The document provides an analysis of Costco Wholesale's recent performance and outlook. It summarizes that Costco reported strong same-store sales growth of 7-8% during the first four months of 2008 despite challenging economic conditions. Channel checks found Costco's local traffic held up well while other retailers saw weakness. The document maintains a positive long-term view of Costco given its consistent growth, strong membership renewal rates, and expansion plans to double its store count over 10 years. In the near term, the stock appears fully valued based on earnings estimates.

1. May 15, 2008 <br />Gregg Carlson<br />carlson.requests@gmail.com<br />COSTCO WHOLESALE <br />Executive Summary<br />Costco reported solid chain-wide comps (7%, 7%, 7% and 8% Jan. – Apr.) during calendar 2008 in the face of a challenging economic climate for consumers. <br />Many consumer / retail names reported declining to outright negative comps during the same period as negative economic headwinds took their toll on consumers(1).<br />Channel checks in Las Vegas market during January – April 2008 of casinos, restaurants, retail stores and malls indicated persistent weakness as overall softness in traffic counts and other volume indicators were prevalent. On the other hand, Costco’s local traffic appeared to have held up during the period (based on two per week store visits between January – April). Costco’s local traffic also appeared to be roughly in-line with same store 2007 and 2006 levels(1).<br />Economic conditions in Las Vegas are currently negative owing to housing, unemployment and gasoline/food inflation issues. Currently Las Vegas is near the top of negative rankings as one of the worst housing markets in the U.S. as well as above the national average for unemployment. As a significant value provider to consumers, Costco appears to be benefiting locally despite these and possibly due to these conditions.<br />So while what happens in Vegas stays in Vegas, my thesis is that this is not the case for the local consumer, as local negative consumer economic issues are consistent with, to worse than negative national issues. While I am not extrapolating a local two store Costco viewpoint over the national footprint, local traffic observations are consistent with positive company wide reported comps. <br />The company is scheduled to report Q3 earnings on Thu 5/29/08. Selected analysts are predicting 7ish comps. Average consensus is .65 eps and $16.3 B in revenue.<br />The attached research report for Costco explores the above issues in greater detail and includes an in-depth analysis (historical, current and prospective) of the company. It also includes a comparison of Costco to its principal competitors on selected key financial metrics. <br />I have maintained a favorable opinion of the company and its stock in recent years. I continue to maintain a positive long term view of Costco’s future equity value prospects. Recently the stock price has adjusted upward as the street reacts to continued positive company performance despite the overall negative economic climate for consumers. As a result, on a near term basis, the stock appears to be near fully valued. Due to its persistent secular growth characteristics, I continue to like the name long term and would recommending adding to positions on pull backs.<br />(1) See Appendix E - Consumer data & survey of comps and other information.<br /> <br />May 15, 2008 <br />INSIDE<br />> Investment Thesis<br />> Recent Results & Trends<br />> Near Term Outlook<br />> Membership Fees<br />> Channel Checks<br />> Industry Sales<br />> Ratio Analysis<br />> Balance Sheet & Cash Flow<br />> P&L<br />> Comps Data<br />> Stores by Location <br />Gregg Carlson<br />carlson.requests@gmail.com<br />GREGG CARLSON research<br />COSTCO WHOLESALE <br />37 Million Chickens (1) (2) (4) (5) <br />Company Description<br />Costco is the dominant warehouse retailer in the industry with 534 stores (391 in the U.S. and 143 abroad). Costco provides value to customers and employees through lower prices and above average compensation. The company has delivered consistent positive comps in each period of the last ten years and also during the most recent 60 months (the period researched) while increasing its footprint on a 10 year CAGR of 6%. FY08 estimates for average sales per warehouse are $135 million which is 2x – 3x higher per store than its principal competitors (3). Costco’s market share has grown from 50% to 56% between 1998 to 2007.<br />Costco’s 10 year average membership renewal rate is 86% - 87%. On a LTM basis, membership fees generated approximately $1.5 billion in free cash flow.<br />The company has an extremely strong balance sheet and generates a significant amount of cash flow from operations that has averaged approximately $1.9 billion per year over the last five years. The company recently increased its debt level from 1x to 2x ebitda to buy back $4.4 billion of stock between 2005 and Q2 2008.<br />The company generated $64.4 billion in revenue during FY 2007. Revenue grew at an 11.4% CAGR over the last decade.<br />Valuation<br />At a recent $71 price, the stock is trading at 21x, 18x FY09 and FY10 earnings estimates which is near recent year peak forward multiples. On a DCF basis, using a 9% earnings growth rate (for 5 year explicit forecast period) and 5% terminal earnings growth assumption implies a 10% rate of return ex dividends and stock repurchases. <br />On a near term earnings basis Costco appears to be fully valued. On a long term basis the stock looks moderately undervalued as the 10% rate of return forecast is based on the assumption that Costco only executes one half of its announced expansion strategy. <br />The company sold 37 million chickens during FY 2007<br />Note: see accompanying models for additional detail and analysis<br />See Appendix C – Sales per Store for additional information<br />(4) See Appendix D – General Overview of the Warehouse Club Industry.<br />(5) See Appendix F – Costco mob checkout scene<br />GREGG CARLSON research page 2 <br />Investment Thesis<br />Costco has been and remains a secular growth story as it has consistently grown its earnings and cash flows over the last ten years. Earnings growth has been function of footprint expansion and same stores sales growth. Over the last 10 years, the company has grown its footprint at a 6% CAGR and plans to do the same over the next decade. The earnings CAGR over the last decade is 11%. The company has consistently generated and grown free cash flow which has been used to fund its expanding store base, pay dividends and repurchase shares.<br />The company has created significant value for consumers and employees based on its pricing and compensation practices. Because of the value proposition and “treasure hunt” experience offered its customers, Costco enjoys strong customer loyalty with high membership retention levels (86% - 87% per year over the last ten years).<br />Costco’s shareholder returns (ex dividends) have outpaced the S&P 500 over the last 5 and 12 year period respectively as follows:<br />Approximate<br /> 5 year return 12 year return<br />Costco100%600%<br />S&P 500 50%450%<br />In the retail space comps are all to important and based on this measure, Costco has posted exceptional results over the last 5 and 10 year periods with positive comps in all periods. Costco has generally outperformed its principal competitors, Sam’s and BJ’s.<br />GREGG CARLSON research page 3 <br />The company currently operates 529 stores and is looking to double the store count to approximately 1,000 over the next 10 year period as follows:<br />LocationCurrentAdditionsFutureUS (1)389323712Canada7534109Mexico303161UK 193150Asia166177Other013135294931,022<br />Costco operates stores in 40 states within the U.S. with the biggest store concentration in California (21% of total).<br />The expansion target implies that the store count could increase 6% - 7% per annum. Assuming that comps grow at 5% and adjusting for slack implies that revenues could grow at approximately 10% for the foreseeable future. Earnings could grow at a higher rate if Costco can achieve some incremental margin expansion, as operating income has ranged from 2.5% - 2.9% between 2003 and 2007.<br />Over the last decade, the stock has traded at a forward PE of approximately 20x – 30x while trading at 18x – 21x over the last five years. At a recent price of $71, the stock is trading at 21x and 18x consensus 2009 and 2010 earnings estimates, near the high end of the recent five year range. On an enterprise value to ebitda basis the stock has traded between 10x – 26x EV/ebitda over the last decade and 10x over the last five years. The stock is currently trading at 9x and 8x FY2009 and FY2010 estimated EV/ebitda. On a DCF basis, at $71 per share assuming earnings grow at an 8% CAGR over five years, using a terminal growth rate assumption of 5% implies a 10% return before dividends and share buybacks. The DCF model also assumes that one half of the current pipeline would be built out, which may be conservative.<br />On a near term basis the stock appears to be fully valued. On a longer term basis the current stock price is lower than my intrinsic value estimate assuming that secular growth characteristics persist.<br />GREGG CARLSON research page 4 <br />06985<br />00<br />GREGG CARLSON research page 5 <br />Recent Results & Trends<br />For the 2nd and 1st quarters of FY2008, revenues increased 12.2% & 11.7% respectively on a YOY basis with 7.2% and 7.8% of the increase attributable to comps, 3.3% – 3.6% driven by new stores with the remainder attributable to other factors.<br />Gross margins were 100 – 200 bps higher than the prior year while operating income increased 60 and 50 bps respectively due to margin expansion and SG&A leverage.<br />EPS was up 37% and 15.7% due to the factors described plus the share count reduction impact from buyback activity.<br />Comps have held up in recent months despite negative economic issues in the U.S. as follows:<br />April 2008 comp8%<br />Average for January, February and March7%<br />Comps for prior 3 months7%<br />Costco’s comps are impressive due to their consistency given the lackluster performance of most other retailers and consumer names during recent months. Costco appears to be doing well in the current negative economic climate. In general, retailer monthly comps have been lackluster to outright negative except for retailers benefiting from value seeking consumer behavior which includes names like Costco, Wal Mart (Sam’s Club), BJ’s and Burger King, for example.<br />Local channel checks of Costco are consistent with the company’s overall positive comp performance. In short, despite challenged local economic conditions, company traffic and consumer spending at Costco have held up so far.<br />At the same time Costco’s sales composition has changed with International sales comping at 16% - 20% in recent months due to U.S. currency weakness with gasoline sales increasing due to the recent significant price increases. Per the company Q2 conference call, a summary of comps, general conditions and other key issues is as follows:<br />Comps for December, January and February were 7%, 7% and 7%.<br />Transaction frequency was 2.5 % while transaction size was 5.5% which totals 7%. The company indicated that frequency picked up some relative to company history.<br />On a regional basis the Northwest, Northeast and Southeast comps are near the company average while California is below the company average but still positive.<br />On a category basis, food and sundries comps are better than the company overall average while hardlines and softlines are below the average. See Appendix B – Sales by Category for category definitions.<br />In hard lines, the deli, electronics and sporting goods categories are solid while office supplies, lawn & garden, home furnishings and jewelry are negative.<br />6)In general, non-discretionary categories have held up while discretionary categories have been weaker due to current negative economic conditions. Private label revenues continue to grow to approximately 17% of total.<br />7)International sales were solid overall. Specifically the UK has been weak but appears to be gaining some traction. Korea, Taiwan and Japan are strong. In Korea, the company recently opened a store with 56k paid members which is the equivalent to the approximate size of the membership base for stores that are 15+ years old. In Korea, the market appears to be under penetrated based on the small store count vs. population sizes of cities.<br />Gross Margins (in bps) increased between Q407 and Q208 on a YOY basis as follows:<br />Q407Q108Q208<br />Core merchandising (90% of company categories)+34+44+29<br />Other adjustments 4 (35) ( 5)<br /> Total increase+38+9+24<br />Costco proceeds with expansion plans that may benefit from macro real estate issues as land parcels are coming into the market at favorable prices after falling out of other development projects. During FY08 the company plans to open 28 net new stores (37 new less 9 relocations). During FY08 new locations will be just north of 75% market in-fills.<br />The company is comfortable with First Call eps estimates for Q3 and FY 2008.<br />GREGG CARLSON research page 6 <br />The company discussed inflationary cost increase impacts on the business. In general inflation could benefit their private label business as price pressures drive consumers to more competitively priced private label products. A big chunk of the price increases is in gasoline where they are in effect, passed on to consumers. Costco does not have to carry every brand or size like, Albertson’s, Wall Mart, Safeway or Target, for example, which allows the company to be flexible and opportunistic in terms of its buying strategy by seeking out the most optimal transactions. In general, it is not clear if margins will be negatively impacted by inflation.<br />In terms of taking market share, the company stated that it takes a little from a lot of competitors with possibly the most from supermarket and drug chains as their merchandise overlaps approximately 60% of Costco’s. <br />Membership counts at the end of Q2 2008 are as follows:<br />28.3 million total member households with total membership at 51.8 million including spouse membership cards. Total member households were 27.8 at Q1 2008 and 27.4 at Q4 2007.<br />Total membership categories break down is as follows:<br />Gold Star 19.3<br />Primary business 5.5<br />Business add on’s 3.4<br />Total member households 28.3<br />On an ex Mexico basis, on average members per warehouse were 56k in both Q2 FY08 and Q1 FY08. Also, paid executive members (6.9 million, 24% of membership base) generate approximately 50% of sales. Finally, Costco indicated that there was little change in sales mix between Gold Star and business members during Q2. See Appendix B – Sales by Category for additional information.<br />Near Term Outlook<br />Comps for March and April were 7% and 8%. The reported underlying trends in the numbers appear to be similar to recent reported results, namely significantly impacted by gasoline sales and positively impacted by currency effects in international markets.<br />During the Q2 2008 conference call, the company indicated it agreed with consensus eps estimates for Q3 and FY 2008 as a whole. Gasoline prices have continued to increase during Q3. The U.S. will soon begin summer driving season. As a result of this and other factors, the general consensus is that gasoline prices will remain elevated for the foreseeable future. On a local price check basis, Costco appears to be priced approximately .10 less per gallon that its immediate located competitors which drives the gasoline business as well as positively influencing store traffic volume.<br />Both Wal Mart and Bj’s have posted positive comps in recent months owing to the consumer trade down value seeking behavior in the current economic climate.<br />Membership Fees<br />Costco derives a significant amount pretax income and cash flow from operations (CFO) from membership fees (see table below). Since 1998 (the period researched) membership fee revenue has increased in each and every year. For FY 2008 and the previous four years, membership fee income has increased at approximately 11% and has contributed approximately 70% of Costco’s net income. Membership fee income is essentially pure free cash flow as there are few direct costs associated with it. Over the last decade approximately 86% - 87% of Costco’s members have renewed their memberships. On average (ex. Mexico) there are approximately 56k members per Costco store.<br />Costco has raised membership fees three times over the last nine years with little if any impact on the overall renewal rate. The most recent fee increase was during May 2006 at $5 per individual (Gold Star) and business member. While it appears that the company could raise membership fees should it choose to, during the Q2 FY2008 conference call the company indicated that it would not raise fees anytime soon. Although it is not planning on raising fees, Costco’s ability to do so hinges on its unique store experience and value proposition offered to its customers. <br />GREGG CARLSON research page 7 <br />Costco has increased it store count by approximately 6% on average in each of the last ten years. Costco back fills existing markets with stores (approximately 75% of FY 2008 new store activity) or builds stores in new markets. Costco’s new stores each year in the aggregate tend to produce above company average comps for a several year period as a given market is developed net of cannibalization on adjacent stores. This pattern, plus the renewal rate have been the primary driver of YOY growth in membership fees. <br />Costco’s goal of doubling its store count over the next ten years implies that this pattern may continue. However in order to be conservative we have reduced the YOY growth assumption in membership revenue from recent levels of approximately 11% to 5.3% and 7.5 % in 2009 and 2010.<br />Costco Membership Fee Analysis<br />Channel Checks<br />Gasoline, chickens, milk and golf shirts. Costco is a unique experience in that shoppers often walk out of the store with a variety of goods including items they may not have planned on purchasing. Ultimately, the best way to understand Costco is to become a member and shop at a store. This is what I did several years ago at a then new store that opened in our neighborhood. After observing store traffic continually increase in recent years I read the chart in the annual report that shows positive sales increases in each and every year for each group of vintage year stores. My personal experience and observations at a local Costco are consistent with this chart (see comps section of report for sales history by vintage year stores). Why is this the case? In no particular order, my thesis is:<br />1)The stores are well maintained and staffed with positive service oriented employees, many of which have been present for sometime.<br />High quality/value proposition merchandise that turns over rapidly means that at Costco, consumers know that goods do not stay on the shelves long. At Costco, “if you like it you better buy it” or take the risk that the merchandise will not be available.<br />The strong comparative value proposition to other retailers in the merchandise/pricing/value combination.<br />A variety of merchandise that allows for shopping consolidation.<br />The treasure hunt atmosphere organization of the store brings out the shopper in its customers.<br />Monitoring traffic at two of the four stores in the local market on a regular basis for several years provided a baseline comparison to 2008(1). Twice weekly store observations during January - April 2008 indicated that traffic levels held up while simultaneously weakening in virtually all other retail/consumer business that I monitor.<br />Although this information is antidotal in nature, it is worth noting that in Las Vegas, consumers currently face overall tough economic conditions including high and rising energy costs, a relatively high unemployment rate and comparatively poor housing market (2). <br />GREGG CARLSON research page 8 <br />Local observations of persistently strong traffic patterns within the context of tough economic conditions are consistent with Costco’s chain-wide positive comps during January – April. So while what happens in Vegas stays in Vegas and may not apply to other markets, I doubt it and believe that there are more similarities than differences between Las Vegas consumer patterns and other regions.<br />In summary, Costco’s business appears to be holding up locally and benefiting from consumer value seeking and shopping consolidation behavior during tough economic times. Based on nationally reported comp numbers, company comments and local observations, local patterns appear to be similar to national patterns for Costco. Based on informal polls of friends, family, acquaintentances and Costco isle surveys, I have detected a high loyalty rate in terms of membership renewals and shopping persistency with a pattern of using Costco as the core shopping point in a family budget while simultaneously using other more specialized retailers to fill in gaps based on selection and preferences. This pattern has the potential effect of Costco taking more wallet share in a small way from other retailers in several categories, at point mentioned in Costco’s recent Q2 conference call.<br />While Costco does little if any advertising, informal polling of Costco employees indicates that there is a positive consumer response to Costco’s periodic mailers as drivers of store traffic. Locally, geographic proximity, gasoline sales, word of mouth and extremely busy weekend parking lots, are some of the factors that drive traffic to Costco stores.<br />See attached model for details. In general, twice weekly January – February store visit observations of parking lot occupancy and store traffic patterns were compared to similar observations in 2007, 2006, and 2005, etc.<br />January – March unemployment rates in Las Vegas were 5.5%, 5.4% and 5.6 (per NV department of Employment security) which were higher than comparable national numbers of 4.9%, 4.8% and 5.1%. On a relative basis, Las Vegas ranks near the top of the list for cities in the U.S. with the high unemployment rates.<br />Housing foreclosure statistics remain at high levels compared to recent years for Las Vegas with approximately 11.5K homes in the foreclosure process. During January foreclosures approximately equaled new home sales at approximately 1k units each. January, February and March median existing home sales prices are approximately -20% on a YOY basis. During Q4 2007 the YOY negative price adjustment was 13%.<br />In March 2008 the NV Department of Employment Security indicated that “locally and nationally job losses plus looming job losses, high gasoline prices, rising food costs, declines in housing values and increases in foreclosures have driven consumer confidence to new lows.”<br />Various economic statistics for Las Vegas (sourced from Applied Analysis – Las Vegas and other sources) for March 2008 are:<br />Existing home sales -31%, Median home price -20%, New home sales -30%, new home prices -18%, housing permits -72%, total employment -.3%, average gasoline price $3.53 per gallon and consumer confidence index -40%. Station Casinos and Boyd Gaming Las Vegas locals net revenues -4% and -6% respectively, on a YOY basis for Q1 2008.<br />Industry Sales<br />At the end of 2007, industry sales were $114.9 billion. Costco’s market share was 55.5% - 56% in 2006 – 2007 and estimated to be 57.4% in 2008. It’s market share is well in excess of its “fair share” based on the number of units as it’s fair share in units was 38%, 39% in 2006 - 2007, and estimated to be 40% in 2008 respectively as Costco’s sales per unit are significantly higher than its competitors Sam’s Club (approximately 1.8x) and BJ’s (approximately 2.6x). I have used street consensus estimates for each company for 2008 – 2010. For 2011 – 2012, I have used a growth estimate assumption. Based on these assumptions, Costco’s market share would grow from the 2008 estimate of 57.4 to 60% by 2012, an approximate 360 bps increase. The forward sales average growth rate assumption included in my model for Costco (2008 – 2012) is approximately 7.3% which is significantly lower than company historical average rate of 10.7% between 2003 to 2007. <br />GREGG CARLSON research page 9 <br />In recent months comps have been positive and have generally met or exceeded expectations while many other retailers have reported weak to negative comps. In Costco’s Q2 conference call the company indicated comfort with forward street estimates for FY2008 implying some level of comfort in connection with the revenue forecast. Costco will increase it’s footprint by approximately 6% during 2008 and possibly 6% - 7% thereafter based on it’s longer term expansion goal of 1,000 stores over a ten year period.<br />GREGG CARLSON research page 10 <br />Costco Sales, Warehouses & Market Share<br />(1)Prior to 2006 for the periods 2003 – 2005 Costco’s market share increased from 52.4% to 53.9% while generating significantly more sales per store than its principal competitors. Similar to the periods reported on Costco’s market share was well in excess of its fair share based on number of stores (see accompanying model sheet titled Warehouse Comps for additional detail).<br />Ratio analysis<br />Costco’s ratios were analyzed on a stand alone and comparative basis from a financial risk perspective as well as operating efficiency and return on capital vantage point. I have compared historical data for Costco to, Wal Mart, Sam’s and BJ’s to understand historic trends and relationships in addition to recent trends.<br />Financial Risk<br />Costco’s risk is viewed as low due to consistency of its revenues, margins and cash flows as well as conservative capital structure. Over the last ten years through FY 2007, Costco’s sales have positively increased in each year with predicable margins (due to the nature of its business model self imposed margin limit).<br />Cash flow from operations has also increased in each and every year except one. Over the last decade Costco has expanded its store foot print at a pace that has been largely self funded by cash flow from operations.<br />On a debt metric basis, Costco is viewed as extremely conservative with a 2007 debt of ebitda ratio of 1.8x after the debt increase made to support stock buybacks. See the table below for details:<br />GREGG CARLSON research page 11 <br />COSTCO debt metrics<br />Operating Efficiency<br />I examined Costco’s current ratio, inventory turns and relationship of working capital to revenues to judge Costco’s operating efficiency. Costco’s efficiency was also compared to Wal Mart and BJ’s.<br />A key component of the company strategy is to adhere to a low margin strategy that creates a high velocity of inventory turnover. Costco turns its inventory over approximately 12x per annum which is approximately 1 – 2 turns higher than Wal Mart and BJ’s. In terms of working capital management, Wal Mart outperforms Costco on revenue to working capital basis as Wal Mart operates by design at a working capital deficit while Costco and BJ’s do the opposite and operate with a surplus.<br />COSTCO efficiency ratios<br />WAL MART efficiency ratios<br />GREGG CARLSON research page 12 <br />BJ’S efficiency ratios<br />Return on Capital<br />Costco’s returns were examined on a historical trend basis and also compared to Wal Mart, Sam’s and BJ’s.<br />In summary Costco has generated similar ROE’s to BJ’s and lower ROE’s than Wal Mart and Sam’s (estimated). On a ROA basis Costco has generated comparable ROA’s to BJ’s and Sam’s (estimated) and lower ROA’s than Wall Mart.<br />The factors that explain the differences are:<br />Costco recently increased leverage to buy back equity that on a pro forma basis will positively impact ROE by approximately 250 BPS between 2008 – 2010. Costco is also taking steps to increase gross margins within the parameters of its overall margin/pricing strategy. Specifically the company has changed its returns policy for consumer electronics where margins had contracted in recent years due to its liberal returns policy. Also Costco may gain some incremental margin on large volume items and private label items where Costco may be able to distinguish itself and drive increases. See the tables below for Costco, Wal Mart, Sam’s and BJ’s ROE/ROA comparison and Dupont analyses.<br />GREGG CARLSON research page 13 <br />COSTCO Dupont analysis and<br />ROE/ROA comparison<br />Wal Mart, Sam’s, & BJ’s Dupont analysis<br />With comparison to Costco pro forma<br />Calculation adjusted for leverage<br />GREGG CARLSON research page 14 <br />Theoretical Growth rate<br />Costco’s historic expected theoretical earnings growth rate was calculated and compared to actual earnings growth. The analysis indicated that the company has grown it’s earnings within the parameters of it’s theoretical growth rate essentially growing the majority of its historical earnings out of ROE and minimizing equity or debt issuance over the last decade.<br />COSTCO theoretical and<br />actual earnings growth rate<br />Balance Sheet and Cash Flow<br />See Appendix A and accompanying model for historic and forecasted Balance Sheet and Cash Flow detail.<br />P&L<br />See Appendix A and accompanying model for historic and forecasted P&L detail.<br />Costco has taken the initiative to increase margins within its business model strategy in connection with increasing private label penetration and changing its electronic product return policy, for example. Based on the FY 2008 estimate, Costco’s eps would increase for operating margin improvement as follows:<br />GREGG CARLSON research page 15 <br />Comps Data<br />Costco’s comps, are a model of consistency. Costco has posted positive comps in each and every year since 1999 (the period researched). The company has also posted positive comps in each and every month over the last 60 month period (through the period ending April 2008). Costco has also increased sales in every year in all vintage year store groups since 1998. In short Costco has delivered stellar consistency while increasing its foot print at a 6.4% CAGR over the last ten years. Costco’s comp results have also outperformed its principal competitors for most of the last five years.<br />As the U.S. economy has weakened during the latter part of 2007 – 2008, the company has continued to post positive comps and appears to be benefiting from overall consumer weakness in connection with consumer value seeking behavior in what has become an increasingly challenging consumer environment.<br />Costco’s International operations have performed strongly as well posting positive comps in local and U.S. currency. International operations currently make up approximately 25% of the store base and are forecasted to be approximately 30% of the ten year 1,000 store company target.<br />The results are a function of a variety of factors for the best in class retailer that include and are not limited to:<br />High quality, long tenured and stable management team.<br />A business model strategy that provides significant value to customers based on the quality of Costco merchandise and ultra competitive pricing/margin strategy.<br />High customer retention.<br />A small base of constantly changing SKU’s (approximately 4,000) combined with core merchandise categories that keep the customer experience fresh while allowing the company to stock the store with merchandise based on changing customer preferences and needs.<br />The company’s ability to seek out buying opportunities based on unique merchandise of cost / pricing opportunities.<br />See the tables below for detailed comp data:<br />GREGG CARLSON research page 16 <br />COSTCO sales per warehouse by vintage year<br /> year + other data<br />GREGG CARLSON research page 17 <br />COSTCO monthly, quarterly, annual comps<br /> vs. BJ’s & Sam’s<br />GREGG CARLSON research page 18 <br />COSTCO monthly comps detail<br />GREGG CARLSON research page 19 <br />Stores by Location<br />The company operates warehouse in 40 states, Puerto Rico, Asia, UK and Mexico. Its biggest concentration of stores is in California. While remaining positive, California comps have diminished somewhat due to gasoline prices and housing issues. As 20.6% of Costco’s store base, California is material to Costco’s performance.<br />Appendix A – Costco Balance Sheet, Cash Flow and P&L<br />Balance Sheet<br />Cash Flow<br />P & L<br />P&L – Common Size<br />P & L – YOY<br />Appendix B – Sales by Category<br />Appendix C – Sales per Store & Online Sales<br />Appendix D – General Overview of the Warehouse Club Industry<br />The wholesale club industry has the lowest expense structure among comparable retail categories offering customers the lowest prices. In 2007 the industry generated $114.9 billion in aggregate revenues, representing an approximate 9% five year sales CAGR, which is above the growth of the overall retail industry (excluding auto and gasoline sales), 6% growth for general merchandise sales and 4% growth for U.S. food stores (1).<br />The industry is dominated by three companies Costco, Sam’s (a Wal Mart subsidiary) and BJ’s. Costco’s stores are located in 40 states with 40% in the U.S. Southwest and approximately 20% outside of the U.S. BJ’s stores are located in 16 states within the Northeast and Southeast while Sam’s operates stores in 48 states.<br />The principal industry competitors are category killer specialty retailers, supermarkets and super centers. As 75% of food and consumables are found in supermarkets, this segment is significantly overlapped to the warehouse industry. <br />While the companies slightly tailor their prices to local markets, a significant determinant of prices within company pricing models is their principal competitor prices.<br />Costco follows pre determined parameters that by design sacrifice margin but drive inventory turnover and customer loyalty. Costco’s self imposed margin limits are 15% on private label goods and 14% on branded goods. The three major players in the industry have continued expansion goals. Recently comps of the three companies have held up in the face of consumer economic issues while many other retail category comps have not.<br />Recent customer surveys by Wal Mart indicate that price is a significant and bigger determinant of where consumer shops in 2008 vs. 2007. Wal Mart – Sam’s have taken initiatives to improve the customer experience in their stores while Costco’s customer experience is viewed as favorable. Costco generates significantly more business per store than its principal competitors. <br />In general the three major players plan to continue to grow their store foot prints at an approximate 6% growth rate. BJ’s recently indicated that they plan to continue to target 3% - 5% annual comp increases. The three major competitors have consistently posted positive comps in recent years.<br />Per presentation by Herb Zarkin - BJ’s CEO at a recent Lehman Brothers industry conference.<br />Appendix E – Consumer data & survey of comps and other information<br />Reading, Watching, Walking and Talking<br />For several years I have covered, researched and invested in the gaming sector. In addition to modeling and other related forms of securities analysis I have monitored the industry as well as other consumer segments by being inside the buildings watching, walking and talking on a regular basis. The effort provides historic and current perspective in terms of traffic and volume metrics and has been an integral part of my overall securities analysis approach for gaming and other consumer names.<br />During the fourth quarter of 2007 and in a more pronounced way, first quarter of 2008, observational evidence began to mount that a slowdown was occurring in a wide variety of consumer related businesses that I was monitoring.<br />Specific example names include:<br />Restaurants<br />Cheesecake Factory<br />Baja Fresh<br />PF Changs<br />Claim Jumper<br />Starbucks<br />Retailers & Malls<br />Kohl’s<br />Nordstom’s<br />Gap<br />Jos Bank<br />Pier One<br />Lowe’s<br />Borders<br />Fashion Show Mall (Las Vegas Strip)<br />Forum Shops (Las Vegas Strip)<br />Palazzo retail (Las Vegas Strip)<br />Casinos<br />STN - Red Rock & other STN<br />BYD - Suncoast<br />The strip including Wynn, Palazzo, Venetian, TI, Caesars, Bellagio, Luxor, etc.<br />Wall Street and these companies have now reported extensively on the slowdown. During Q1 2008, quarterly company reports and monthly comp reports indicated widespread weakness that is consistent with what I observed. By category, the Gaming industry reported weak volumes and overall results within Las Vegas and across the U.S. Broadline retailers like Dillards, JC Penny Kohl’s and Nordstrom’s have reported negative comps. Restaurants have reported negative comps and higher input costs. At the same time discount style grocery stores like Kroger have reported positive numbers while the premium chain segment of Safeway and Whole Foods have not. Despite the negative environment and likely because of it, discount staples retailers like BJ’s, Wal Mart and Costco have reported strong national comps which are consistent with my local channel checks.<br />As the consumer pressures mount, consumer discretionary businesses have felt the negative impact of the slowdown while a pattern shift has occurred in non discretionary names like Costco and Wal Mart with mounting evidence that the consumer has traded down and exhibited value seeking behavior.<br />