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<br />
<br />company open~d five new warehouses, so that there were 20 units in operation
<br />at the end of the period. In comparison, at the end of the first quarter of
<br />1985, Costco was operating 12 warehouses. Membership fees provlded 2.20% of
<br />the first quarter's total revenue, or $3.029 million. This represented a
<br />year-over-year gain of 224.7%, which was largely the result of the recent
<br />introduction of two paid group membership programs into nearly all of Costco's
<br />warehouses. In addition, sign-ups for new members at units open for more than
<br />one year continued to be strong, with wholesale membership sign-ups growing at
<br />an annualiz~d rate of 51% and group memberships at 29%.
<br />
<br />Since it is the company's policy to reduce merchandise prices as group
<br />membership fees are received, the gross margin declined to 11.9% in the first
<br />quarter of fiscal 1986, from 12.3% in the first quarter of fiscal 1985.
<br />However, the 1985 figure compares favorably with the 11.4% gross margin
<br />reported in toe fourth quarter of fiscal 1985. Importantly, S,G&A expenses
<br />continued to decrease as a percenLage of total revenue, to 10.7% in the first
<br />quarter of 1986 versus 12.1% in the first quarter of 1985. The company cited
<br />two major sources of the economies of scale which produced this favorable
<br />reduction: net sales increased more rapidly than certain central and reglonal
<br />administrative expenses; and net sales at individual warehouses rose faster
<br />than each respective unit's operating expenses. Although Costco opened five
<br />warehouses in DG,th periods, preopening expenses declined from $1.251 million
<br />or 2.1% of total revenue in the first quarter of fiscal 1985, to $1.068
<br />million or 0.8% of total revenue in the first quarter of fiscal 1986.
<br />Therefore, the company reported its first operating profit -- of $62,800 in
<br />the first quarter of fiscal 1986. Significantly, tGts was one quarter earlier
<br />. than management had projected at the time of the initial public offer~ng in
<br />November, 1985.
<br />
<br />Deferred compensation fell substantially, to $11,000 in the fir:;t quarter of
<br />fiscal 1986 from $253,000 in the first quarter of fiscal 1985~ In contrast,
<br />interest expense reflected the impact of the loans discussed in thp. prior
<br />section, so that it rose year-over-year, from $95,000 to $662,000. Due to a
<br />higher average invested cash balance, interest inco~e increased
<br />year-over-year, from $34,000 in the first quarter of fiscal 1985 to $83,000 in
<br />the first quarter of fiscal 1986. Thus, Costco swung from a pretax loss of
<br />$1.420 million in the first per.iod last year to pretax income of $38,000 in
<br />the comparable 12 weeks of fiscal 1986. After an income tax provision of
<br />$17,000, the company's net income before an extraordinary item was $21,000.
<br />However, the utilization of $17,000 of its tax loss carryforward (which it
<br />showed as an extraordinary item on th~ income statement) resulted in Costco's
<br />net income equalling $38,000 in the first quarter of fiscal 1986. ~hile this
<br />was too small an amount to result in the company's reporting earnings per
<br />share, it compared favorably with the $1.420 million loss (equivalent to a
<br />deficit or SO.13 per share) in the first quarter of 1985.
<br />
<br />EARNI~GS OUTLOOK FOR THE REMAINDER OF 1986 (YEAR ENDING SEPTEMBER 1, 1986)
<br />
<br />While Costco does not release monthly s~les figures, we believe that second
<br />quarter tren~s in both net sales of .warehouses and in membership fees were
<br />strong ~na in li~e with budget. Management indicates that pricing competition
<br />has eased in some areas. However, we anticipate some decline in the gross
<br />margin. This is partially caused by Costco's policy to utilize membership
<br />fees to reduce prices. The second contributing factor is the rising number of
<br />group members choosing the Gold Card program in order to avoid the 5%
<br />surcharge. In our opinion, S,G&A expense as a percentage of sales should
<br />favorably decline during the second ~Jarter, as newer warehouses achieve
<br />higher sales. In contrast, the delay of expenses related to openings of
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