COSTCO WHOLESALE CORP /NEW 10-Q

Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, percentages and warehouse count data) FORWARD-LOOKING STATEMENTS Certain statements contained in this document constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. For these purposes, forward-looking statements are statements that address activities, events, conditions or developments that the Company expects or anticipates may occur in the future and may relate to such matters as net 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. In some cases, forward-looking statements can be identified because they contain words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “likely,” “may,” “might,” “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, inflation or deflation, 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 the Ukraine conflict), the ability to maintain effective internal control over financial reporting, regulatory and other impacts related to climate change, COVID-19 related factors and challenges, and other risks identified from time to time in the Company's public statements and reports filed with the Securities and Exchange Commission (SEC). Forward-looking statements speak only as of the date they are made, and the Company does not undertake to update these statements, except as required by law. OVERVIEW The following Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to promote understanding of the results of operations and financial condition. MD&A is provided as a supplement to, and should be read in conjunction with, our condensed consolidated financial statements and the accompanying Notes to Financial Statements (Part I, Item 1 of this Form 10-Q), as well as our consolidated financial statements, the accompanying Notes to Financial Statements, and the related Management's Discussion and Analysis of Financial Condition and Results of Operations in our fiscal year 2022 Form 10-K, filed with the United States Securities and Exchange Commission (SEC) on October 5, 2022. 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 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 often sell inventory before we are required to pay for it, even while taking advantage of early payment discounts. We believe that the most important driver of our profitability is increasing net sales, particularly comparable sales. Net sales includes our core merchandise categories (foods and sundries, non-foods, and fresh foods), warehouse ancillary (gasoline, pharmacy, optical, food court, hearing aids, and tire installation) and other businesses (e-commerce, business centers, travel and other). We define 17 Table of Contents comparable sales as net 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 our international operations); inflation and changes in the cost of gasoline and associated competitive conditions. The higher our comparable sales exclusive of these items, the more we can leverage our 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 net sales growth is the health of the economies in which we do business, including the effects of inflation or deflation, especially the United States. Net 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” – consistently providing the most competitive values. Merchandise costs in the first quarter of 2023 was impacted by inflation higher than what we have experienced in recent years. The impact to our net sales and gross margin is influenced in part by our merchandising and pricing strategies in response to cost increases. Those strategies can include, but are not limited to, working with our suppliers to share in absorbing cost increases, earlier-than-usual purchasing and in greater volumes, offering seasonal merchandise outside its season, as well as passing cost increases on to our members. 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 and gross margin as a percentage of net sales (gross margin percentage). We believe our gasoline business enhances traffic in our warehouses, but it generally has a lower gross margin percentage relative to our non-gasoline businesses. It also has lower SG&A expenses as a percent of net sales compared to our non-gasoline businesses. 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, government actions in various countries, particularly China and the United States, have affected 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. Higher tariffs could adversely impact our results. We also achieve net 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, domestically and internationally, generally has a lower gross margin percentage than our warehouse operations. 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 18 Table of Contents 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 require 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 SG&A expenses, can have substantial impacts on net income. Our operating model is generally the same across our U.S., Canadian, and Other International operating segments (see Note 9 to the condensed consolidated financial statements included in Part I, Item 1, of this Report). Certain operations in the Other International segment have relatively higher rates of square footage growth, lower wage and benefit costs as a percentage of sales, less or no direct membership warehouse competition, or lack e-commerce or business delivery. 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 differences between the foreign-exchange rates we use to convert the financial results of our international operations from local currencies into U.S. dollars. This impact of foreign-exchange rate changes is calculated based on the difference between the current and prior period's currency exchange rates. The impact of changes in gasoline prices on net sales is calculated based on the difference between the current and prior period's average price per gallon sold. Our fiscal year ends on the Sunday closest to August 31. References to the first quarter of 2023 and 2022 relate to the 12-week fiscal quarters ended November 20, 2022, and November 21, 2021. 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 2023 versus 2022 include: • Net sales increased 8% to $53,437, driven by an increase in comparable sales of 7% and sales at 22 net new warehouses opened since the end of the first quarter of 2022; • Membership fee revenue increased 6% to $1,000, driven by new member sign-ups, upgrades to Executive Membership, and an increase in our renewal rate; • Gross margin percentage decreased 45 basis points, driven primarily by our core merchandise categories and a charge of $93, $0.15 per diluted share, predominantly related to downsizing our charter shipping activities. This was partially offset by increases in warehouse ancillary and other businesses; • SG&A expenses as a percentage of net sales decreased 35 basis points, primarily due to a write-off of information technology assets of $118, $0.20 per diluted share, recorded in the first quarter of 2022, and leveraging increased sales in the first quarter of 2023. • The provision for income taxes in the first quarter of 2023 was positively impacted by a benefit related to stock compensation of $53, $0.12 per diluted share, compared to $91, $0.21 per diluted share, in the first quarter of 2022. • Net income was $1,364, $3.07 per diluted share, compared to $1,324, $2.98 per diluted share in 2022; and • On October 12, 2022, our Board declared a quarterly cash dividend of $0.90 per share, which was paid on November 10, 2022. 19 Table of Contents RESULTS OF OPERATIONS Net Sales 12 Weeks Ended November 20, 2022 November 21, 2021 Net Sales $ 53,437 $ 49,417 Changes in net sales: U.S 11 % 16 % Canada 3 % 19 % Other International — % 17 % Total Company 8 % 17 % Changes in comparable sales: U.S 9 % 15 % Canada 2 % 17 % Other International (3) % 13 % Total Company 7 % 15 % E-commerce (4) % 14 % Changes in comparable sales excluding the impact of changes in foreign-currency and gasoline prices: U.S 7 % 10 % Canada 8 % 8 % Other International 9 % 11 % Total Company 7 % 10 % E-commerce (2) % 13% Net Sales Net sales increased $4,020 or 8% during the first quarter of 2023. This improvement was attributable to an increase in comparable sales of 7% and sales at the 22 net new warehouses opened since the end of the first quarter of 2022. Sales increased $2,033, or 5.1% in core merchandise categories, led by foods and sundries and fresh foods; while non-foods decreased slightly. Sales increased $1,987, or 21.5% in warehouse ancillary and other businesses, led by gasoline, business centers and travel businesses. During the first quarter of 2023, higher gasoline prices positively impacted net sales by $1,216, 246 basis points, compared to 2022, with a 17% increase in the average price per gallon. The volume of gasoline sold increased approximately 10%, positively impacting net sales by $650, 131 basis points. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $1,534, 310 basis points, compared to the first quarter of 2022, attributable to our Canadian and Other International operations. Comparable Sales Comparable sales increased 7% in the first quarter of 2023 and were positively impacted by increases in shopping frequency and the average ticket, which includes the effects of inflation and changes in foreign currency. 20 Table of Contents Membership Fees 12 Weeks Ended November 20, 2022 November 21, 2021 Membership fees $ 1,000 $ 946 Membership fees increase 6 % 10 % Total paid members (000s) 66,900 62,500 Total cardholders (000s) 120,900 113,100 Membership fee revenue increased 6% in the first quarter of 2023, driven by sign-ups, upgrades to Executive Membership, and an increase in our renewal rate. Changes in foreign currencies relative to the U.S. dollar negatively impacted membership fees by $32, compared to the first quarter of 2022. At the end of the first quarter of 2023, our member renewal rates were 93% in the U.S. and Canada and 90% worldwide. Renewal rates continue to benefit from more members auto renewing and increased penetration of Executive members, who on average renew at a higher rate. Our renewal rate, which excludes affiliates of Business members, is a trailing calculation that captures renewals during the period seven to eighteen months prior to the reporting date. We account for membership fee revenue on a deferred basis, recognized ratably over the one-year membership period. Our membership counts include active memberships and memberships that have not renewed within the 12 months prior to the reporting date. Gross Margin 12 Weeks Ended November 20, 2022 November 21, 2021 Net sales $ 53,437 $ 49,417 Less merchandise costs 47,769 43,952 Gross margin $ 5,668 $ 5,465 Gross margin percentage 10.61 % 11.06 % Total gross margin percentage decreased 45 basis points compared to the first quarter of 2022. Excluding the impact of gasoline price inflation on net sales, gross margin percentage was 10.85%, a decrease of 21 basis points. This was primarily due to a 31 basis-point decrease in core merchandise categories, predominantly in non-foods and fresh foods, and an 18 basis-point charge, primarily related to downsizing our charter shipping activities. Gross margin was also negatively impacted by five basis points due to increased 2% rewards. Warehouse ancillary and other businesses positively impacted gross margin by 30 basis points, predominantly gasoline, partially offset by e-commerce. A smaller LIFO charge in the first quarter of 2023 compared to the first quarter of 2022 positively contributed three basis points. Changes in foreign currencies relative to the U.S. dollar negatively impacted gross margin by approximately $153, compared to the first quarter of 2022, attributable to our Canadian and Other International operations. The gross margin in core merchandise categories, when expressed as a percentage of core merchandise sales (rather than total net sales), decreased 31 basis points. The decrease was primarily due to fresh foods and non-foods, partially offset by foods and sundries. This measure eliminates the impact of changes in sales penetration and gross margins from our warehouse ancillary and other businesses. 21 Table of Contents 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), decreased across all segments. All segments were negatively impacted by decreases in core merchandise categories as described above and increased 2% rewards, partially offset by increases in warehouse ancillary and other businesses. Gross margin in our U.S. segment was also negatively impacted by the charge primarily related to the downsizing of our charter shipping activities, partially offset by a lower LIFO charge. Selling, General and Administrative Expenses 12 Weeks Ended November 20, 2022 November 21, 2021 SG&A expenses $ 4,917 $ 4,718 SG&A expenses as a percentage of net sales 9.20 % 9.55 % SG&A expenses as a percentage of net sales decreased 35 basis points. SG&A expenses as a percentage of net sales excluding the impact of gasoline price inflation was 9.42%, a decrease of 13 basis points. The comparison to last year was favorably impacted by 24 basis points from a write-off of certain information technology assets in the prior year. Stock compensation was also lower by one basis point. Warehouse operations and other businesses were higher by nine basis points, largely attributable to the wage increases we instituted in 2022. Central operating costs were higher by three basis points. Changes in foreign currencies relative to the U.S. dollar decreased SG&A expenses by approximately $121 compared to the first quarter of 2022. Interest Expense 12 Weeks Ended November 20, 2022 November 21, 2021 Interest expense $ 34 $ 39 Interest expense is primarily related to Senior Notes and financing leases. Interest expense decreased in the first quarter of 2023 due to repayment of the 2.300% Senior Notes on December 1, 2021. Interest Income and Other, Net 12 Weeks Ended November 20, 2022 November 21, 2021 Interest income $ 54 $ 8 Foreign-currency transaction gains (losses), net (9) 26 Other, net 8 8 Interest income and other, net $ 53 $ 42 The increase in interest income in the first quarter of 2023 was primarily due to higher global interest rates. Foreign-currency transaction gains (losses), net include the mark-to-market adjustments for forward foreign-exchange contracts and the revaluation or settlement of monetary assets and liabilities by our Canadian and Other International operations. See Derivatives and Foreign Currency sections in Item 8, Note 1 of our Annual Report on Form 10-K, for the fiscal year ended August 28, 2022. 22 Table of Contents Provision for Income Taxes 12 Weeks Ended November 20, 2022 November 21, 2021 Provision for income taxes $ 406 $ 351 Effective tax rate 23.0 % 20.7 % The effective tax rate for the first quarter of 2023 was impacted by net discrete tax benefits of $56, primarily attributable to $53 in excess tax benefits related to stock compensation. Excluding discrete net tax benefits, the tax rate was 26.1% for the first quarter of 2023. The effective tax rate for the first quarter of 2022 was impacted by net discrete tax benefits of $97, primarily attributable to $91 in excess tax benefits related to stock compensation. Excluding discrete net tax benefits, the tax rate was 26.4% for the first quarter of 2022. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our significant sources and uses of cash and cash equivalents: 12 Weeks Ended November 20, 2022 November 21, 2021 Net cash provided by operating activities $ 2,610 $ 3,258 Net cash used in investing activities (1,057) (912) Net cash used in financing activities (863) (839) Our primary sources of liquidity are cash flows from our operations, cash and cash equivalents, and short-term investments. Cash and cash equivalents and short-term investments were $11,673 and $11,049 at November 20, 2022, and August 28, 2022. Of these balances, unsettled credit and debit card receivables represented approximately $2,488 and $2,010 at November 20, 2022, and August 28, 2022. These receivables generally settle within four days. Material contractual obligations arising in the normal course of business primarily consist of purchase obligations, long-term debt and related interest payments, leases, and construction and land purchase obligations. Purchase obligations consist of contracts primarily related to merchandise, equipment, and third-party services, the majority of which are due in the next 12 months. Construction and land purchase obligations consist of contracts primarily related to the development and opening of new and relocated warehouses, the majority of which (other than leases) are due in the next 12 months. Management believes that our cash and investment position and operating cash flows with capacity under existing and available credit agreements 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. Cash Flows from Operating Activities Net cash provided by operating activities totaled $2,610 in the first quarter of 2023, compared to $3,258 in the first quarter of 2022. Our cash flow provided by operations is primarily from net sales and membership fees. Cash flow 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 23 Table of Contents impacted by several factors, including inventory turnover, the forward deployment of inventory to accelerate delivery times, payment terms with suppliers, and early payments to obtain discounts. Cash Flows from Investing Activities Net cash used in investing activities totaled $1,057 in the first quarter of 2023, compared to $912 in the first quarter of 2022, 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 2023, we spent $1,057 on capital expenditures, and it is our current intention to spend approximately $3,800 to $4,000 during fiscal 2023. These expenditures are expected to be financed with cash from operations, existing cash and cash equivalents, and short-term investments. We opened eight new warehouses, including one relocation, in the first quarter of 2023 and plan to open 19 additional new warehouses, including two relocations, in the remainder of fiscal 2023. There can be no assurance that current expectations will be realized, and plans are subject to change upon further review of our capital expenditure needs and the economic environment. Cash Flows from Financing Activities Net cash used in financing activities totaled $863 in the first quarter of 2023, compared to $839 in the first quarter of 2022. 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 On October 12, 2022, our Board declared a quarterly cash dividend of $0.90 per share, payable to shareholders of record on October 28, 2022, which was paid on November 10, 2022. Share Repurchase Program During the first quarter of 2023 and 2022, we repurchased 285,000 and 77,000 shares of common stock, at an average price per share of $495.94 and $455.08, totaling approximately $141 and $35. These amounts may differ from the repurchase balances in the accompanying condensed consolidated statements of cash flows due to changes in unsettled 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. Bank Credit Facilities and Commercial Paper Programs We maintain bank credit facilities for working capital and general corporate purposes. At November 20, 2022, we had borrowing capacity under these facilities of $1,244. Our international operations maintain $756 of this capacity under bank credit facilities, of which $171 is guaranteed by the Company. Short-term borrowings outstanding under the bank credit facilities were $37 and $88 at the end of the first quarter of 2023 and at the end of fiscal 2022. The Company has letter of credit facilities, for commercial and standby letters of credit, totaling $226. The outstanding commitments under these facilities at the end of the first quarter of 2023 totaled $187, most of which were standby letters of credit that do not expire or have expiration dates within one year. The bank credit facilities have various expiration dates, most 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. 24 Table of Contents 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 August 28, 2022. There have been no material changes to the critical accounting estimates previously disclosed in that Report. Recent Accounting Pronouncements There have been no material changes in recently issued or adopted accounting standards from those disclosed in our Annual Report on Form 10-K, for the fiscal year ended August 28, 2022. 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 August 28, 2022.