, cash and cash equivalents, and short-term investments. Cash and cash equivalents and short-term investments were $10,020 and $9,444 at November 24, 2019, and September 1, 2019, respectively. Of these balances, unsettled credit and debit card receivables represented approximately $1,743 and $1,434 at November 24, 2019, and September 1, 2019, respectively. These receivables generally settle within four days. Cash and cash equivalents were positively impacted by a change in exchange rates of $7 and negatively impacted by a change of $17 in the first quarter of 2020 and 2019, respectively.
Management believes that our cash position and operating cash flows will be sufficient to meet our liquidity and capital requirements for the foreseeable future. We believe that our U.S. current and projected asset position is sufficient to meet our U.S. liquidity requirements. We no longer consider earnings after 2017 of our non-U.S. consolidated subsidiaries to be indefinitely reinvested.
Cash Flows from Operating Activities
Net cash provided by operating activities totaled $2,102 in the first quarter of 2020, compared to $2,177 in the first quarter of 2019. Cash provided by operations is primarily derived from net sales and membership fees. Cash used in operations generally consists of payments to merchandise suppliers, warehouse operating costs, including payroll and employee benefits, utilities, and credit and debit card processing fees. Cash used in operations also includes payments for income taxes. Changes in our net investment in merchandise inventories (the difference between merchandise inventories and accounts payable) is impacted by several factors, including how fast inventory is sold, payment terms with our suppliers, the amount of early payments to obtain discounts from suppliers, and the shift in timing of the Thanksgiving holiday to the second quarter of 2020.
Cash Flows from Investing Activities
Net cash used in investing activities totaled $630 in the first quarter of 2020, compared to $737 in the first quarter of 2019, and is primarily related to capital expenditures. Net cash from investing activities also includes purchases and maturities of short-term investments.
Capital Expenditure Plans
Our primary requirements for capital are acquiring land, buildings, and equipment for new and remodeled warehouses. Capital is also required for information systems, manufacturing and distribution facilities, initial warehouse operations, and working capital. In the first quarter of 2020, we spent $715 on capital expenditures, and it is our current intention to spend approximately $3,000 during fiscal 2020. We opened four new warehouses, including one relocation, in the first quarter of 2020 and plan to open 17 additional new warehouses, including two relocations, in the remainder of fiscal 2020. There can be no assurance that current expectations will be realized; plans are subject to change upon further review of our capital expenditure needs.
Cash Flows from Financing Activities
Net cash used in financing activities totaled $836 in the first quarter of 2020, compared to $700 in the first quarter of 2019. Cash flow used in financing activities was primarily related to the payment of dividends, withholding taxes on stock-based awards, and repurchases of common stock. Dividends totaling $573 were paid during the first quarter of 2020, of which $286 related to the dividend declared in August 2019. Subsequent to the end of the quarter, on December 16, 2019, we paid the outstanding principal balance and associated interest on the 1.70% Senior Notes from cash and cash equivalents and short-term investments.
Stock Repurchase Programs
During the first quarter of 2020 and 2019, we repurchased 100,000 and 150,000 shares of common stock, at an average price per share of $295.97 and $229.35, respectively, totaling approximately $30 and $34, respectively. These amounts may differ from the stock repurchase balances in the accompanying condensed consolidated statements of cash flows due to changes in unsettled stock repurchases at the end of a quarter. Purchases are made from time to time, as conditions warrant, in the open market or in block purchases, pursuant to plans under SEC Rule 10b5-1. Repurchased shares are retired, in accordance with the Washington Business Corporation Act.
Dividends
On October 18, 2019, our Board of Directors declared a quarterly dividend of $0.65 per share payable to shareholders of record on November 1, 2019. The dividend was paid on November 15, 2019.
Bank Credit Facilities and Commercial Paper Programs
We maintain bank credit facilities for working capital and general corporate purposes. At November 24, 2019, we had borrowing capacity under these facilities of $873, including a $400 revolving line of credit, which expires in June 2020. Our international operations maintain $360 of the borrowing capacity under bank credit facilities, of which $147 is guaranteed by the Company. There were no outstanding short-term borrowings under the bank credit facilities at the end of the first quarter of 2020 or at the end of 2019.
The Company has letter of credit facilities, for commercial and standby letters of credit, totaling $224. The outstanding commitments under these facilities at the end of the first quarter of 2020 totaled $150, most of which were standby letters of credit with expiration dates within one year. The bank credit facilities have various expiration dates, most of which are within one year, and we generally intend to renew these facilities. The amount of borrowings available at any time under our bank credit facilities is reduced by the amount of standby and commercial letters of credit outstanding.
Contractual Obligations
As of the date of this Report, there were no material changes to our contractual obligations outside the ordinary course of business since the end of our last fiscal year.
Critical Accounting Estimates
The preparation of our consolidated financial statements in accordance with U.S. GAAP requires that we make estimates and judgments. We base these on historical experience and on assumptions that we believe to be reasonable. Our critical accounting policies are discussed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of our Annual Report on Form 10-K, for the fiscal year ended September 1, 2019. There have been no material changes to the critical accounting policies previously disclosed in that Report.
Recent Accounting Pronouncements
See discussion of Recent Accounting Pronouncements in Note 1 to the condensed consolidated financial statements included in Part I, Item 1 of this Report.
Item 3—Quantitative and Qualitative Disclosures about Market Risk
Our direct exposure to financial market risk results from fluctuations in foreign currency exchange rates and interest rates. There have been no material changes to our market risks as disclosed in our Annual Report on Form 10-K, for the fiscal year ended September 1, 2019.
Item 4—Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934, as amended) are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and to ensure that information required to be disclosed is accumulated and communicated to management, including our principal executive and financial officers, to allow timely decisions regarding disclosure. The Chief Executive Officer (CEO) and the Chief Financial Officer (CFO), with assistance from other members of management, have reviewed the effectiveness of our disclosure controls and procedures as of November 24, 2019, and based on their evaluation have concluded the disclosure controls and procedures were effective as of that date.
Changes in Internal Control over Financial Reporting
In the first quarter of 2020, we adopted ASU 2016-02 Leases (ASC 842) which required changes to certain of our business processes and internal controls over financial reporting.
There have been no other changes in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) of the Exchange Act) that occurred during the first quarter of fiscal 2020 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.